Emerging Europe: Credit Ratings Or Credit Default Swaps, Which Is Right?
Over the past several months, there has been a clear disconnect between credit default swap (CDS) markets and sovereign ratings in the emerging Europe region. While CDS spreads across the board have spiked to record highs, in some cases beyond 1,000 basis points (Kazakhstan, Russia, Ukraine, Latvia), the downgrades from the ratings agencies have been limited and if at all, taking place well after spreads have widened. For example, while Romania’s benchmark 5-year CDS spread surged through September and early October amid deteriorating macroeconomic fundamentals and heightened risk aversion among foreign investors towards domestic financial assets, ratings agency Standard and Poor’s only yesterday decided to downgrade its rating on the sovereign to sub-investment grade. Similarly, Russia maintains its investment grade status, while its CDS has surged to over 1,100bps, which would suggest growing default pressures.
This begs the question: Which is right – credit ratings or credit default swaps? I believe that the answer lies somewhere in between. On the one hand, movements in credit default swaps have far better reflected developments in the global economy and the ongoing deterioration of foreign investor risk sentiment. That said, in many cases the derivatives do appear to have got ahead of themselves. Indeed, while the Russian CDS market would suggest that there are significant risks of a sovereign default, I believe that this is highly unlikely and certainly not part of Business Monitor International‘s core scenario.
Moreover, while credit ratings have gotten lost behind the curve in failing to address the rapid deterioration in macroeconomic outlooks amid banking sector meltdowns, I at least concur that the actual risks of widespread sovereign default (beyond Ukraine and Latvia) in the CEE region are limited.
In short, credit ratings agencies need to step up their game in making timely revisions which more accurately reflect the changing sovereign dynamics. Credit default swaps too though, should not necessarily be taken so literally. This is especially the case when considering the opaque nature of the CDS market. Even calling CDS trading a ‘market’ is misleading as the only exchanges that are done are over the counter and there is no statutory regulation. Moreover, we have to take into account the counter-party risk when pricing CDSs, especially when the risks of CDS providers going bust have risen dramatically (e.g. Lehman Brothers).