“The financial risk for a fund domiciled in a country under stress would be if the assets or the cash could not be transferred out of the country,” says Aymeric Poizot, head of Emea fund and asset manager ratings at Fitch Ratings, which seems a remote risk for European countries. About as likely, perhaps, as finding a blue frog.
Currently two of Europe’s four main financial centres are either on a rating agency’s watch list or have been downgraded.
Luxembourg and France both maintained their triple-A ratings from all three main rating agencies, but the UK and Ireland on the other hand have had some trouble. Ireland was downgraded last year and the UK was put on negative outlook by Standard & Poor’s. Moody’s said the debt ratings on the UK may “test the triple-A boundaries”.
Although the possibility of either of these countries introducing a freeze on assets is very remote, the financial crisis has (supposedly) taught us that investors should take heed of even the most unlikely of risks.
The most important determinants of sovereign debt ratings, according to the European Central Bank (ECB), are GDP per capita, real GDP growth, government debt, government effectiveness, external debt, external reserves, sovereign default indicators, and EU membership status.
The authors of an ECB working paper, António Afonso, Pedro Gomes, and Philipp Rother, say: “Sovereign credit ratings are a condensed assessment of a government’s ability and willingness to repay its public debt… they are forward-looking qualitative measures of the probability of default put forward by rating agencies.”
They studied the determinants of sovereign debt credit ratings of the three main international rating agencies – Standard & Poor’s, Moody’s and Fitch Ratings. According to their findings, the models, across agencies, performed well and had overall good prediction power.
But although the ratings assigned by agencies generally look at the sovereign credit risk, investors or investment managers considering doing business in one of Europe’s fund centres should take a closer look at the country risk.
Fitch says the risks to doing business in a particular country include weak property rights, unpredictable tax and legal regimes, and a volatile operating environment. The agency says that deterioration in country risk conditions does not necessarily imply a worsening in sovereign creditworthiness, though often that will be the case.
According to research by Wharton, a US business school, the economic outlook for Europe as a whole is relatively bleak.
“In addition to an anaemic recovery, Europe will face a number of key challenges that will shape the business and economic environment in 2010 including concerns about economic integration, sovereign debt default, regulatory change and the European Union’s place in the global economy,” says Wharton management professor Mauro Guillen.
Arguably this could mean that the stability of some of Europe’s fund centres may be at risk.
But it seems that most industry players have not even considered the potential risks around a downgrade in sovereign debt ratings. Furthermore, one manager says that investors don’t really take it much into account either.
“I don’t think a consideration of the domicile’s debt rating forms part of any investor’s due diligence process,” says one source.
True as this may be, they might want to consider putting it on their radar – especially when investing cross-border. A potential freeze on assets could mean that money cannot be repatriated following a sale. Again, although the likelihood of this happening is relatively far flung, for countries like the UK, which is not a euro country, this argument may be particularly relevant.
Of the European fund and investment management centres, London and Dublin were the two caught up in sovereign rating issues and therefore these are the two that may breed concern.
The UK has maintained its triple-A rating from ratings agencies, but S&P and Moody’s put the country on negative outlook. S&P says the outlook revision was based on the view that “even factoring in further fiscal tightening, the UK’s net general government debt burden may approach 100% of GDP and remain near that level in the medium term”.
The question is, does this affect the investment industry?
According to S&P, investors in the UK’s financial markets may actually help the country hang on to its rating and claw its way out of debt.
The agency says: “The funding flexibility provided by the UK’s deep capital markets and strong demand for long-dated gilts by domestic institutional investors, should, in our view, support the UK’s contribution to the heavy sovereign issuance on international debt markets in coming years.”
The Bank of England (BoE) came under pressure as it swooped in to purchase government debt. The BoE has since announced that it will be halting its quantitative easing (QE) exercise, although the jury is out as to whether this has actually stopped yet.
There were fears that a pause in QE would see a collapse in the demand for UK government debt, but this argument does not seem to hold water since gilts issued in the week following the announcement were still highly sought after.
What will become of investor appetite for UK assets in the coming months is another question.
Philip Saunders, head of the Investec multi-asset team, says: “We believe investing in government bonds is more likely to produce dismal than disastrous returns.” Although this is not a brilliant outlook, it is better than some could have hoped.
Aside from the stance on investing in the bond markets themselves, has the negative outlook on the UK had a negative impact on the way fund managers based there do business?
Arguably, regulatory overhaul could help the UK stabilise its outlook in the eyes of certain rating agencies and these are the changes that fund managers need to be aware of.
Financial services based in London have become a major engine of economic activity. Professor Felipe Monteiro, tutorial fellow of the management department at the London School of Economics and Political Science, says: “London has always been on the vanguard of what’s happening in financial services and I have no doubt all the things that are being discussed now in terms of restructuring financial markets and financial services will have a great impact on London and will have cascading effects in financial markets worldwide, for good or for bad.”
On the whole, investment managers don’t feel that a potential downgrade of the UK’s sovereign rating would have much of an impact on their business. But this also depends on where their clients are based.
One manager says that if anything had to happen within the UK, his firm would not be much affected because its clients mainly hail from the UK. Were it to have foreign clients, those foreign clients may possibly have more concern.
As already mentioned, the worst-case scenario would be for the UK government to freeze assets. This would cause problems for managers trying to repatriate assets or liquidate funds and the like, due to the fact that the UK has its own currency.
This is really not an issue when it comes to talking about Ireland since it is a euro country, although there may be other concerns around the country’s rating.
Just like in the UK, in Ireland the government also provided extensive support to the financial system.
S&P says: “The net general government debt burden will rise to around 100% of GDP, largely as a result of the upfront fiscal costs to the government of supporting the Irish banking system.”
In June last year, Ireland’s minister for finance, Brian Lenihan, said in a statement: “The government is taking the necessary measures to allow the domestic banking sector to service effectively the needs of the real economy and to restore the reputation of the country as a sound and secure centre of excellence in international financial services.”
One of these measures was the proposed creation of the National Asset Management Agency (Nama). Lenihan said this was “being established on a statutory basis to deal with the negative impact on the economy resulting from deficiencies in the asset quality in the banking system”.
Nama will be replacing €77bn of bank assets with government bonds, to strengthen the bank balance sheets and improve confidence in the financial system. Of that figure, it has been estimated that around €49bn is in land and development and approximately €28bn is in associated loans.
The Irish funds industry has been thriving with over €700bn in assets domiciled there and a total of €1,353bn in total assets under administration.
Administration and domiciliation
Poizot, at Fitch, says: “With regard to the sovereign risk, it is important to distinguish fund administration and fund domiciliation. Administration is a service and there is no direct financial risk. For instance, there are €700bn of fund assets domiciled in Ireland but Ireland also administers €650bn of funds not domiciled in Ireland.”
Therefore, the assets not domiciled in Ireland would not be at risk should there be a cataclysmic event that caused the country to shut down it’s financial markets.
Actually, as with the UK, Ireland’s financial markets could be its saving grace. Gary Palmer, chief exeutive of the Irish Funds Industry Association, says: “In fact, when discussing economic activity the government has highlighted the potential of the funds industry in this regard and as such in a somewhat ironic way the economic issues the government is addressing will positively impact the investment funds industry as the government is determined to enhance the legal, regulatory and fiscal environment for investment funds.”
©2010 funds europe