Credit where it's due
While the Tories talk down Britain's economy, Labour has been steering the responsible course
The global financial crisis has made us familiar with a lexicon of financial terms that few people had encountered previously. Articles about the credit crunch have been littered with terms such as “collateralised loan obligations” and “credit default swaps”. Governments have been forced to issue public debt to bail out both banks and economies and now we must consider the sovereign credit rating. It is driving government decisions, including on spending and taxation, worldwide. The stringent budgets in Greece and Ireland last month were the latest examples. If we do not understand the role of credit ratings and markets, we will not appreciate what can keep financial ministers awake at night. Moreover, our debates about public spending will be totally irrelevant.
Most people are familiar with credit scoring. When we apply for a credit card or a mortgage, our credit rating, or score, is checked. Banks are looking for evidence that shows we are a good risk. Our payments record, income and existing debt levels might be examined. In credit terms, are we reliable and are we able to meet loan repayments? The better our score, the more money (relative to various factors) we may be able to borrow. If our credit score falls, banks may charge higher rates of interest or refuse to lend at all.
Agencies such as Moody’s, Standard and Poor, and Fitch ascribe credit ratings to companies. These are drawn from their opinions about the strength of a company’s balance sheet and its ability to take on more debt. For example, Standard and Poor’s top rating is AAA (or ‘triple A’). Companies with higher ratings usually find it easier or cheaper to issue debt (for example, the rate of interest they pay is lower). Market participants usually regard any rating below BBB- as more speculative.
If a company’s financial position deteriorates, it can face a credit rating downgrade (for example, from AA to A). Investors make their own judgements but regard the ratings highly. The lower the rating, the more compensation they may expect for the increased risk that the company may default on its loans. In practical terms, if a company wants to invest money in a new factory, for instance, it may find it more difficult or more expensive to raise the funds.
Government, or sovereign, debt is also rated. Britain is rated AAA or equivalent, as are the United States, Canada, Germany and France, among others. Governments have defaulted on debt, such as Russia in 1998, but these tend to be emerging market governments. When investors are looking for prudence and resolve, they also want to know inflation will be low because it erodes the value of the debt they hold. Opinions can change, especially if economic growth is stronger than expected or if new investment is combined with a clear and credible plan to control the level of public debt.
The rating agencies believe this country’s fiscal position needs to be improved. They are looking for more certainty that this will happen, probably after the election. They do believe the Government has time and there is a political consensus for action.
Japan manages to fund its much worse debt position at low interest rates with a lower credit rating. However, compared to Britain, a lower proportion of Japan’s debt is held by overseas investors who can be more disposed to sell (the US deficit has been funded to a great extent by Chinese purchases of treasury bonds). British gilts have also been bought by the Bank of England through quantitative easing (electronically printing money), which is scheduled to end soon.
The Chancellor’s April budget forecast a deficit this financial year of £175 billion (revised to £178 billion), falling steadily after next year, but this was not a matter of science. It probably reflected a judgement the deficit markets would find acceptable while combining a short-term economic stimulus with responsible management of public finances. If investors believed debt levels would be too high, reinforced by credit rating downgrades, the Government might have to pay more to fund its debt. In very different circumstances, President Bill Clinton found himself in a similar position in 1993 when he had to shift economic strategy towards balancing the budget due to concerns about the bond market’s reaction. He had the benefit of interest rate cuts to compensate, which is not possible today.
The Conservatives’ position on the nation’s public finances and spending plans has been irresponsible, as Alistair Darling highlighted this week. David Cameron has been talking down Britain. In his conference speech last year, the Tory leader actually raised the possibility of the United Kingdom defaulting on its debt, only to dismiss it. By reviewing default as an option, despite rating agencies believing it highly unlikely, Cameron contributed to market anxieties. That makes the Chancellor’s (and the country’s) task just a little bit harder.
Labour has steered a steady course through this crisis and, particularly when economic growth resumes, this should be increasingly recognised. It is clear that governments must face reality. However, bold political and economic leadership can change that reality with clear and credible plans for public finances.
This article was first published in Tribune.
Tribune 8 January 2010, 07/01/2010