Moody’s Moods (on Italy)

In a recent report on the Euro Area Periphery, the rating agency Moody’s makes the point that the implementation of structural reforms by the
euro area’s periphery countries have achieved improvements,  although have
not yet fully resolved the external imbalances that developed in these
countries prior to the crisis. The report also says that the correction is at
best only half-way complete, depending on the country in question, and could
take several years. Based on a comparison between Sweden in in the 1990’s and
Italy, Moody’s  report argues  that, conditional on completing the
structural reform process, Italian GDP growth may come back in positive territory
as soon as next year. The change in mood from about one month ago , could not be more
“U-turn”. In July the agency downgraded Italy’s debt by 2 notches, to
Baa2 from A3. July-Moody’s justified the downgrade by the following
arguments:  1) a likely increase in the cost of debt and contagion risks
from Greece and Spain; 2) a slower growth, higher unemployment and likely
inability to meet fiscal balance in 2013. By the way, also Fitch yesterday has
praised Monti’ credibility and has suggested that efforts should be now
targeted to improve growth.
Now, two questions arise: A) what has changed since July? B) Should we care
about Moody’s  (and Fitch’s) moods?
A.What has changed?
Not much:
  • Among “up-side “risks (which in the official
    jargon means the things that may turn better than expected) July-Moody’s
    mentioned progress on structural reforms. Apparently, August-Moody’s did
    appreciate Monti’s spending review and privatization programs, but
    their extent as well as their implications for growth are yet to be tested.
  • On contagion from Greece and Spain,
    August-Moody’s seems to be betting on: a) Draghi being able to do
    something about spreads, Bundesbank notwithstanding. b) Spain being able
    to rescue its banks with the help of EFSF, c) Greece getting more time to
    achieve fiscal targets and using it to address fiscal imbalances. All or some of these
    presumptions may not materialize
B. Should We
  • The point here is that even if Moody’s and
    Fitch are optimistic
    on the effects of structural reforms and developments
    in the EU, still their change of mood may be useful and self-fulfilling. Recent
    work on contagion
    by Luca Zavalloni and myself suggest that while
    credit ratings do not affect spreads during normal times,
    so that rating agencies belatedly “ratify” market sentiments
    already embodied in market prices, changes in ratings do have an impact
    on spreads and countries’ vulnerability to contagion during economic
 Thus, provided September-Moody’s doesn’t differ too much from
August-Moody’s , and provided market fundamentals in Italy improve, albeit
slowly, the windfall gains from lower interest could be large, possibly up to
100-150 basis points, which in turn would allow Monti’s reduce (initially very
slowly) taxes, sustaining aggregate demand and strengthening the
political  constituency in favor of further structural reforms. This in turn would
help employment and growth.
 So Moody’s moods should not be dismissed.