S&P hits euro zone with downgrades

Ratings agency Standard & Poor’s on Friday stripped France of its coveted triple-A credit rating and reduced Portugal’s debt status to junk as part of a broad reassessment of Europe’s financial soundness that highlights the severity of the euro zone’s persistent sovereign debt crisis and complicates efforts to resolve it.

Germany escaped S&P’s scrutiny unharmed. It’s triple-A credit rating was left unchanged and given a stable outlook.

S&P’s steps were certain to make it more difficult for European leaders to solve the debt crisis and could trigger a period of volatility in financial markets similar to what investors experienced in the wake of S&P’s downgrade of the United States last year, said Jeremy Hare, Managing Director of Investments at Gilford Securities. S&P’s moves would also, Hare said, shine a harsh light on the leaders’ ineffectual efforts to solve the crisis.

“It hits them right on the chin,” Hare said. “S&P is calling (German Chancellor Angela) Merkel out and saying, ‘Hey, fix the problem’.”

S&P cut France, Austria, Malta, Slovakia and Slovenia by one notch, stripping France and Austria of rare triple-A ratings that were key to their ability to support efforts to rescue struggling euro zone members. The ratings agency also downgraded by two notches Italy, Spain, Portugal and Cyprus. Portugal and Cyprus were cut to junk status.

Of the countries mentioned in Friday’s statement, only Germany and Slovakia were given stable outlooks. The rest received negative outlooks, meaning S&P believes there is at least a one-in-three chance they may be downgraded in 2012 or 2013.

S&P said it was taking the actions because Europe’s leaders had failed at recent meetings to take decisive steps to solve the region’s debt crisis. It specifically noted that a Dec. 9 summit deal did not go far enough.

“The political agreement does not supply sufficient additional resources or operational flexibility to bolster European rescue operations, or extend enough support for those euro zone sovereigns subjected to heightened market pressures,” S&P said in a statement.

S&P went further, casting doubt on Europe’s approach of insisting on tough austerity measures as the main path to restoring financial stability in Europe.

“We believe that a reform process based on a pillar of fiscal austerity alone risks becoming self-defeating,” the agency said.

Instead, it highlighted “rising external imbalances and divergences in competitiveness between the euro zone’s core and the so-called ‘periphery’” as a significant source of the bloc’s problems that needed to be addressed.

The news of S&P’s action was greeted with dismay by European leaders.

“This is not good news,” French Finance Minister Francois Baroin said in an appearance on French national television. Baroin called the downgrade “a semisurprise” and added that it was “not a catastrophe.”

Baroin, who spoke after a day of swirling rumors about an imminent downgrade of France, also said that France’s economic policies would not change as a result of the downgrade.

“It is not the rating agencies who dictate French policy,” he said.

European Commission Vice President Olli Rehn said the euro zone had taken decisive action to fix the crisis.

“I regret the inconsistent decision earlier today by Standard and Poor’s concerning the rating of several euro area member states, at a time when the euro area is tak[ing] decisive action in all fronts of its crisis response,” Rehn said in a statement.

The news, along with an apparent breakdown in negotiations over writedowns for Greek government debt, was credited with sending the euro to a fresh 16-month low versus the dollar.

“To the extent that [a downgrade] has been anticipated ever since S&P launched its review of euro area sovereign ratings in early December, a smattering of downgrades should have already been priced in,” said Grant Lewis, economist at Daiwa Capital Markets.

S&P last month warned that downgrades were possible for 15 euro-zone countries, including triple-A rated France, Germany, Austria and the Netherlands.

Still, a downgrade for France all but ensures that the European Financial Stability Facility, the euro-zone’s temporary rescue fund, will also lose its triple-A rating, Lewis and other economists noted.

“A downgrade to France’s rating will be a severe blow to the useless EFSF,” said Stephen Pope, managing director of Spotlight Ideas, a London consulting firm.

Efforts to boost the firepower of the EFSF by employing leverage or attracting overseas funding have fallen flat in recent months. German Chancellor Angela Merkel and French President Nicolas Sarkozy have urged bringing forward the launch of the permanent rescue mechanism, the European Stability Mechanism, from 2013 to this summer.

Merkel opened the door to increased funding of the ESM in a news conference earlier this week.

A downgrade will make life difficult for Italy as it struggles to convince investors it can get a grip on its debt burden.

Italy this week saw borrowing costs fall dramatically at a pair of debt auctions, but bigger tests loom in coming weeks as the government prepares to issue longer-term debt.

A two-notch downgrade by S&P would put Italy into the B-bracket, the lowest investment-grade category, noted Kathleen Brooks, research director at Forex.com. That could result in a rise in margin requirements, which would in turn put more upward pressure on yields, she said.

Meanwhile, France is poised to sell €8.7 billion of debt on Monday, while the EFSF and Germany also plan to auction debt next week, she noted, ensuring a “tense market open” when Europe returns to work next week. 

Credits -By William L. Watts and Christopher Noble, MarketWatch