Yesterday the rating agency Moody's downgraded the status of Ireland's debt from Baa3 to Ba1 with a negative outlook.
The significance of a negative outlook is that further downgrades are seen as possible given the current unstable situation. The new rating takes Ireland's debt into sub-investment grade territory or junk status, albeit still several notches above Greece.
The change in ratings follows closely behind the recent downgrades of Portugal and Greece and, in that respect, was not surprising although it received the inevitable criticism from the Irish government and will increase the clamour among the Eurozone political circles that the rating agencies have too much power and a major destabilising influence. For the moment, Ireland is still rated as IG by the other 2 major rating agencies (S&P and Fitch) and therefore it will still be included in the Markit iBoxx Euro Area sovereign index which will limit the selling by institutions. However, if one of the other rating agencies also downgrades it will be demoted.
In my view, the rating is correct and recognises reality. After all, if 2 year bonds are yielding over 16% they can hardly be deemed to be investment grade. It is a further wake up call in the light of contagion spreading to Italy this week to get their act together and provide a workable proposal to the crisis that addresses the vital issue of solvency. The rating agency cited the likelihood that Ireland would need further help after the original bailout expires in 2013 as a reason for the downgrade; however, of more significance, it took into account recent developments in Greece by noting that future bailouts would require private sector invovlement (PSI) and comments over the last few days from Euro ministers confirm that policy is moving in that direction. If private investors have to take a haircut, and the probability has increased considerably of them doing so over the last few days, then the downgrade is more justified.
The implications for other countries are that it means that further downgrades can be expected, including Spain and Italy. Yesterday, in Spain the local government region Castilla La Mancha announced that it had underestimated its deficit by half! In April it said it had a fiscal deficit of 1.78% of local GDP compared to a central government imposed limit of 2%. It now believes it is nearer 4%. This highlights the vulnerability of Spain (where local governments have a significant amount of public sector debt) at the same time as the market is focused on the travails of Italy. The markets have sensed this and it has contributed to a large increase in shorting of government bonds in the peripheries that has led to the rise in the yields in recent days.
Until the troika can annouce a credible plan the situation is likely to remain unstable with both speculation and the action of rating agencies adding to the disquiet.
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