Moody Markets: What Happens When a Nation’s Debt is Graded as Junk?

S Hood

It now seems that Thursday’s near 1,000-point intraday drop in the Dow Jones Industrial Average index will go down in history as the result of a trading systems malfunction. But there’s little doubt that the historic plunge, which at market close May 6 was down to “just” 347 points, was largely fueled by the unstable political and financial situation in Greece. 

“Combine one part nervous traders, one part Greek crisis and one part trader error. Stir in one part central bank complacency. Bring to boil. Panic,” wrote New York Times chief financial correspondent Floyd Norris.

Why is the Greek crisis spiraling out of control — in turn causing markets worldwide to behave like moody teenagers?

To answer that question, it helps to better understand a seemingly boring concept: what happens when a country’s bond rating is downgraded to “junk” status? 

Bonds, when issued by a country, are basically a way for that country to bridge the gap between the money coming into its coffers (tax revenue) and the money going out (government spending). While government bonds issued by Western nations have generally been considered among the safest investments around, that is no longer always the case.

Some countries — enter Greece — are seeing their bonds downgraded to junk.

And some fear a similar fate awaits the United States.

Investor Confidence

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In the corporate world, bonds are assessed by rating agencies like Moody’s and Standard & Poor’s. The bonds of a fledgling startup company with little or no financial history is typically rated as riskier than those of a mature corporation like Microsoft. Investors use such ratings to help decide which and how many bonds to buy. Companies with low ratings find that they can only entice investors by offering higher-than-average yields. In the worst case scenario, firms that consistently spend more than they make (or default on their obligations) see their debt graded as junk, causing all but the most risk-tolerant investors to stop buying it.

In principle, national government bonds are subject to the same process. Although it is rare for whole governments to default, that’s exactly what is happening now in several European countries. The most recent example is Greece. On April 27, Standard & Poor’s downgraded Greece’s sovereign debt rating to junk status due to a “weak macroeconomic structure” in that country. Predictably, news of Greece’s junk rating “sent investors scurrying to the safer havens of UK gilts, German bunds and US Treasury bills”, according to the UK’s Times Online. Norbert Barthle, a German budget spokesman, voiced the possible implications for investors when he said that Greek bond investors likely wouldn’t be made whole: “whoever bought Greek bonds wouldn’t get 100 per cent of their value but, say, only 80, 90 or 70 per cent — it depends.”

Inflation, Reduced Spending & Higher Taxes

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As we already mentioned, countries issue bonds whenever the taxes they collect aren’t enough to meet their financial commitments. The problem, amplified by junk ratings, is that this gap is often gigantic.

The United States, for example, collected roughly $2.105 trillion in federal taxes in 2009 (according to the Tax Policy Center) but projects to spend $4 trillion. On top of that, the U.S. is obligated to pay another $4.3 trillion on previously issued bonds that will come due this year. The only way to move forward with these plans is to borrow the $6 trillion difference, which is done by selling more bonds: a situation painfully similar to that in Greece.

But when a country’s debt is graded as junk, selling more bonds is no longer an option. Neither is keeping the current and planned spending levels that relied on selling more bonds. The sole financial focus of the country immediately becomes how to repay the debts it already owes on outstanding bonds.

With continued borrowing off the table, there are essentially three options: inflate the currency, cut spending or raise taxes.

The most politically popular “solution” throughout history has been inflating the currency. When inflation occurs, consumers have to pay more for virtually everything they buy. Spending cuts hurt the various constituencies in the receiving end, while higher taxes reduce the buying power of all affected taxpayers. Ugly picture throughout.

Fallout in Other Countries

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A country’s debt being downgraded to junk can affect events happening oceans and continents away. That is already happening with Greece, whose junk ratings were said by the Times Online to have spread panic of a “Mediterranean virus of insolvency and bad debts” that could engulf all of Europe. On the day of the downgrade — April 27 — the U.S. Dow Jones Industrial Average fell by 213 points, or 1.9%, below 11,000. 

Peter Cardillo, chief market economist at Avalon Partners, testified that the “fear factor” regarding Greek and Portuguese debt instability was “rattling the market.” The Euro sank to below $1.30 for the first time since April of 2009, fueled by fears that a planned aid package for Greece would not be enough to head off similar debt crises in other Euro zone nations, Reuters reported. Anthee Carassava of AOL News spoke of fears that Greek’s problems could spill over into Spain, setting off a monetary disaster across Europe.

As riots in Greece turned violent on May 6, the Dow plummetted nearly 1,000 points on intraday trading — its largest drop ever that will likely go down in history as “the crash of 2:45,” referring to the EDT time stamp of the plunge, which lasted roughly 1o to 15 minutes before stock prices started recovering. While the drop was later found out to have been assisted by a technology glitch and the Dow closed only 347 points, or 3.2%, lower, the situation in Greece has been cited as one of the top reasons for the market’s volatile behavior.

What Lies Ahead

Worrisome as these events are, keep in mind that Greece is a relatively small slice of the world economy. If junk debt in Greece can diminish the currency of an entire continent, who could say what could occur if the U.S. defaulted on its bonds? It is not a stretch to imagine the entire world financial system in mayhem.

Whether that happens tomorrow, next year or ever is beside the point. What’s important to understand is that nothing, in principle, separates Greece from the United States — or any other country. Devaluation of national debt occurs by way of a mundane, predictable process and can befall any country that ventures down a similar path.