UBS Explains Why AAA-Loss Is Actually Relevant

As the buy-the-ratings-downgrade-news surge on European sovereigns stalls (following a few weeks of sell-the-rumor on France for example), the ever-ready-to-comment mainstream media remains convinced that the impact is priced in and that ratings agencies are increasingly irrelevant. UBS disagrees. In a note today from their global macro team, they recognize that while the downgrades were hardly a surprise to anyone (with size of downgrade the only real unknown), the effect on 'AAA-only' constrained portfolios is important (no matter how hard politicians try to change the rules) but of more concern is the political impact as the divergence between France's rating (and outlook) and Germany (and UK perhaps) highlights harsh economic realities and increases (as EFSF spreads widen further) the bargaining power of Germany in the economic councils of Europe. Furthermore, the potential for closer relationships with the UK (still AAA-rated) increase as the number of AAA EU nations within the Euro only just trumps the number outside of the single currency.


Chart: Bloomberg

UBS Global Macro: La politique lorsqu'on n'est plus AAA

The news that credit rating agency Standard and Poor’s were downgrading economies across the Euro area was hardly a surprise to financial markets. The number of notches of each of the moves and precisely which countries were to be involved were really the only elements of surprise left to investors. The reaction has tended to focus on the downgrade of France from AAA status. This was perhaps inevitable. Credit rating agencies do not generally command the respect of the markets. However, the loss of AAA status is still something that matters at a time when a number of portfolios are still constrained to “AAA only” holdings.


It is not the threat of default that concerns France’s loss of AAA status is hardly likely to raise concerns about creditworthiness in definite terms. The popular media have tended to explain the consequences of the downgrade as “France’s borrowing costs will rise”, but even that is not certain in absolute terms (and in relative terms France has already seen its spread to Germany widen). The integrity of the French government’s credit is not really in question. Indeed, the British financiers the Rothschilds profited handsomely in the nineteenth century by observing that, since the revolution of 1789, French governments would honour the debts of their predecessor regimes. The cycle of republics, monarchies and empires did not threaten the credit of the French state. In France, the state transcends the market’s perception of credit risk.


This does not mean that markets can afford to ignore the downgrade of France. For once, economics is not perhaps the most important facet of this decision. This may be one of those rare occasions where politics is more important than economics.

The politics of relative decline

France has not only lost its AAA status. Critically, France has lost AAA status at a time when Germany has not. France also retains a negative outlook against a stable outlook for Germany, compounding the distinction. The relative decline of France’s credit rating is something that has potential political implications. There are parallels here to the relative positions of the UK and the US in 1949, in the wake of sterling’s devaluation against the dollar. The devaluation was simply a confirmation of economic reality, but the visible confirmation of that shift in relative economic reality served as a defining moment in the shift of the bilateral relationship in political terms.


Since the foundation of the Coal and Steel Community in 1951, the history of (continental) European politics has been essentially a story of France and Germany holding each other in check. Indeed, this was the explicit aim of the ECSC’s founders. With the downgrading of France relative to Germany, there is now a de jure as well as a de facto inequality between the two states. The ability of France to act as a counterbalance to Germany in economic decision-making has been compromised.


In the wake of the downgrade of the EFSF, it is clear that the actions of S&P have elevated the role of Germany (and perhaps, to a lesser degree, the Netherlands) in any collective economic decisions within the Euro area. Any economic decision that requires money to be spent will require wholehearted German endorsement if rating agency determined credit credibility is to be maintained. The bargaining power of Germany in the economic councils of Europe has been correspondingly increased.

So what?

So what does this mean? The consequences are not that clear. There may be disquiet from several Euro area countries (and not just those of the periphery) at the idea of a more dominant Germany. This was not the vision of Europe motivated the foundation of the EU.


France could choose to tie itself closer to Germany – to co-opt Germany’s presumed credit (or possibly economic) superiority, in effect. This was generally the course that the British took towards the Americans in the post-war era – the Suez and Vietnam conflicts being aberrations. There is also a Franco-German precedent for such a “borrowed clothes” approach in the French attempts to wear Germany’s monetary credibility during the “franc fort” regime of the 1990s.


Such an alliance would generate a very Teutonic accent to the Euro area. To some extent we have that already – the bias has been to a more German-centred approach to resolving the series of crises that have plagued the Euro area.


However, a France that seeks to bind itself more closely to Germany would presumably mean that the current bias becomes an established trend. The risk here is that a tighter Franco-German alliance under more explicit German leadership would alienate peripheral countries within the EU, and lead to more acute EU policy sclerosis or overt policy discord.


The alternative is that the Euro area pursues a more holistic approach to negotiation. Rather than having decision-making driven by France and Germany (deciding the main conclusions with a bilateral meeting ahead of each emergency summit), there is the possibility of a more shifting coalition of interests shaping the outcome of the assorted emergency summits. Euro area countries would look to achieve a broader coalition to defend their interests, rather than rally to the French standard or the German standard as appropriate.


In extremis, it is possible to imagine that the Euro area will seek to end its isolation from the United Kingdom, and instead solicit UK help as a possible (AAA-rated) foil to German policy initiatives. The involvement may be a step too far, however (from the perspective of the UK as much as of the Euro area). To the extent that a broader coalition including non-Euro countries is brought in to play, it could be construed as more market-friendly: the non-Euro countries tend to be more inclined to favour the markets. This could also be seen as a more pro-market, competitive measure. Before dismissing the idea of non-Euro alliances being sought, it is worth reflecting that there are now almost as many AAA EU countries outside of the Euro 17 as within the single currency.

Politics means this matters

The downgrading of France from AAA was not, of itself, a major surprise. France has not traded as a AAA economy for many months now. This does not mean that investors should dismiss the downgrade as irrelevant. Rather, we should perhaps view this as a 1949 moment. A key bilateral relationship may be redefined by the visible confirmation of what is already an economic reality. How this political situation resolves is of great economic import.