A solid investment-grade credit rating? Photographer: Manjunath Kiran/AFP/Getty Images
A solid investment-grade credit rating? Photographer: Manjunath Kiran/AFP/Getty Images

Have credit-rating companies slept through the start of an economic recovery in Europe? Analysts at Berenberg Bank, the German private and merchant bank, believe they have.

It's an easy case to make. Since the 2008-2009 financial crisis, eurozone countries have made a lot of progress in cutting external deficits and removing fiscal imbalances, improving competitiveness and fixing their banking systems. Consequently, economic growth is back, even in crisis-hit countries such as Portugal, which grew 1.6 percent in the fourth quarter of 2013, faster than Germany. The markets have rewarded Europe, but the ratings companies haven't budged, still saddling the recovering countries with abysmal ratings.

"Fast-reforming and politically stable Portugal is rated three notches below crisis-stricken Turkey, Indonesia and India or five notches below Russia, Thailand and South Africa. Is this justified?" the Berenberg analysts ask.

Consider a couple of other discrepancies:

  • Standard & Poor's rates both Ireland and Thailand BBB+. Five-year credit-default swap spreads for the two countries, however, differ as substantially as the political situations in stable Ireland and revolution-prone Thailand: 74 and 127, respectively.
  • Russia has almost twice Italy's CDS spread. That is understandable given that Russia, unlike Italy, faces international sanctions for biting off part of a neighboring country. The fact that Russia and Italy are lumped together in the BBB category is harder to understand.

I did a little back-of-the-envelope experimentation with the S&P ratings and five-year credit default swap spreads of 40 developed and emerging countries. For the list as a whole, the correlation between their ratings (converted to numbers) and bond yields is 0.76, which suggests a strong enough connection between ratings and market perceptions of credit risk. Separating developed and emerging countries separately results in even stronger correlations: 0.88 for the mature economies and 0.81 for the developing ones.

On the one hand, this is evidence that the ratings are not as useless as Berenberg's analysis might suggest. So what if European countries' ratings haven't changed fast enough to catch up with market optimism about their recovery? As a whole, S&P's ratings more or less accurately reflect market sentiment.

On the other hand, the strong correlation between ratings and CDS spreads suggests that a world without ratings companies, in which investment grades are determined by the market, would work just as well or better. For example, Brazil and Spain would not be lumped together on the basis of their BBB- rating. Italy and Slovenia would be next to each other instead of two notches apart. Institutional investors should be able to live with that just as easily as they do with ratings, which they often automatically follow. Why not let the market sort out the default risks? Mistakes will be made, of course, but they would be no worse than those of S&P, Moody's Investors Service and Fitch Ratings.

To contact the writer of this article: Leonid Bershidsky at lbershidsky@bloomberg.net.

To contact the editor responsible for this article: Marc Champion at mchampion7@bloomberg.net.