Regional Ratings for Global Markets
Ian Mackintosh*

Monetary union and the millennium have at least two things in common. Both are scheduled to occur at nearly the same time in history; and no one except European political leaders knows what will happen next. Nonetheless, with a humility that accepts the unreliability of prediction, this article attempts to discuss what might happen next, at least in terms of EMU’s effects on the bond markets and on credit ratings in the European region.

Marketplace trends over the past year have changed little, but the global, as opposed to regional, effects of EMU are now becoming increasingly apparent. The euro will likely be a world trade and reserve currency, not just a new home currency, for the member states that adopt it—rather like the U.S. dollar. And actually, some of what might happen has already been happening. Financial markets have (at least in Europe) already begun to move in accordance with what bond professionals think a post-EMU world will look like. It all started well over five years ago, as investors started to anticipate convergence factors in the markets. To date, we have witnessed:

Most recently in 1996 and 1997, we have also seen some remarkably efficient practical progress in relevant financial centers toward the resolution of the many technical and operational problems posed by monetary union. Taxation questions apart, securities markets now seem substantially ready for the big changeover.

The Effects On Bond Markets

A new world currency and a single home currency may very well spur the related evolution of three bond markets defined by their investor bases. Fiscal discipline, low inflation goals, and reduced currency risk coupled with operational efficiencies and enhanced liquidity are likely to translate into a major boost for the supply and demand sides of debt markets denominated in euro. At the same time, European institutional investors, traditionally shy about taking on credit risk, will have to consider using credit risk more assiduously to generate performance in a single currency environment. It’s a bit like a man suddenly blinded by an accident. Used to making his way through the world visually, he must now use his other senses, particularly his ears, to get around.

First, EMU is likely to lead to the development of a large domestic bond market challenging the U.S. debt markets in size. All domestic government debt will be issued through this market, as will issues by corporations, financial institutions, and regional and local governments of member states. This sector will eventually need riskless benchmarks and contracts. Obligations denominated in euro of ‘AAA’ borrowing institutions could act as benchmarks for long-term issues in euro, but in the foreseeable future German and French government issues seem likely to continue to fill the gap.

One of the more interesting early trends in today’s European bond markets is the emergence of a high yield corporate sector. The continued growth of this sector, widely expected, would mark a change from the status quo; currently one-quarter of the U.S. market is high yield, compared with only about 5% or less of European markets. This movement could be fueled, in part, by the financing needs of smaller European companies, newly freed from the FX risks and execution costs of external trade, and seeking to add longer term fixed-rate funding to complement their reliance on banks. It will also be fueled by the same demographic factors at work throughout much of the developed world; namely, a large and aging population that is putting more money into pensions and other savings accounts, to fund comfortable retirement early in the next century. Other features of the EMU domestic bond market that can be expected are a valuation process increasingly dominated by credit and liquidity factors and, to a lesser extent, tax and regulation; and potentially massive investment by Asian and U.S. institutions seeking currency and interest rate diversification_primarily in the govern-ment bond sector.

The latter point is illustrative of the impact EMU will have on a global scale. Much of the analysis of EMU to date has focused on the markets, businesses, and governments of Europe itself. But the reality is that investors, businesses, and issuers around the world will be affected by EMU in ways that they may not even imagine today.

This will almost certainly be true for the second market that will continue after EMU, the Eurobond market, which may become even more global than it is today. Whenever conditions are favorable, public and private sector borrowers from around the world will continue to access this sector to fund their needs or to arbitrage below market floating- or fixed-rate funding.

The "Euro-euro" component of the market in common with other sectors will remain currency sensitive, free of withholding tax, and will favor bearer paper. Asset-backed securities in particular, straddling the domestic and Eurobond sectors, should benefit from increased volumes and economies of scale. Hitherto, American mortgage and asset-backed transactions have tended to dominate consumer receivables securitisation; post-EMU we may see greater volumes of homogenous asset classes inviting cost-effective, single-currency securitisation in our region.

The third market will be a new and slowly evolving foreign bond sector—the euro counterpart to the Yankee and Samurai bond markets of the U.S. and Japan. European institutional investors will provide euros to foreign issuers through this market. Unlike Eurobond investors, these institutions, taking courage from matching liabilities in their new home currency, will be less averse to credit risk and more open to longer maturities than their Eurobond counterparts. Of course, following the lead of the Yankee and Samurai markets, Europe’s new market will have to be named in an appropriately Euro-centric manner. Perhaps the "Charlemagne market" or, as one insurance company wag suggested, the "Euro-Monnet-Market," in honor of one of the "founding fathers" of modern Europe, Jean Monnet.

EMU And Investor Relations

The global impact of EMU will require European issuers to focus increasingly on investor relations. Nowadays, with different currencies in each relatively small nation, many borrowers and lenders play on a small field, and tend to know each other, if not personally, then at least by local reputation. But after EMU, issuers will be thrust into unfamiliar pan-European and even trans-continental playing fields, where they may have relatively fewer friends and a lot of competition. As one international investment banker says, "After EMU, government bonds will be a backwater for many of our clients. We’ll be chasing corporate credits for yield like American investors." Ratings should help both national and local governments and small companies to gain appropriate access to global investors. The Finnish utility trying to attract an Asian lender will have a much easier time if its issue carries an internationally recognized credit rating. Lenders will use ratings to calibrate the relative risks of investing in various European signatures. Credit ratings assigned to regional borrowers will have global as well as regional relevance.

The Effect On Sovereign Ratings

The credit quality of sovereigns expected to join the EMU is likely to remain strong. Euro and foreign-currency ratings for each government will be identical, reflecting the transfer of monetary policy responsibilities to the new European Central Bank.

That central bank will clearly be of the highest credit quality, and the ratings of sovereigns joining the EMU in 1999 will likely fall within the ‘AAA’ and ‘AA’ categories. Because of their loss of monetary and exchange-rate policy flexibility, the main rating factors affecting sovereigns in EMU will be similar to those now emphasized in ratings for local governments. The factors of most importance include:

Fiscal analysis, in other words, while important in the past, will prospectively now be the dominant criterion for differentiating the credit quality of sovereigns inside the monetary union.

Secession risk merits a separate comment.. Despite convergence, the states adopting EMU are likely to face significant adjustment costs. Confronted with economic shock, public opinion in some countries may come to question the wisdom of discarding the tool of exchange-rate flexibility—especially in EMU's early years. There may be no legal provision for member states to opt out of EMU in a crisis, but that possibility cannot be excluded.

The Effect On European Corporate Ratings

While substantial rating changes are not expected once EMU arrives, the overall effect is expected to be positive for European corporate credit quality. Well-prepared and well-operated companies are likely to thrive in the competitive environment of the EMU’s larger and deeper domestic market, with its greater price and cost transparency. The real cost of capital for corporations may decline if interest and inflation rates stabilize at a level lower than the weighted average of the participating countries. Borrowing should generally be easier since, as described above, the capital markets will be larger and more liquid, and weaker credits will be more attractive to investors (see chart 2). Foreign-exchange risks and transaction costs will greatly diminish; banking relationships may diminish in number and complexity; and many export contracts are likely to be denominated in the producer’s "home currency," the euro.


Chart 2 Corporate Rating Distribution Outside The U.S.


On the other hand, European corporations will face new challenges. Economic growth rates across Europe have been impaired as the nations struggle to meet public debt and budget deficit criteria as stipulated in the Maastricht treaty. This may affect profitability in many sectors in the short term, at least. Corporations will also bear the transitional costs of switching to the euro. Though these are "one-time" costs, they will be substantial for many firms, since they involve everything from information technology, accounting, and financial management to legal and payment systems, marketing, and planning. These costs could be especially burdensome for the retail sector (and consider, too, that it will be happening at a time when corporations also face the technology costs of the "year 2000" problem).

Nevertheless, for firms that are well prepared, the overall positive potential for corporates is strong.

The Effect On Financial Institutions

The technical challenge of a new operating currency is hardly intimidating to banks and insurers, many of whom have routinely established lines of business in new currencies for many years past. Nevertheless, European banks view EMU with some misgivings. The elimination of currency risk and the expected reduction of transaction fees constitutes a blow to financial institutions that have been the main intermediaries in cross-border transactions. Financial institutions will have to bear the same transaction costs cited above that all corporations in Europe must pay, and the smaller players will find these costs relatively more painful than their larger competitors. In addition, such costs are magnified for banks by the fact that they will have to offer accounts in their domestic currencies as well as euro during the three-year transition period (and longer in countries that do not join first). But most importantly, the permanent loss of regional foreign-exchange revenues from cross-border transactions and trading could constitute a major challenge to banks.

All this comes in a climate where deregulation, privatization, and a growth spurt in capital markets have already unleashed fierce competition among banks over the past 10 years. Competition is no less rife in the insurance industry whose battles will now also be fought on an even larger field.

EMU will further accelerate the wave of mergers and acquisitions, a consolidation trend that is already evident in European financial services. In fact, EMU will finally nail down the logic for cross-border mergers and resulting economies of scale for banks and insurance groups seeking to offer pan-European products and services. Weak banks not "saved" by consolidation with stronger competitors may not find much help from their governments, however, because the Maastricht treaty has a "no bail out" clause that inhibits, although it does not necessarily eradicate, public support for private financial institutions.

But the many survivors should have encouraging business opportunities. This is particularly true for banks that specialize in investment, underwriting, trading, and brokerage. Greater capital flows in Europe will increase business flow in all these lines. In addition, the demographic changes mentioned earlier will increase the demand for many new personal savings products, and financial service groups that can offer such products cross-border may be well positioned to reap substantial rewards. There should also be a prize for the bank that offers its wholesale and retail customers the best navigational system to steer through the inevitably choppy waters of changeover.


Some other statements and predictions about "life after EMU":

  1. The benefits of scale may mean there will be fewer financial markets in Europe. Thirty stock exchanges and 20 foreign-exchange centers in Europe seem out of balance with eight and seven, respectively, in the U.S.
  2. As the European equity markets harmonize, we may see an "S&P Euro 500."
  3. The euro will become a reserve currency.
  4. Existing central banks throughout Europe will continue to play an important role in the implementation of the single currency but "real" power will flow to the European Central Bank.
  5. The European Union will eventually start issuing its own bonds in addition to those of its agencies, to provide for social, retirement, and development programs throughout the region, as well as to build reserves and provide benchmarks.
  6. Investment advisers and investment consultancies will proliferate across the Continent like prospectors chasing a gold rush.
  7. Workers, too, will "follow the money" and cross borders in increasing numbers in pursuit of jobs. We might even witness something akin to the American "sunbelt vs. rust belt" phenomenon within Europe, as businesses and workers seek friendlier economic and weather climates. EMU certainly will make such movement easier to accomplish, though linguistic, cultural, and possibly fiscal differences will still provide formidable obstacles to total mobility. Enlargement of the European Union toward the East will enhance this trend.


I have left out of this vision of the EMU world any assessment of the financial and credit implications of failure of EMU to take hold. Some observers, particularly those who focus on public attitudes toward EMU and the euro, are pessimistic about the chances of EMU survival. Others say the institutional and political momentum is too powerful a force to be halted in its tracks. One recent commentator likened the onset of EMU to "Thatcherism," a political idea that doesn’t necessarily make perfect sense at any particular point in time, but does have a kind of inevitability about it.

But financial markets professionals cannot afford the luxury of opinion on the inevitability of EMU, when the reality, should it occur, is destined to have such a powerful effect. For investors, issuers, credit rating services, and many others, EMU must be treated like the millennium—a real event that will happen soon with global as well as regional implications.


*Managing Director, Business Development, Standard & Poor's Ratings Service, 18 Finsbury Circus, London EC2M 7BP