We've Just Witnessed A Major Turning Point In The Euro Crisis
December 5, 2011
Standard & Poor's decision to put 15 eurozone countries on downgrade watch today threatens the fabric of programs that are meant to salvage the euro, in particular the European Financial Stability Facility (the euro rescue fund).
That fund has been at the heart of all plans to fix the euro to date. Now it's all but dead, and that may not be such a bad thing.
With S&P threatening to cut France's rating by two notches, it's unlikely that S&P would refrain from making at least a one-notch cut to the country's sovereign rating. Moody's and Fitch have long been warning that they will follow suit.
While we doubt that S&P—or any of the other ratings agencies—would actually go ahead with a ratings cut for Germany, the fact that the country is on downgrade watch is nonetheless troubling, particularly for the EFSF.
All 17 eurozone states contribute to the EFSF's €440 billion ($590 billion) war chest, but its AAA rating is highly dependent upon the ratings of France and Germany. Right now, AAA-rated sovereigns contribute 58% of those funds, with France alone contributing 20.3%.
Thus even if France were the only AAA-rated sovereign to be downgraded, the entire EFSF would be downgraded, too. Lack of a triple A rating would introduce risk (albeit limited) into the Facility's dealings, materially reducing the impact it can make. Plans to insure first losses on bonds or even the attractiveness of EFSF bonds as an investment will be jeopardized by such a downgrade.
But the death of the EFSF means EU leaders no longer have any credible short-term backstop to prevent the crisis from spreading in the short-term. They can no longer rely on a mechanism which analysts have long questioned; they have to do something bigger.
German Chancellor Angela Merkel and French President Nicolas Sarkozy said they have bigger plans in mind, proposing a new EU treaty that could correct the problems that caused the crisis. But their proposals do not provide for the here and now.
With market pressure mounting on Italy and Spain (despite occasional lulls, like the last week or two)—not to mention France and Belgium—it seems clear that Italy and Spain may not last until March, the earliest date that treaty changes to go into effect. Something drastic needs to be done right now to halt market momentum, regardless of how unappealing that solution may be to Germany, the Netherlands, and Finland.
With the EFSF dead, now EU leaders will have no alternative—they'll be forced to face the cold, hard truth.