How S&P Factors In Monetary Union Membership In Its Sovereign Ratings

Primary Credit Analyst: Moritz Kraemer, Frankfurt (49) 69-33-999-249; moritz.kraemer@standardandpoors.com Secondary Contact: Marko Mrsnik, Madrid (34) 91-389-6953; marko.mrsnik@standardandpoors.com

Table Of Contents
Eurozone Membership And The External Score Eurozone Membership And The Monetary Score EMU Accession Preceded By Rising Sovereign Ratings Related Criteria And Research

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How S&P Factors In Monetary Union Membership In Its Sovereign Ratings

In 2004, Standard & Poor's Ratings Services started lowering its ratings on a number of sovereigns in the European Economic and Monetary Union (EMU or eurozone). The pace of negative rating actions accelerated at the onset of the eurozone crisis. On a GDP-weighted measure, the average rating of eurozone sovereigns declined from 'AA+' in 2008 to a little above 'A+' in March 2014. By contrast, we lowered the long-term sovereign ratings on the U.S. by only a single notch to 'AA+' in August 2011. This led some commentators to suggest, among other things, that Standard & Poor's ratings display "home bias" or are otherwise prejudiced against eurozone sovereigns (see "Standard & Poor's Sovereign Ratings Have No "Home Bias,"" published on Feb. 10, 2014, on RatingsDirect, for a discussion of the claim that our ratings give undue advantage to the U.S.). More recently, we have been asked to describe how, under our criteria, monetary union membership can affect the ratings on individual eurozone sovereigns. Overview Standard & Poor's, in rating a sovereign, often views membership in a monetary union as "credit positive," under its criteria. Accordingly, we typically raise the sovereign ratings on eurozone accession prospects, as was the case with Lithuania. This shows that our criteria are not biased against eurozone sovereigns. Being a member is in most cases likely to benefit a sovereign's monetary and external scores, two key rating factors that refer explicitly to monetary union.

As we explain in detail below, a sovereign's membership in a monetary union will often be viewed as "credit positive." This view is consistent with our track record for sovereigns that are getting closer to joining the EMU. In the run-up, we typically raise the ratings on accession sovereigns, which today's two-notch upgrade of Lithuania illustrates.

Eurozone Membership And The External Score

A sovereign's monetary score reflects a country's ability to obtain funds from abroad necessary to meet public--and private-sector--obligations to nonresidents. According to our sovereign criteria (see "Sovereign Government Rating Methodology And Assumptions," June 24, 2013), we consider that external risks are lessened in situations where the respective monetary authority issues a currency that enjoys widespread use beyond national borders. Having control over such an "actively traded currency" will facilitate the sovereign's access to funding sources in domestic currency outside the national jurisdiction. We consider this funding flexibility to be credit positive for sovereigns, as they may be less vulnerable to shifts in investors' portfolios of cross-border holdings than are other countries. This benefit is in our view even more pronounced and weighted in the criteria in cases where the monetary authority issues a currency widely used as a store of value for central banks when holding official foreign exchange reserves ("reserve currency").

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How S&P Factors In Monetary Union Membership In Its Sovereign Ratings

We define an "actively traded currency" as one that accounts for more than 1% of global foreign exchange turnover, based on the Bank for International Settlements' Triennial Central Bank Survey, while a "reserve currency" is one that accounts for more than 3% of the world's total allocated foreign exchange reserves based on the IMF's report, "Currency Composition of Official Foreign Exchange Reserves" (COFER). Our abovementioned sovereign criteria assign "reserve currency" status to France and Germany (see paragraph 56), and "actively traded currency" status to the other EMU members (see paragraph 57). The world's central banks typically view sovereign bonds issued by France and Germany as preferred euro-denominated instruments as they are (a) issued by highly rated sovereigns and (b) benefit from a deep and liquid secondary market. In our view, no other sovereign in the eurozone enjoys the same two advantages to the same extent. According to the estimates in our report "European Sovereign Debt Report 2014: Gross Commercial Borrowing To Decline 2.4% To EUR1.3 Trillion," published on Feb. 28, 2014, France and Germany had outstanding sovereign debt accounting for 24% and 18%, respectively, of eurozone sovereign debt. In comparison, the remaining 'AA' or 'AAA' eurozone sovereigns accounted for only 16.7% of the total (Belgium 6%, Netherlands, 5.9%, Austria 3%, Finland 1.6%, and Luxembourg 0.15%). The rest is issued by lower rated sovereigns of the so-called periphery. According to the IMF (COFER), the French franc, and especially the German mark, were the dominant euro legacy currencies used for official foreign exchange reserves prior to 1999. The third-largest euro legacy currency used in international foreign reserves investments was the Dutch guilder, which totaled less than one-fifth of the reserves held in French francs (1998). All other legacy currencies were negligible and not even listed individually by the IMF compilation. It is important to note that even for eurozone sovereigns other than Germany and France, belonging to the eurozone is in most cases more beneficial than not belonging. Being assigned "actively traded currency" status leads to a better external score than for "normal" currencies in most cases (see table 5 of our sovereign criteria). BIS data for 1995 and 1998, when the eurozone's "legacy currencies" were still in existence, suggest that only the German mark and the French franc would have qualified as "actively traded currencies" on their own (see the "Triennial Central Bank Survey, Global foreign exchange market turnover in 2013," February 2014, page 72). Therefore, elevating all other eurozone sovereigns to "actively traded" status bestows a benefit to eurozone sovereigns under our criteria, arising from eurozone membership

Eurozone Membership And The Monetary Score

A sovereign's monetary score reflects the extent to which its monetary authority can fulfill its mandate while supporting sustainable economic growth, and attenuating major economic or financial shocks. The score comprises two subscores, one reflecting the nature of the exchange rate regime, and the second our assessment of monetary policy's credibility and effectiveness as well as inflation trends. Paragraph 119 of our sovereign criteria describes how we assign the monetary score for monetary union members. We begin by scoring monetary flexibility at the monetary union level, which in the case of the eurozone is "1", the highest

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How S&P Factors In Monetary Union Membership In Its Sovereign Ratings

possible score (on a scale from 1 to 6). This result is based on our view that "the ECB's monetary policy flexibility is supported by the euro's role as a reserve currency, the euro's free-floating exchange rate regime, and the credibility of the ECB's monetary policy" (see Standard & Poor's report, "European Central Bank," published Jan. 22, 2014). In the case of the eurozone, we then apply the union-wide monetary score to each sovereign member, but then lower each sovereign's monetary score by one (to "2") to reflect our view that the ECB's policy will not reflect the need of individual sovereigns, but of the eurozone overall. Where the economic conditions in an individual eurozone sovereign are, in our view, unsynchronized with the eurozone overall, we apply an additional negative adjustment (to "3") reflecting our view that ECB monetary policy will be inappropriate (too lose or too tight) for the needs of the individual sovereign's economy. Again, under our sovereign criteria, eurozone membership is generally an advantage (or at least neutral) for a member sovereign's monetary score. This conclusion is based on assessing the hypothetical scores for EMU sovereigns in a pre-accession monetary environment. The current sovereign criteria were introduced only after the euro was created, therefore the counterfactual hypothesis ("What would the monetary score be if an EMU member were outside the eurozone?") has not been validated by a rigorous committee process that underpins all of Standard & Poor's sovereign ratings. In recognition of this caveat, a few approximations can be made, however. Before 1998, the EMU legacy currencies were effectively pegged to the German mark, which according to table 9A of our sovereign criteria ("exchange rate regime") would correspond to a "4" score of the exchange rate regime. As for the second monetary subscore assigned by table 9B ("monetary policy credibility and effectiveness and inflation trends"), it is probably a fair assumption that the subscore would have coalesced around a score of "2", leading to a total score of "3". This is inferior to the standard monetary final score of "2" under the current criteria (derived from "1" for ECB monetary flexibility, plus "1" for membership in monetary union). Even if we were to more optimistically assume that a stronger score of "1" would have been assigned for policy credibility (table 9B), the resulting overall monetary score would have been "2", equal to the current standard monetary final score.

EMU Accession Preceded By Rising Sovereign Ratings

Compared to remaining outside monetary union, being a member of the eurozone is likely to benefit a sovereign's monetary and external scores, which are the two out of five key rating factors that refer explicitly to monetary union. It is therefore incorrect to state that Standard & Poor's criteria are biased against eurozone sovereigns. In fact, Standard & Poor's conducted some simple simulations as early as 2005, finding that the lower-rated EMU sovereigns with weaker fiscal profiles would diminish their creditworthiness if they left the EMU (see "Breaking Up Is Hard To Do: Rating Implications Of EU States Abandoning The Euro," published on Nov. 24, 2005). This theoretical observation is consistent with our rating record of sovereigns joining EMU, be they founding members or later adopters: we typically raised the ratings once we arrived at a view that EMU membership was becoming highly likely. (See, for example, "Republic of Estonia Upgraded To 'A' On Eurozone Accession; Outlook Stable," published June 10, 2010, "Latvia Long-Term Rating Raised To 'BBB+' On Expected Adoption Of Euro; Outlook Stable," June 10, 2013, "Lithuania Long-Term Rating Raised To 'A-' On Expected Adoption Of Euro; Outlook Stable," April 14, 2014,

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How S&P Factors In Monetary Union Membership In Its Sovereign Ratings

and "Outlook On Slovak Republic Revised To Positive On EMU Prospects," March 3, 2008).

Related Criteria And Research

Related criteria
Sovereign Government Rating Methodology And Assumptions, June 24, 2013

Related research
Lithuania Long-Term Rating Raised To 'A-' On Expected Adoption Of Euro; Outlook Stable, April 11, 2014 European Sovereign Debt Report 2014: Gross Commercial Borrowing To Decline 2.4% To EUR1.3 Trillion, Feb. 28, 2014 Standard & Poor's Sovereign Ratings Have No "Home Bias", Feb. 10, 2014 European Central Bank, Jan. 22, 2014 Sovereign Government Rating Methodology And Assumptions, June 24, 2013 Latvia Long-Term Rating Raised To 'BBB+' On Expected Adoption Of Euro; Outlook Stable, June 10, 2013 S&P's Ratings Are Not "Self-Fulfilling Prophecies", Aug. 27, 2012 Republic of Estonia Upgraded To 'A' On Eurozone Accession; Outlook Stable, June 10, 2010 Outlook On Slovak Republic Revised To Positive On EMU Prospects, Mar. 3, 2008 Breaking Up Is Hard To Do: Rating Implications Of EU States Abandoning The Euro, Nov. 24, 2005 Under Standard & Poor's policies, only a Rating Committee can determine a Credit Rating Action (including a Credit Rating change, affirmation or withdrawal, Rating Outlook change, or CreditWatch action). This commentary and its subject matter have not been the subject of Rating Committee action and should not be interpreted as a change to, or affirmation of, a Credit Rating or Rating Outlook.
Additional Contact: SovereignEurope; SovereignEurope@standardandpoors.com

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