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Credit Rating Cuts Can Kill a Currency

By    |   Tuesday, 18 Nov 2008 04:31 PM

Upgrades and downgrades of a country's credit rating don't happen often. But when it does, it can have important implications on the country's currency.

If the country's credit rating is lowered, it will hammer the currency in the short term and potentially in the long run if things don't start turning around in the coming months to a year.

However, on the flip side, if a country's credit rating is raised, it can be a big blessing to the country and its currency.

There are many pension funds and other money managers that are barred from investing in countries below a certain rating. So if a country's rating slips below the levels at which they are allowed to inves, they can't invest any more capital into those countries at all, not their stocks nor their bonds.

Also, many times they will even be forced to liquidate their present positions because their in-house rules will dictate that the risk level that they are taking on is now beyond what the fund is willing to handle.

So, when you see a country's ratings change, mark those currencies down and watch them. Many investors will actually go in and short a currency if it gets a downgrade due to the fact that confidence is lost and funds will have to start backing out of the country, consequently putting selling pressure on the country's currency.

On the other hand, they will also "go long" and buy up currencies of countries that experience a credit rating upgrade because it allows for even more money to flow into the country.

There are investment managers just itching to get into some countries, but the credit ratings hold them back. However, once those ratings are upgraded, they tend to cause money to flood in because these managers can now further diversify into countries that they had been eyeing for a long time.

So, which are some of these countries that have gotten these downgrades lately? Well, I tell you, it's been a tough week on some countries, to say the least.

Let's start with South Africa. On Nov. 11, S&P downgraded South Africa's rating from stable to negative. Their widening account deficit and slowing economic growth really had these rating services concerned, which caused the downgrade. In fact, Fitch reduced the country's rating on Nov. 10. So the country got two back-to-back reductions in their credit rating.

It's bad when you get one downgrade, but when you get two downgrades it almost ensures that the pension funds and other money managers will have to pull out of the country. This massive, forced liquidation causes a tidal wave of cash to flow out of the country, which causes the currency to plummet as it is sold and repatriated back into the home currency of the investment company.

South Africa's currency has already fallen over 30 percent against the dollar this year just off of the economic slow down. However, this could quickly worsen due to the downgrade alone.

But South Africa isn't alone.

Mexico also got a downgrade from stable to negative by Fitch. It has been so hard on their peso that their central bank had to buy $85 million worth of pesos last week just to support the currency. In fact, they've had to dip into their reserves in order to support the peso to the tune of $13.6 billion since October.

The peso has already plummeted 24 percent since August when it had reached a six year high vs. the dollar.

Lower oil prices have really hurt Mexico and also have caused less capital flows into the country. Oil accounts for about one-third of the Mexican government's revenue. The problem with that is that oil has declined 60 percent off of its highs. So they aren't making near the money they once were off of each barrel of oil pumped out of the ground.

Russia's ruble has also fallen recently on the decline in oil and also on the news that their country was downgraded by rating services, Fitch and S&P.

Even Turkey had its credit rating lowered this past week too.

So it's been a rough week, to say the least.

Credit rating downgrades warn the rest of the world that the country may not be able to pay its debts as well as it did in the past.

These downgrades also boost the interest rate on any new debt that the country takes on since they are seen as being a higher risk now.

When a country's credit rating is upgraded, the inverse can happen. This past year, for example, Brazil got two upgrades in their credit rating. This causes inflows into their country and at the same time lowers the interest they will have to pay on any new debts.

Brazil currently has the wind to its back. But if commodities don't start recovering soon, the rating services could reconsider their ratings on the country.

These are huge "edges" for the currency investor who has their antenna up listening for this type of news. You know the strikes against a country and you have a huge insight into which way the money may be flowing. That tells you what to do with the country's currency.

With upgrades, you have an edge in buying their currency. In downgrades you have an edge in selling the downgraded country's currency especially if you sell it against a healthy country (rating wise).

So, keep all of these things in mind because in booms and in busts, you will see these ratings change. When you do, it gives you a clue as to what you should do with their currency: buy it or short it.

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SeanHyman
Upgrades and downgrades of a country's credit rating don't happen often. But when it does, it can have important implications on the country's currency.If the country's credit rating is lowered, it will hammer the currency in the short term and potentially in the long run...
currency
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2008-31-18
Tuesday, 18 Nov 2008 04:31 PM
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