Firstly credit ratings are an evaluation of how likely a country is to default on government debt (bonds)
- A triple A rating is known as prime lending. A triple A rating means there is no risk of the country defaulting on its debt.
- An A- means there is a small risk of default.
- A B- indicates the investment is highly speculative with a reasonable chance of default
- A CCC rating indicates the investment is highly speculative with the country starting to default with little chance of recovery. It is also sometimes referred to as junk status. The Ukraine has currently a CCC rating
- A D Rating indicates ' junk' status with the country in default.
If a country has a credit rating reduced it has certain effects.
- It becomes more expensive for government to borrow. If investors see a countries bonds as risky, they will require a higher interest rate to compensate for risk. The greater the risk, the higher the interest rate required. If you are borrowing £175bn a year, even a 1% increase in bond yields can cause a large increase in interest payments on your debt.
- More expensive to insure against default. In Feb of 2009 it would have cost $5.95 million in advance and $500,000 a year to insure against $10 million of Ukraine government bonds for 5 years. In other words if you bought $10 million Ukraine bonds you would have to spend about $8.5 million in insuring against default. This reflects the markets anticipation of debt default.
- Downward pressure on currency. If investors felt the UK was likely to default, foreigners would be less willing to hold UK bonds and therefore UK currency. This lower demand would cause a depreciation in the currency.
- Smaller Current Account Deficit. If less foreigners want to hold US treasuries, it means there are less capital flows into the US, therefore, the US would have to run a smaller current account deficit. This could limit US growth.
- Risk of Hyperinflation. If you have junk status and noone wants to buy your debt, there is a risk a government would resort to printing money thereby causing inflation.
The problem is that borrowing increases because of a recession. The solution to a downgrade in credit rating is to reduce governments deficit. This could involve higher tax or lower spending. But, in a recession, this fiscal tightenening could worsen the recession.
The other solution is to monetise the debt. i.e. create money to deal with deficit. However, this can very easily lead to inflation and a depreciation in the currency, making foreigners less willing to hold your currency.
It can be a fine line to walk between running a fiscal deficit to boost growth and not borrowing too much to cause a credit rating downgrade.
Countries who have seen Sovereign Credit Ratings downgraded this year
- Ireland, Spain, Greece, Iceland, Latvia (reduced to junk status)