Downgrades seen likely to hinder EU crisis action

By bne IntelliNews January 16, 2012

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EU officials reacted with anger over the weekend to the downgrade of nine Eurozone countries announced by Standard & Poor's on Friday, January 13. While the ratings agency stuck to its guns in reiterating the market's lust for the EU to build a big bazooka to shoot down the debt crisis with cash, analysts suggest the move is likely to raise the political obstacles to concerted action.

After putting 15 Eurozone countries on negative watch in December, S&P cut its ratings on France, Austria, Malta, Slovakia and Slovenia by one notch, and knocking Italy, Spain, Cyprus and Portugal two notches lower. Belgium, Estonia, Finland, Ireland, Luxembourg and the Netherlands joined Germany in keeping their ratings untouched, leaving the latter with the only stable 'AAA' rating in the Eurozone. The question now is whether the other ratings agencies will follow.

The announcement from S&P rocked the markets and sent the euro crashing to a 16-month low against the dollar and an 11-year low against the yen. Just a day earlier, the currency had spiked following Spanish and Italian debt auctions at lower yields than the previous month.

S&P was unapologetic in accusing Eurozone leaders of failing to step up to the plate to head off the crisis. "In our view," S&P continued, "the policy initiatives taken by European policymakers in recent weeks may be insufficient to fully address ongoing systemic stresses in the euro zone."

Points out Jacques Caillou, chief European economist at RBS: "The criticism seems to be aiming at the lack of firepower of the fiscal backstops."

Gallic shrug

France's loss of its 'AAA' rating is the headline stealer. Although Finance Minister Francois Baroin said the loss of the top rating is "not a catastrophe," it is likely to dampen France's enthusiasm for the stiff austerity measures it has been pushing on the rest of the currency union in tandem with Germany, which was conspicuous in keeping its rating despite a heavy debt burden.

As Caillou puts it: "The French downgrade comes at a bad time and will likely complicate domestic politics ahead of the critical general elections. Likewise, France's position at the European negotiating table is likely to be weakened vis-à-vis Germany. This might render future negotiations surrounding fiscal integration even more difficult."

European Commissioner for Economic and Financial Affairs Ollie Rehn led the objections, criticising the move as clearly "political", and pointing out that several EU countries have applied strong austerity measures. Whilst Brussels, Berlin and Paris all insisted that the downgrades are "only an opinion," the downgrades reflect the market view that action has been slow; the process remains bogged down by political wrangling and - most importantly - the cash commitment is insufficient.

Lead analyst on the report for S&P Moritz Kraemer said January 14 that policymakers have yet to come up with solutions to the "systemic stresses" that plague Eurozone nations. Among these, he said, according to Marketwatch, are tightening credit conditions; weakening prospects for economic growth in the region; and continued disagreement among government officials over how the situation should be addressed.

German Chancellor Angela Merkel moved the same day to use the news as a further impetus to push her plan to cement the "fiscal compact" agreed in December. She stated that the downgrades demonstrated the importance of rapid implementation to reinforce fiscal discipline, and added that the region's permanent bailout facility, the European Stability Mechanism, should be funded soon.

However, Caillou suggests that the downgrades mean that "neither the EFSF nor the ESM will be able to maintain their 'AAA' rating. This in turn is likely to make any significant increase in the lending capacity of either institution more difficult."

In terms of Central Europe, although Slovakia's long-term sovereign credit rating dropped to 'A' from 'A+', it was the only country out of the 15 to join Germany to avoid a negative outlook. However, it's difficult to see from where S&P finds its confidence that the country will continue to reduce its deficit and debt burden, as well as ploughing on with reforms, ahead of snap elections in March.

For the other Central European economies, the effect of the downgrade remains unclear. On the one hand, ironically, should the other agencies follow suit it could potentially loosen the purse strings at the Austrian banks that dominate many of their markets. The country's regulator placed restrictions on cross-border funding by the country's banks in November in a bid to protect its 'AAA' rating. Without that restriction, the banks may be granted more freedom to raise their funding for certain select markets with significant potential; Poland springs to mind. On the other hand, bank ratings themselves are more than likely to follow the sovereign at some point soon, which threatens to hit their own funding costs.

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