The recent downgrade of France from its triple-A rating underscores the extent to which the global financial crisis continues to cast its shadow over the global economy. Although the downgrade had no discernible, immediate impact on spreads, this is not always the case. Indeed, such actions sometimes have very large effects — albeit manifested, perhaps, in more subtle means. This might be the case with respect to the French downgrade.
What accounts for these effects? Chalk them up to potential "non-convexities" that are introduced in decision making.
Mathematical purists (my brother included) will no doubt recoil in horror, but these can be thought of as anything that introduces discontinuities — or, to use the technical term, "kinks" — in the set of policy choices over which agents optimize. Smooth, orderly adjustment requires that small changes in one variable (x) lead to proportionally small changes in the dependent variable (y). But if there are discontinuties, small changes in x can lead to disproportionately large changes in y.
Consider the case of a ratings downgrade. It could be argued that the underlying differences in "fundamentals" (the set of economic indicators, institutions and policy frameworks that shape the economic outlook) between a AAA and a AA bond are minor. I'd agree. However, what if prudential regulations restrict large institutional investors from holding any asset that is not rated AAA? The result then might be a small change in fundamentals and a very large change in bond yields; if the change in yields is large enough and the stock of debt high enough, a vicious circle of rising risk premia, increased debt charges and deteriorating economic performance could set in. (Of course, with well-functioning financial markets, this effect would be offset by forward-looking, risk-taking investors who, recognizing that the initial deterioration in fundamentals is minor, use leverage to make very large bets that the downgrade will be reversed.)
A vicious circle scenario is unlikely in France, at least in the near term. But, as noted above, sometimes small changes can have subtle effects. In this respect, recall that the European Financial Stability Facility is an agreement among euro zone members to pool resources to assist a troubled member cope with financial difficulties.
This is important because there is an expectation that Spain will eventually request assistance from the EFSF, which would trigger the ECB's Outright Monetary Transactions. This, it is believed, would allow Mario Draghi to make a credible commitment to support Spanish debt, creating certain losses for bond traders foolhardy enough to short Madrid's debt. The objective of OMT is to move from the current "bad" equilibrium characterized by concerns about speculation of default and high bond yields to a "good" equilibrium of low bond yields, improved public finances and a return to growth.
To some extent, the expectation of this sequence of events has already relieved pressure on Madrid and delayed the implementation of the strategy (not surprising, given the conditions attached to EFSF funding). Yet, the success of the strategy depends on the EFSF. Countries in need have to go through it to call on Super Mario for assistance.
This is where the downgrade of France may have disproportionate, unexpected effects. As the second largest member of the euro zone, France is critical to the effective operation and credibility of the EFSF. The credit worthiness of the facility, after all, is a synthetic composite of the ratings of its members. Downgrades of key members will affect the rating of the facility and its ability to issue the debt it needs to assist its members; if markets sense that the facility is encumbered, the ECB might not be able to engage in OMT and the relative calm in the euro zone that has prevailed since "Draghi's European Vacation Put" might be shattered.
Small changes. Big consequences.