Completing the series on the role of Credit Ratings Agencies (CRAs) in assessing sovereign government debt, today’s entry borrows heavily from the financial markets themselves. I’m going to pick through the main messages contained in a report from HSBC Global Research on the risks of certain European governments defaulting on their debt. Then I’ll finish with the chief economist of Nomura Research Institute on why Standard & Poor’s downgrade of the US credit rating to ‘negative’ is, in his words, ‘absurd’.

Yesterday’s blog entry entitled ‘CRAs in the Firing Line’ ended with my note that growing numbers of commentators doubt that there are really default risks in countries whose debt is denominated in their own currency. To be clear, this means that the US issues debt in US Dollars, their own currency; the UK issues debt in the Pound Sterling, its own currency; but, the Eurozone countries issue debt in Euros, which is not solely their sovereign currency – they cannot create or print their own currency, this is the role of the European Central Bank. They also face other constraints on their monetary and fiscal policies.

As the HSBC report notes: “A Sovereign can issue bills and bonds in its own currency, tax its citizens and ultimately, has the power to create money.” It adds that there is never the risk of a true sovereign not paying its coupons (interest on debt) or redeeming bonds (paying back the debt). It goes on: “Default risk for a Sovereign issuer in its own currency is effectively zero.” Why then are sovereign governments in the UK and the US having to deal with threats of their credit rating being downgraded? According to the report, "Investors in UK Gilts should worry about inflation and interest rate risk, not default."

Returning to the HSBC report, the writer notes that two options confront policymakers in the post-financial crisis period: “Some countries will hope growth increases in response to the radical loosening of policy, whilst others will focus on austerity measures.” This matters more in the Eurozone, as many members of the currency area do not have flexibility to respond. They have effectively surrendered sovereignty over their currency by joining EMU. With their currency pegged, devaluation is no longer an option. The report notes that although CRAs were criticised for their role in the financial crisis, they continue to have a big influence on sovereign debt valuations.

Which brings us to Nomura’s chief economist’s view that S&P’s US credit rating downgrade is absurd. Richard Koo was invited to present to the US Committee on Financial Services in July 2010 to advise on avoiding economic depression. In Koo’s view the government needs to step in to maintain economic growth because the private sector is trying to minimise debt rather than maximise profit at this stage. He notes that this is what happens after the bursting of an asset price bubble. “When a debt-financed bubble bursts, asset prices collapse while liabilities remain, leaving many private sector balance sheets underwater.” Households and firms repair their balance sheets by repaying debt or building their savings. This leaves a big hole in aggregate demand.

Koo coined the term ‘balance sheet recession’ to characterise the current economies of the UK, US, Spain, Portugal and Italy. Here we can see massive private sector deleveraging (paying off debt), even with interest rates near their historical lows. Koo points to the behaviour of the US private sector after the Great Depression which began in 1929: in that case, households and firms repaid debts and were averse to taking on any new debt, leading to interest rates staying low for thirty years. Koo believes that the G20 is ill advised to agree to halve deficits by 2013. Not only this, he thinks that by cutting growth through austerity measures, countries’ fiscal positions may well worsen.

S&P’s US downgrade is absurd in Koo’s view because government borrowing is merely a corollary of private sector saving. For as long as private households and firms want to pay off net debt, government budgets will remain in deficit. In the UK, the Office for Budgetary Responsibility calculates that household debt will rise by around £500bn by 2015, taking it from 160% of household income to 175%. This reflects one way in which UK government net debt could fall, but it remains highly unlikely in Koo’s analysis that UK households will take on this degree of new debt.

If this proves the case then for the UK government’s net debt to decline, either the UK’s balance of payments current account would have to go into reverse, creating a big surplus, or companies would have to take on large amounts of net debt. One wonders what the CRAs would make of the UK’s credit rating if these arguably remote outcomes fail to materialise. Tomorrow, I'll turn my attention to the commonly expressed fears about hyper-inflation in countries trying to recover from the financial crisis. Are the UK and US really the next Weimar Germany or current-day Zimbabwe?