New geography of high risk

New geography of high risk

A senior economist from an international credit rating agency who visited our Mumbai office earlier this year for an informal chat was grilled by our banking writer, who insistently wanted to know why India should have a lower credit rating than European economies battling fiscal ruin.

That was when financial markets had been rattled by the problems in Greece. New tremors have now emerged with Ireland as their epicentre. The former Celtic tiger may not need to refinance its international loans immediately, but a bailout is in order to soothe investor nerves. There is no knowing where the next crisis will erupt, with most peripheral European economies struggling with dangerous levels of debt and deficits.

The international credit rating agencies continue to cling on to the same old assumption that credit quality is a function of geography. Financial markets have been more sensitive to the changes in economic balance. The cost of insuring against a sovereign default in Europe has been climbing through this year while the cost of protection against a default in emerging markets has declined.

Bloomberg reports that credit default swap (CDS) spreads for Europe and emerging markets are converging. It now costs $203,000 a year to protect a $10 million portfolio of emerging market bonds for five years. The comparable amount for Western European bonds is $166,000. In other words, the gap between the respective CDS rates is down to just 18.25 basis points. We would not be surprised that the gap narrows down even further in the months ahead, unless the members of the European Union get their financial houses in order and emerging markets mismanage their economies.

Old assumptions about portfolio risk will need to be reassessed. The immediate beneficiaries could be companies from emerging economies, who can raise money from the international markets at finer rates

The mandatory premiums over US bonds could be bid away. We have already seen equity valuations in the West slipping below valuations in the emerging markets.

There are important caveats here. Those countries that fund their public debt through domestic savings are less at risk than those who borrow from international investors. The US has the huge advantage of managing the world’s reserve currency; it can conceivably print dollars to meet its obligations. And shallow and short-term debt markets in countries such as India will keep away global bond investors.

A Chinese credit rating agency downgraded the US this month in response to the latest round of monetary easing in that country. Most think this is a cheeky example of power politics. But it is also a sign that a high credit rating is nobody’s birthright.

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