I don’t quite understand what this means. Could someone please explain to me in vaguely educated layman’s terms what this means for Ireland?
Well, it means a respected agency, Moody’s, thinks Ireland bonds are riskier. This will lead to fewer people buying them, which means if Ireland needs to raise short-term cash, it will have to make their bonds more attractive by offering a higher interest rate, which make the bonds more expensive for Ireland in the long run.
Overall, not good for Ireland.
Here are what the Moody’s ratings mean and where the line is between what is considered investment grade versus junk (non-investment grade).
Essentially they are simply saying is that the sovereign debt of Ireland has a risk of being repaid. In their opinion, Ireland needs a bailout and otherwise they have potential to default.
What this means for Ireland is that it might be more difficult for them to issue debt and they might have to pay a higher rate of interest when they do issue debt.
Hopefully this means that Ireland will raise its corporate tax, and that we will get fair competition within Europe. It is not decent of Ireland to complain about shortage of money, and receive help from EU, while at the same time having low taxation.
I mean, in Sweden we could cut the world’s highest taxes and then cry in Brussels for help to pay our bills.
Raising corporate taxes would probably not increase tax revenues, as more companies would relocate to other EU nations with similar corporate tax rates. Besides you only have the second highest taxes in the world. Being bested by Denmark.
That’s the scare tactic they always trot out, but never actually do. Lowering taxes doesn’t attract businesses, raising them doesn’t drive them away (barring something outright kleptocratic).
Short answer - the Irish government will have to pay higher interest rates on further borrowings. Long answer follows.
Moody’s and the other ratings agencies (Standard & Poors and Fitch, there may be others I can’t recall at the moment) attempt to provide guidance on the credit worthiness of various financial instruments/entities. In essence they gather together publically available information (and in the case of company bonds and the like may also have access to the company’s own internal info) and use it to forecast the likelihood of a default. The end product is one of the grades listed in LonghornDave’s post.
So a Moody’s team of analysts have looked at Ireland’s budget and forecasts (and presumably other economic data) and decided that there is a substantial risk that the Irish government will not make full payment of outstanding Irish debt (in particular government bonds and the like). The actual grade given Ba1 is the highest of the non-investment grades (rather endearingly known as junk grades).
The effects of this have largely been summarised above. As Irish debt has been labelled by Moody’s as being riskier than before the return offered to investors will need to be higher. Any further issues of Irish bonds will have to be at a higher interest rate to entice buyers to buy them. Moreover some potential buyers may be prohibited from buying non-investment grade securities, so will not be able to buy Irish bonds even if they wished to. For example, many pension funds have internal rules (or in some jurisdictions are required by law) that require all their investments to be rated as investment grade.
Downgrading a company can often affect existing loans as well. It’s quite common to see a clause saying that the interest rate payable on a loan will increase if the company’s rating is downgraded. I’m not sure whether this also applies to sovereign debt though so it may not happen in Ireland’s case.
How accurate are the ratings? Well none of the ratings agencies covered themselves in glory in the subprime crisis. It was their initial ratings of the various flavours of securitised debt offerings (basically a large number of mortgages clumped together in a single security) as AAA that helped precipitate the whole financial mess. Nor have ratings agencies been particularly good at predicting some of the more spectacular corporate crashes in the past (I think Enron was still rated AAA when it crashed and burned). However those failures of the ratings agencies might be attributable to the relative novelty of the products being rated (in the case of the subprime CDOs) or the outright fraudulent information the agencies were given to work with.
However the rating of sovereign debt is a more well-practised art and personally I think the ratings agencies are a bit more reliable in this area.
Denmark may have the highest taxes, but it also has the happiest people. It seems to get this ranking every year. (My source is the Gallup Poll quoted in the Huffington Post.) Yes, I know that you are from Denmark, Rune. It’s the cleanest, friendliest, most relaxed place I’ve ever stayed. But that was a very long time ago.
Cite?
The low tax rate was very important for all the multinational investment in the country in the 80’s/90’s. Intel, IBM, Motorolla, HP, Google all have major operations here (90%+ of intel chips were manufactured in Ireland about a decade or so ago). I worked for IBM and we were always told that the main reason for them being here was tax incentives followed by access to Europe, English speaking and eduacated workforce but they were always clear that money was the main reason.
I don’t know about Ireland specifically, but the way US government bonds work is by auction, in which the interest rate is set by the buyers, not by the government. The government sets the terms of the bond (face value, term, coupons etc.) and the bidders determine the price, which translates to the yield, or interest rate. (This is a technicality, of course, in the context of this discussion.)
I don’t think it was AAA, but it was investment grade.
The odd thing about Enron was that its ultimate implosion was sealed by the debt downgrade. They had debt covenants that required immediate repayment of certain debt if their rating dropped below investment grade. And due to their precarious position, they were not getting new financing. So a debt downgrade meant immediate bankruptcy.
Their only hope was being taken over by a competitor (Dynegy). As long as the takeover looked likely to happen, the ratings agencies kept Enron at investment grade. Then Dynegy backed out of the deal, the ratings agencies immediately downgraded Enron, and they immediately filed for bankruptcy.
It was an incredible drama, especially for guys like me who were following it closely due to having money in Enron at the time. [I was not a long-term holder, but had put in a small bet on the company avoiding bankruptcy a couple of days before the final collapse.]
Thanks for the clarification regarding the Enron situation Fotheringay-Phipps. So in addition to an interest rate hike a ratings drop can also trigger some acceleration clauses. I’m not sure whether such a clause is in any of Ireland’s contracts. I rather doubt it as sovereign debtors tend to have the heft to avoid having such things included in their loan contracts.
They most definitely do consider taxes, and if rates change, business quite frequently close operations, limit operations, or simply never add investment. Taxes aren’t the only consideration, but they are a major one, particularly as high-tax state regimes frequently offer poor business support, horrifically stupid regulatory schemes, hostile government entities, and inherently antagonistic local relations*.
Now, short-term tax changes, which are often used by stupid or selfish politicians to attract new business or development, are incredibly bad. They attract business which vanishes as soon as the tax rebate. But long-term tax decrease can indeed offer long-term benefits, not the least because they spur more business formation.
Why would they relocate if they don’t set the tax rate higher than the other countries’?
And the same thing is true for a surprisingly large percentage of the corporations that go belly-up.
Other EU and Euro nations have lower taxes or taxes comparable to the existing Irish corporate taxes.
Ours in 12.5%.
Getting back to the OP, one of the significances of the term “investor grade” is that certain large institutional investors are required, either by law or by the terms of the document setting them up, that they only invest in reasonably safe, “investment grade” securities.
Pension funds, for example, typically have large amounts of cash to invest, and are usually required to restrict their investments to safe securities, to protect the long-term interest of the pensioners. The same typically goes for investments by a trust, unless the trust document gives the trustees greater discretion.
That means that if the debt rating of a particular financial instrument is downgraded, pension funds and other institutional investors may be legally required to sell their holdings in that instrument.
Government bonds are normally high on the list of investment grade instruments, so pension funds and other institutional investors usually hold a high proportion of different types of government bonds. But just like any other financial instrument, if a government bond is downgraded, they normally have to get rid of it.
Assuming that’s how it works in Ireland, one possible implication of the downgrade is that Irish institutional investors may have to sell off their holdings in Irish government bonds, or not renew them as they come due. However, they still have to invest that money prudently, so that may have the result that given the current state of the Irish economy, they may have to invest their money more out of Ireland, to meet their prudential requirements. Net result: Irish investment money is drained from the Irish economy and invested in the economies of other countries with better debt ratings.
Missed the edit window.
Or, as a former Premier of Saskatchewan once put it, “There’s nothing as nervous as a million dollars.”
Following the Italian mini-crisis early this week the interests on Danish bonds and on Danish real estate loans plummeted, so that now they are again nearing the record lows of December last year. Meaning the Danish state and private Danish borrowers are going to save billions. The same happened in Germany. I expect the Irish junk status will drive more money to safe economies.