MAY 2010 GLOBAL SOVEREIGN

SPECIAL COMMENT Rating Governments Through Extraordinary

Times – A 10-Point Summary
Analyst Contacts:

LONDON 44.20.7772.5454
Our December 2009 Sovereign Outlook stated that 2010 may prove to be a “tumultuous”
Pierre Cailleteau 44.20.7772.8735 year for sovereign debt issuers. So far, 2010 has certainly lived up to that forecast. Not
Team Managing Director,
Sovereign Risk Group surprisingly, recent developments have shown that there is some degree of credit risk in most
Pierre.Cailleteau@moodys.com government debt – indeed, risk-free assets are extremely rare. However, the virulence of
Arnaud Marès 44.20.7772.5390 market reactions to changes in government credit metrics – ranging from subdued in some
Senior Vice President, Sovereign Risk Group countries to disproportionate in others – is complicating the assessment of creditworthiness.
Arnaud.mares@moodys.com

This brief note presents Moody’s view of the key challenges in assessing sovereign risk, recaps
NEW YORK 1.212.553.1653
our rating approach throughout the financial crisis and explains how we intend to manage
Naomi Richman 212.553.0014 sovereign ratings in the future, especially in light of the extraordinary decisions announced
Team leader,
Sovereign Risk Group
over the weekend by European governments to tackle the ongoing European sovereign debt
Naomi Richman@moodys.com crisis. In our view, the considerable inter-governmental support coupled with strengthened
Thomas J. Keller 212.553.7210 multilateral surveillance demonstrate the European authorities’ commitment to address not
Senior Managing Director, only the symptoms, but also the causes of the crisis with an impressive arsenal of measures.
Public and Infrastructure Finance
Thomas.Keller@moodys.com
1. The sovereign debt crisis – the third stage of the crisis after the financial and economic
Bart Oosterveld 212.553.7914
crises – is of an unprecedented nature. The governments of most advanced economies
Chief Credit Officer,
Public and Infrastructure Finance will need to stabilize their debt ratios, and this will be painful.
Bart.Oosterveld@moodys.com
Richard Cantor 212.553.3628 2. The European authorities’ drawn-out process for mobilizing support for Greece – in
Chief Credit Officer contrast to the more decisive action taken in support of Hungary, Latvia and more
Richard.Cantor@moodys.com generally the European banking system – has had at least three consequences: (i) the cost
for Greece of regaining control of its public finances has risen considerably in the past
three months; (ii) the mere existence of the euro has become a mainstream topic of
debate; and (iii) the discussion over the past few months about the timing of "exit
strategies" from fiscal stimulus is now over: there will now be a simultaneous
fiscal tightening across the Eurozone. The timing of fiscal retrenchment has been
expedited by market jitters.

3. Contagion has spread from Greece – historically a weaker credit in the context of the
Eurozone – to sovereigns with stronger credit metrics like Portugal, Ireland and Spain.
 GLOBAL SOVEREIGN

4. Currently, a key concern for investors is whether Eurozone countries have the ability to face
speculative attacks and whether there could be a dislocation of the Eurozone – which would be
highly disruptive for bondholders. While grave tensions have appeared within the Eurozone over
the past few months, this scenario remains highly implausible for at least two reasons:

(i) The "negative" reason is that no one knows how to "de-construct" the Eurozone. In addition,
the fate of the euro cannot be dissociated from the fate of European integration itself. While
there is now much less uniform enthusiasm for the European project, the cost – in terms of
political capital – of taking a risk with the most successful regional political project of the past
few centuries would be exorbitant.

(ii) The "positive" reason is that its members still have ammunition in the form of
concerted interventions on bond markets (including purchases by the ECB), and mechanisms
to issue European debt based on joint EU government guarantees. In extremis, Eurozone
members could also resort to a European debt agency. This past weekend, the European
authorities also demonstrated unequivocally that they are not short of ammunition nor a
willingness to deploy it: they effectively pooled their credits to back up around €500 billion of
financial support to those EU governments that might need it. Moreover, the ECB announced
its extraordinary decision to conduct interventions in the government bond markets, as
required. By pooling their resources while reinforcing multilateral surveillance and
coordination, European countries are effectively taking another step forward on the road to
integration.

5. Ratings are typically based on structural economic and financial factors, but our analysis is
now challenged by the recent appearance of "tail risk" in advanced economies – in this case, the
risk of a catastrophic loss of market confidence leading to a material risk of default. Such "tail risk"
had previously been seen as a defining feature of emerging market economies only. For instance,
the risk of a buyers’ strike is what prompts panic/contagion – with this panic/contagion then
validating the fear. It is true that governments, unlike corporates or banks, cannot usually pass on
their problems. That being said, given that their central banks do not consider the objective of
financial stability as being completely secondary to the objective of price stability, having a lender
of last resort can help governments for some time. Central banks have shown plenty of
imagination so far and they are sovereign in deciding what to do with their balance sheets – the
sole, albeit critical, constraint being the preservation of their inflation-fighting credibility. Overall,
it is almost axiomatic that advanced economies, which borrow in their own currency with
properly functioning financial systems and credible central banks, can be price-constrained but
not quantity-constrained. Therefore, while "tail risk" seems to have risen, it can be contained.

6. Our ratings and market spreads have occasionally come to reflect considerable differences
of opinion. A similar divergence occurred at the height of the banking crisis in late 2008, when
our bank ratings were in the Aa-A range while spreads suggested quasi-default situations – before
returning to levels more consistent with our ratings. Also, for several years, our single-A rating for
Greece appeared to some to be "behind the curve" because it was much lower than market prices
suggested and apparently ignored the market’s favourable momentum. Unlike market spreads,
Moody’s credit opinions on governments do not change very often because the fundamental
drivers of sovereign creditworthiness rarely change precipitously in direction or degree. However,
because market spreads are often volatile and affected by momentum-driven trades, our ratings
may at times be perceived to be behind an imagined curve.

2 MAY 2010 SPECIAL COMMENT: RATING GOVERNMENTS THROUGH EXTRAORDINARY TIMES – A 10-POINT SUMMARY
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7. Our ratings provide a forward-looking, methodology-based rank ordering of credit risk, and
give greater weight to medium-term considerations than to transient short-term problems. This
rank-ordering is itself anchored in the historically tested and extremely low risk of our Aaa-
rated governments. Defined this way, our credit ratings can help anchor market prices in a
rational and predictable way. To be sure, short-term problems may not be transient – indeed,
liquidity risk can be very harmful. That is why our medium-term-oriented rating approach,
should it under-estimate unmanageable short-term refinancing constraints, may expose us to
(statistically rare) errors, such as investment-grade defaults. But beyond the fact that short-term
liquidity tensions are often exaggerated, we would emphasize that the alternative proposition –
that of relentlessly chasing market prices – would be certain to severely and permanently impair
the value of our ratings.

8. The question for Moody’s is whether and how it should change its sovereign ratings to account for
a very low-likelihood/high-severity event. On balance, we believe it is better to flag possible
migration risk in our research than to change our ratings based on highly hypothetical concerns –
such as the exit from the Eurozone, the end of the euro, or a run on the sterling or the US dollar.
For these types of risks to affect a sovereign rating, they would have to be plausible rather than
simply vaguely possible. Moreover, since the circumstances that might prompt such extraordinary
events could prove to be even more adverse for non-sovereign than for sovereign credit, we might
risk ranking credits incorrectly if we were to place undue weight on such extreme events within
our sovereign rating analysis.

9. Our rating approach is best illustrated by the cases of Greece and Portugal.

» As regards Greece, we first placed its rating on review for downgrade in October 2009. We
moved at a pace that was dictated by fundamentals (data, policy decisions) and based on the
assumption that liquidity risk was minimal because we could not envisage the ECB
disqualifying Greek government bonds for its repo operations. However, our assumption
that a support package would be confidence-enhancing was certainly violated – and this led
us to downgrade the rating to reflect that the bar had risen for Greece. However, in late
April, with financial markets in disarray, we decided to wait until the IMF package was
announced and adopted before telling investors where we believe Greece’s medium-term
creditworthiness is positioned. We could have decided to act more forcefully earlier based on
less information; however, we came to the conclusion that this would have been at the
price of rating inaccuracy and at the risk of possible short-term rating reversals – a bit like
"shooting in the dark".
» As regards Portugal, we also flagged concerns in October 2009 by assigning a negative
outlook. Given that increased borrowing costs – based on what we expect to be structural
risk differentiation going forward – outweighed the fiscal adjustment plans of the
government, we decided to formally place the Aa2 rating on review this past week. Our view
remains that concerns about a contagion from Greece were overdone because Portugal’s
fundamentals were different – in line with the views we had expressed earlier in 2010 in a
Special Comment entitled "Contagion or Confusion?".
10. In conclusion, Moody’s does not intend to deviate from its medium-term, methodology-
based rating approach. While we want to be cognizant of transient short-term problems, we will
continue to give greater weight to medium-term considerations. This means that we may have to

3 MAY 2010 SPECIAL COMMENT: RATING GOVERNMENTS THROUGH EXTRAORDINARY TIMES – A 10-POINT SUMMARY
 GLOBAL SOVEREIGN

explain further why we do not share some investors' heightened concerns. All the same, the
travails of some European economies – low economic vitality, large debt, ageing, etc. – may lead
us to implement some rating adjustments in the future. However, we would always do so in an
orderly and transparent manner.

What is Next for Ratings?

Given the unusual degree of uncertainty, and mindful of the key role of transparency
and predictability in helping to bring market prices more in line with credit fundamentals, Moody's
is committed to following, to the extent possible, its usual practice of clearly communicating to
the market the evolution of its credit opinions through its research, rating outlooks, rating reviews,
and, ultimately, rating changes.

Moreover, in light of the disruptive impact of unfounded rumours on investors and markets, we
are taking the unusual step of providing more information about the timing and extent of our
forthcoming rating actions. It goes without saying that this focus on transparency does not in any way
prevent us from making whatever rating adjustment necessary in case unexpected events occur.

Of the countries that have been hit by the turmoil to different degrees, three have negative outlooks or
are under review for downgrade:

» Ireland (Aa1, negative outlook): No significant rating action is expected in the short run. The
negative outlook reflects the risk of a further, gradual deterioration in terms of both debt
affordability – i.e. the share of government revenues used for interest payments – and
financeability – i.e. the cost at which Ireland could raise further debt. The rating is supported by
the fact that both Ireland's economic strength and its institutional strength compare
very favourably to some of the countries in the southern periphery of EMU.
» Portugal (Aa2, on review for possible downgrade): We expect to conclude the review in the
coming four weeks or so. A downgrade to Aa3 is probable; but an adjustment to A1 cannot be
ruled out. It will depend on the tug of war between sharper fiscal adjustment on one side, and the
higher cost of funding and continued anaemic growth prospects on the other.
» Greece (A3, on review for possible downgrade): We expect to conclude our review in the
coming four weeks. The migration will most likely be substantial, probably within the Baa range;
but an adjustment to below investment grade is also possible. This will depend on developments
in the Greek economy once the fog of financial panic, support-mobilisation and street
demonstrations dissipates. The country’s debt is large but not unbearable; however, the required
adjustment is obviously very painful, and short-term economic prospects are clearly dismal –
though not out of proportion with developments already seen in several European economies last
year. Once we have concluded our review, we will publish a detailed explanation of our rationale
for re-positioning the rating.
In addition, there are other countries that seem affected by market contagion (Spain, and to a different
degree, Italy) and carry stable outlooks. We have no plan to change these ratings in the near future.
However, if we were to change these – as we clearly cannot commit to indefinite rating stability for
any country – we would also aim to clearly communicate our evolving views through the full set
of tools available to us.

4 MAY 2010 SPECIAL COMMENT: RATING GOVERNMENTS THROUGH EXTRAORDINARY TIMES – A 10-POINT SUMMARY
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Moody’s Related Research

Moody’s recent rating actions and announcements on Greece and Portugal, 2009-2010

Greece
Press Release:
» Moody's reiterates stance on Greece amid turmoil; maintains review for downgrade,
» Moody's downgrades Greece's sovereign ratings to A3; on review for further possible downgrade,
April 2010
» Moody's: New ECB collateral rules reduce liquidity risk for Greece, March 2010
» Moody's: Greece's New Austerity Measures Lend Credibility to Fiscal Adjustment Plan,
March 2010
» A Ten-Point Analysis of Greece's A2 (Neg) Rating, March 2010
» Moody's Restates Need for Differentiation Between Spain, Portugal & Greece, February 2010
» Moody's: Greece's Fiscal Programme Addresses Short-Term Challenges, January 2010
» Moody's downgrades Athens' issuer rating to A2, with negative outlook, December 2009
» Moody's downgrades Greece to A2 from A1, December 2009
» Moody's: Investor Fears Over Greek Government Liquidity Misplaced, December 2009
» Moody's places Greece's ratings on review for possible downgrade, October 2009
» Moody's assigns Aa3/P-1 to National Bank of Greece EUR2.6 billion government- guaranteed
MTN programme, April 2009
» Moody's: Pressure on 'Emerging' European Sovereigns Needs to be Differentiated, March 2009
» Moody's changes the outlook for Greece's A1 rating to stable from positive, February 2009
Issuer Comment:
» IMF-EU Help Mitigates Greece's Short-Term Risk, But Path to Debt Stabilisation Is Arduous,
April 2010 (124467)
» Central Bank Exit Strategies May Gradually Exert Pressure on European Government Finance-
ability, November 2009 (121480)
» Spain, Portugal & Greece: Contagion or Confusion?, February 2010 (123151)
Special Comment:
» Investor Fears of Liquidity Crisis in Greece are Overdone, December 2009 (121522)
» Greece's Downgrade: The Real Problems Are Longer Term, December 2009 (122052)

5 MAY 2010 SPECIAL COMMENT: RATING GOVERNMENTS THROUGH EXTRAORDINARY TIMES – A 10-POINT SUMMARY
 GLOBAL SOVEREIGN

Portugal
Press Release:
» Moody's: Portugal's Aa2 ratings on review for possible downgrade; P-1 affirmed, May2010
» Moody's Restates Need for Differentiation Between Spain, Portugal & Greece, February 2010
» Moody's changes the outlook on Portugal's Aa2 rating to negative, October 2009
» Moody's: Portugal's latest budget projections reveal challenges ahead, January 2010
Issuer Comment:
» 2010 Budget Reveals the Scale of Challenge Facing Portugal, February 2010 (122981)
» Finance Minister's admission about budget deficit reinforces Portugal's negative outlook,
November 2009 (121430)
Special Comment:
» Spain, Portugal & Greece: Contagion or Confusion?, February 2010 (123151)
To access any of these reports, click on the entry above. Note that these references are current as of the date of publication of
this report and that more recent reports may be available. All research may not be available to all clients.

6 MAY 2010 SPECIAL COMMENT: RATING GOVERNMENTS THROUGH EXTRAORDINARY TIMES – A 10-POINT SUMMARY
 GLOBAL SOVEREIGN

Report Number: 125036

Author Senior Production Associate

Pierre Cailleteau Wing Chan

Editor
Maya Penrose

© 2010 Moody’s Investors Service, Inc. and/or its licensors and affiliates (collectively, “MOODY’S”). All rights reserved.
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7 MAY 2010 SPECIAL COMMENT: RATING GOVERNMENTS THROUGH EXTRAORDINARY TIMES – A 10-POINT SUMMARY