The Power of Sovereign Credit Ratings
(August 13, 2011)
Summary: One of the most important economic forces in the world is "sovereign debt", money owed by a country as a whole. When the credit rating for United States' sovereign debt was lowered, it created substantial fear among investors around the world.
In the long term, it is possible to understand the economy. Production, growth, revenue, and debt all fluctuate according to financial principles which can be understood — as long as we are looking backwards.
It is only when we try to understand short-term economic changes that we encounter the type of uncertainly that leads to anxiety. This is actually considered normal because, in the short-term, the economy suffers day-to-day mood swings that are controlled by two important emotional forces: fear and greed.
One of the most important economic forces in the world is what we call sovereign debt. Indeed, sovereign debt is so powerful that it can, under special conditions, create so much fear or greed as to cause massive waves of anxiety or elation to sweep through the world within hours.
The term "sovereign debt" refers to money that is owed by a country as a whole. For example, when the U.S. Treasury borrows money by selling bonds, it has the effect of increasing our sovereign debt. When the government raises the "debt ceiling", it allows the country to increase its sovereign debt by borrowing more money.
As you know, in the U.S., your credit worthiness is rated by three different companies (Equifax, Experian, Trans Union), each of which awards you a specific credit score. If your score is high, you pay less interest on what you borrow.
If a country's credit rating goes down, it is forced to pay more interest, which can put a significant strain on the country's economy.
A similar system is used for sovereign debt. The countries with the highest credit ratings pay the least to borrow money. If a country's credit rating goes down, it is forced to pay more interest to borrow money. That interest comes directly out of the national budget, which can put a significant strain on the country's economy.
This raises an interesting and important question: How many countries in the world actually have the highest possible credit rating? Here is how it works.
There are three companies that rank the credit worthiness of countries. These companies are:
• S&P (Standard and Poor's)
Each of three companies publishes its own independent ratings. Thus, to understand the credit worthiness of a country, we need to look at what all three companies have to say about sovereign debt of that country.
The three companies each use their own particular rating system. However, they all use the same designation, AAA, for the top countries.
Which countries have AAA ratings?
To discover which countries have AAA ratings, I went to the Web site for each company and hunted for the latest rankings for long-term sovereign debt. I then extracted this information, and eliminated all but the AAA countries. The results are shown in the table below.
The countries with AAA ratings are marked with a bullet (&bull). As you can see, not all countries are considered AAA from all three rating companies. In particular, the U.S. has a AAA rank from only two of the three rating companies.
To simplify the table, let's include only those countries that have AAA ratings from all three companies. In the entire world, there are only 11 such countries:
Compared to these 11 countries, all the other countries in the world pay more to borrow money.
For decades, the U.S. was a member of this rarified club. However, on August 5, 2011, S&P lowered the United State's long-term credit rating from AAA to AA+. This action created substantial fear among investors all over the world, resulting in severe short-term "mood swings" in the global stock markets.
To make sense out of all this, all you have to do is tease out the emotional problems from the financial problems:
The U.S. does have important, long-term obligations that will, in the fullness of time, need to be re-balanced. Realize, however that, in the short-term, very little has actually changed. The United States, on August 6, 2011, was pretty much the same as it was on August 5.
What did change was that investors around the world became a lot more fearful, creating a significant amount of anxiety and a huge "mood swing".
The anxiety, however, will pass. In the meantime, if you want to make money, with so much fear in the air, this is the time to be greedy.
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