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Tuesday, 17 January 2012

Rating Downgrades for the Eurozone Sovereigns and the EFSF: Implications


S&P downgraded the EFSF today – Jan 16th -  from triple A to AA+. This followed on the coat-tail of the rater’s downward adjustment on Friday of nine Eurozoners. France and Austria lost the triple-A status as it was adjusted down a notch, as were Malta, Slovakia and Slovenia.

What does this mean in terms of the Euro-crisis thus far and looking ahead?

  • The S&P downgrade was flagged in early December so it was expected and priced in. The French government in particular had had time to prepare its public, and in time-honoured fashion, have a dig at the English. And neither was there was much of an effect on sovereign bond yields during trading in Europe during Monday.

  • That said the US was on holiday today and the announcement on Friday was also late in the day, so expect a delayed reaction – and possible second round effects in other geographies thereafter. And expect the other raters to join ranks in the coming weeks, with more “noise” and market volatility around these events. This may will lead to further compression of yield in northern bond markets - following the negative yield posted in Germany recently. 

  • In the medium-term, the loss of a single notch will not effect France or Austria’s financing capacity at the margin. There is clearly a risk that both countries could get sucked away from the Division 1 or Euro-zone Core that is de facto emerging…or being re-acknowledged as the convergence plays of the last decade reverse back to the old DM-zone…(plus Estonia…”Tere” to my friends there)….

  • I expect French polity to kick-in further fiscal structural adjustment post presidential elections, whoever’s elected – be it VAT reform or further, and politically difficult, cuts in the welfare state. Baseline: if anything expect the S&P rating and possible follow-ups  by Moody’s and Fitch, to increase the probability of French regaining its drive to re-join the Eurozone core….rather than the reverse.

  • More interesting is the fate of the EFSF, which at the end of the day is simply a derivative, relying as a pooled-fund for guarantees provided by the EU 27 Member States. The French and Austrian downgrades will have a significant effect of reducing by 41% the AAA rated guarantees the facility can tap to €260bn.

  • In turn this means two choices: a lower kitty or higher subscriptions. With Germany’s Finance minister already scoffing the idea (…which normally means the country will change its mind at some late stage) of a top up, this means the fire-power for the EFSF is lower. Does this matter? Its successor – the more muscular European Stability Mechanism (ESM) comes into effect in July 2012. Given the programme of debt management in the EU in H1, the loss of the EFSF rating will likely inspire the Eurozone group to raise the benchmark from the touted €0.5trn facility to a higher “shock-and-awe” €0.7-0.9 trn – the higher range the more likely the greater the likelihood of a “disorderly default” in Greece.

  • It does however leave a shortfall should another need emerge in the coming weeks beyond the pencilled in support to the Irish, Portugal and the €100bn odd to Greece. 

  • The one big concern about the ESM is the same as for the EFSF  - its leverage to around a factor of 6 and use of financial engineering that the same policy-makers continuously referred to as “toxic” till the onset of the sovereign debt crisis….ahh the irony of it all.

  • Do the ratings effect the likely calculus of outcomes for Greece? Directly no, but in practice it will act to further strengthen European political will to not give in to “Anglo-Saxon” market forces. In one sense Greece is in default already and the question now is how the debt-resolution is played out…whether the settlement is voluntary, involuntary and the extent of possible contagion in the southern Euro periphery.

  • Impact on the Fiscal Compact? The ratings will give fillip to the tough-love fiscal northern countries. Ironically the S&P assessment – whatever the critique of its pro-cyclical assessments– was clear in lambasting the policy focus in the EU on fiscal retrenchment rather than the external weaknesses and competitive problems. Any attempt to revert back to the original early-December draft of the Compact that effectively implies an external sanction on domestic budget choices will simply not work. The ECB's already had a dig at the watering-down of the original blueprint and in effect it means an unlikely shift from the current status-quo. 

  • Austria’s rating downgrade is an interesting case given the potential contingent liabilities that could emerge given banking exposures to Central and Eastern Europe.

  • Which will leave continued role for the ECB…following its increasing involvement since the inauguration of Mr Draghi…and in particular the successful 3-year liquidity facility for banks….although it won’t solve the solvency problem for banks in the Eurozone (last point)

  • The IMF as an additional “backstopper”? The idea of the EU sending payments to DC to then have it returned seems ludicrous…but in reality is a ruse to get around the Bundesbank-inspired restrictions placed on central bank financing that exists for the Eurozone. With the emerging world and also the US politely turning the other cheek, this won’t happen – although it’s to be hoped that the Fund can continue knock sense in the EU-mindset for the current on-going negotiations in Greece ----at least on the Maths.

  • So more fun and games….lots of summits, agreements, downgrades, economic revisions…volatility to continue into 2012....

  • But...to end on a brighter note...upside risks also...the consensus-forecasts are likely over-shooting the negative sentiment about global growth prospects. The Euro will continue to slide both against the dollar and in effective terms, helping to boost EU growth and complementing some positive economic data in the last few weeks, and there's a real chance of above-forecast growth for the US and continuing - if slightly less hot - growth in emerging Asia. 



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