Several pieces of news out of Europe last week pointed to the fact that a resolution of the euro crisis remains distant. The most attention-catching was the announcement on Friday by the credit rating agency Standard & Poor’s that it was downgrading nine European economies. In some ways, the new ratings merely reflect fundamentals that were already transparently visible to market participants — and thus it could be argued that they had, to an extent, been priced in. However, their impact on the ability to raise funds and roll over debt is considerable. Heavily indebted Italy now has a rating of BBB+; its sovereign paper is now just three notches away from losing investment-grade status. France and Austria have lost their AAA ratings. Some funds require AAA-equivalent ratings for their investments, so the effect on borrowing capabilities should not be ignored. Indeed, it directly impacts Europe’s fire-fighting ability, as the European Financial Stability Facility is a facility, not a fund: it has no reserves of its own worth the name, but depends on the ability of better-rated countries to raise debt to stabilise weaker economies.
This fire-fighting capability might be needed. Talks to reduce Greece’s debt burden stalled at the end of last week — precisely the period when they should have been close to finalisation. March 20, when bonds worth 14.5 billion euros need to be redeemed, might seem distant. But the details of the deal will need weeks to work out; a consensus on how much of the loss will be borne by bondholders needs to be arrived at well before then. Any rescue plan for Greece financed by the European Union and the International Monetary Fund will need that consensus to be in place — and those talks are scheduled to start on Tuesday. Greece is rated CC by Standard and Poor’s, and is in uniquely poor shape.
Some good news seemed to emerge when debt auctions by Spain and Italy, on Friday and Thursday respectively, seemed to meet solid demand. Bond yields fell, raising hopes that the cost of rolling over debt for the largest of the euro zone’s sick economies — both faced with a particularly busy refinancing schedule in the next few months — would not be too high. There are concerns, however, that the rally was driven by domestic banks seeking to take advantage of deeper lending from the European Central Bank, for which short-term Italian and Spanish bonds are cheap collateral. The spread between yields on short- and long-term debt in the auctions would tend to bolster that theory. Sentiment is thus on a knife-edge, and will depend on the euro zone’s leaders continuing to address the issue as seriously as possible. After the downgrade, the new leaders of Spain and Italy called for an effort to clean up the banking system and to push growth-boosting reform, respectively. Meeting last week, Chancellor Merkel of Germany and President Sarkozy of France tried to hammer out a consensus on austerity and reform which would be presented first to Italy, and later to the full European Union on January 20. Those meetings, and the talks with Greece, will be closely watched.
