Terrorist Attacks Are Unlikely To Dent Sovereign Ratings In Western Europe

An increase in terrorism, Islamist or otherwise, would by itself be unlikely to affect European sovereign ratings. That said, terrorism could eventually start to weigh on some of the factors we look at when we rate sovereigns, particularly our assessment of a country’s growth and fiscal prospects

The multiple and apparently coordinated terrorist attacks in Paris on November 13 have raised radical Islamist terrorism in Europe to a new horrific level. Attacks orchestrated by the so-called Islamic State (IS) have surged recently: In the past month alone, IS has claimed, or is believed to have been behind, attacks in Ankara, the Sinai, Beirut, and now Paris. This is to be seen as part of a wider trend. According to a database compiled by the University of Maryland, the number of terrorist incidents worldwide has been on the rise for a decade, mostly in the Middle East and South Asia. In 2013 it reached 12,000 discrete events, four times the long-term yearly average since the 1970s.

Notwithstanding this mounting threat, we believe that a surge in terrorism, Islamist or otherwise, is by itself unlikely to affect the sovereign ratings of European economies. That said, we will monitor the impact on economic growth prospects and potential fiscal consequences when assessing the more indirect influences terrorism can have on a sovereign’s credit standing. We will also analyze whether security threats will lead to delays to growth-enhancing economic reforms.

Our sovereign criteria explicitly describe the risk of “geopolitical/external security risks, including war or threats of war” as a factor that would lead us to revise down a country’s institutional assessment. We consider that the spirit of our criteria description captures some of the terrorist incidents. President Francois Hollande has explicitly referred to the recent Paris attacks as an “act of war”.

As far as Western European sovereign ratings go, we currently do not believe the frequency or severity of terrorist attacks will reach a scale that, by themselves, would lead us to make the aforementioned adjustment to the institutional assessment, let alone lead to sovereign downgrades. This contrasts with countries in other regions where terrorism is much more pervasive, such as Iraq (B-/Stable/B), Pakistan (B-/Positive/B), or, on a lesser scale, Nigeria (B+/Stable/B). In those countries, terrorism is such that we believe it significantly impedes economic development and burdens the fiscal accounts with outsized security outlays, thereby weighing on the sovereign rating. Europe is, and will remain, far from such levels of security risks, in our opinion.

While it is unlikely that terrorism will lead directly to sovereign downgrades, it could gradually weigh on some of the factors we take into consideration when we rate sovereigns. In particular, our assessment of a country’s growth and fiscal prospects could prove susceptible to a terrorist surge.

In Western Europe, the possibility of repeated incidents could depress consumer and investor confidence. With fears of further terrorist attacks on the rise, tourism could take a hit not only in Paris but possibly more broadly. Aviation and certain service industries may drag on economic growth as consumers retreat from what they consider exposed and crowded locations of commerce and leisure activities. The weak recovery in Europe could become weaker still and have negative implications for fiscal adjustment, employment, and social cohesion.

Even in the absence of another attack, if growing border controls became a quasi-permanent feature this could heighten the costs of doing business. Less-permeable borders will impair economic integration and the growth of EU economies. Reducing transaction costs was precisely the motivation behind the creation of the Schengen passport-free travel area, a logical consequence of the common market. Enthusiasm for broader European integration has already been dented by the protracted eurozone crisis. Unhinging the benefits of Schengen could further undermine European citizens’ appreciation of the tangible benefits of such integration. We believe that policymakers will likely go to great lengths to prevent lasting damage to what encapsulates the very essence of the EU. We also think that they will resist an unravelling of Schengen as this could be viewed as an ineffective countermeasure: most of the identified November 13 Paris terrorists carried EU passports.

A growing sense of insecurity and a perceived roll-back of free movement of people also carry the risk of strengthening populist and even outright xenophobic parties and candidates (see “European Sovereign Creditworthiness Might Diminish If Eurosceptics Take Power,” published on Jan. 23, 2015). Such a development might shift the focus of incumbent governments toward containing populist surges. Doing so could imply moving away from pushing ahead with budgetary and structural reforms. Fiscal sustainability and more dynamic growth potential underpin all sovereign ratings. Slowing down or even backtracking on policies conducive to achieving those dual goals could, over time, increase downward pressure on sovereign ratings (see “The Surge Of Refugees In The EU: Boon Or Burden For Sovereign Ratings?” published on Sept. 15, 2015).

Further, we cannot confidently gauge the fiscal implications of terrorism at such an early stage. It is reasonable to assume that governments will boost budget allocations for security operations. Where these unanticipated spending commitments take on a quasi-permanent nature, governments would need to identify and implement offsetting savings to avoid an erosion of public finances. President Hollande has already announced a budget increase for France’s security forces. This extra spending will burden an already challenging budgetary position. It remains uncertain as to whether savings in other areas or tax increases might compensate for this extra spending.

In conclusion, no immediate downward rating pressure is likely as a direct consequence of the renewed terrorist threat. At the same time, sustained security concerns might over time have implications for individual countries’ growth and fiscal prospects. It might also lead to a rise of populist parties, complicating the ongoing pursuit of unpopular economic reform measures conducive to enhancing potential growth in Europe.

Moritz Kraemer – Primary Credit Analyst – Standard & Poor’s