How to Rate Uncertainty: Sovereign Risk and the Eurozone

The world will hold its breath this week as the Eurozone finance ministers meet to discuss Greece’s ability to repay its debts. While the finance ministers meet, investors will turn to sovereign ratings issued by credit rating agencies (CRAs) that look at exactly those qualities: a country’s willingness and ability to repay or rollover its debt. In light of the current situation of the Eurozone, the Bertelsmann Foundation’s INCRA (International Non-profit Credit Rating Agency) project is offering analysis on three Eurozone countries: France, Germany and Italy, factoring in the risk of a potential Greek default.

The INCRA Project

The Bertelsmann Foundation’s INCRA project proposes a new model for an International Non-profit Credit Rating Agency aimed solely at analyzing sovereign risk. The project was launched in the wake of the 2008 financial crisis in response to criticism of the major credit rating agencies (CRAs). INCRA proposes a new methodology and non-profit legal structure for issuing sovereign credit ratings. The formula for assessing sovereign risk includes a broad and transparent set of indicators, including factors like crisis management, investment in research and development, and political communication. These political risk indicators, when combined with traditional macroeconomic data, comprehensively illustrate a country’s current situation and its trajectory. In order to provide the highest level of analysis, the project has brought together economic and political science experts, as well as experts on country ratings, to analyze each country in detail and assess potential risks and boons based on INCRA’s methodology.

INCRA previously produced six country ratings and is in the process of updating these ratings. This week, the project has launched four new ratings: France, Germany, Italy, and the United States. These assessments are based on an economic and political-risk indicator set and expert analysis and discussion. The United States’ rating was upgraded from AA+ to AAA, given the country’s recent growth, stable economy, and proven resilience. INCRA concluded that although the Eurozone’s future may appear shaky, Italy, France, and Germany remain creditworthy, with Germany maintaining its AAA rating (the highest rating a country can merit).

The Eurozone: Contingent Liabilities and the Potential for Contagion

It is high time to begin a renewed debate about the accuracy of sovereign ratings, particularly given the current Greek debt situation. As Europe bites its nails waiting for Greek payments, it is more important than ever that sovereign debt assessments are timely and precise. And the probability of Greece repaying its debts not only affects Greece’s sovereign debt rating, but could potentially affect the other Eurozone countries’ ratings as well. For Germany, the contingent liabilities emanating from countries on the periphery, like Greece, could have an impact on the German economy. Likewise, the way the Eurozone would deal with a potential Greek default has bearing on the rating of other potentially shaky countries like Italy. The INCRA ratings for France, Italy, and Germany recognize the interconnectedness of the global financial system and take into account the current situation in the Eurozone.

Although there is some risk from the Eurozone, all three countries have proven resilient and have largely recovered from the financial crisis. Germany is facing extremely low levels of unemployment and its economy is expected to grow by 1.8% in 2015. Although France and Italy are not performing nearly as well as Germany, they are still creditworthy, earning AA and AA- ratings.

For an overview of the analysis on these three countries, INCRA has produced “rating radars”. These list the average committee scores for each of the indicator categories, and show, at a glance, how well or poorly a country is performing in relation to other indicators.

With eyes on Greece and the future of the Eurozone, right now we have an ideal opportunity to take a second look at CRAs. The industry’s ability to predict the next crises and adequately take into account financial contagion and potential risks must continue to be evaluated. Ratings are ultimately the opinions of analysts based on data and trends, and should be viewed as such. However, in order to develop a more responsible financial system, we must look carefully at the CRA world, particularly when there is a chance for great changes in the financial system.

For more information on the INCRA project, please visit the project’s website at www.incraglobal.org.