European governments have suffered a triple setback. Standard & Poor’s has stripped France and Austria of their triple-A ratings, and cut Italy to the same level as Ireland. Greek debt talks have broken down, while the European Central Bank has criticised the region’s fiscal pact. After a brief lull, the euro zone’s sovereign debt crisis is back with a vengeance.
The S&P downgrades had been widely anticipated and were less severe than some feared: Germany kept its triple-A rating. Investors have taken the news in their stride: yields on French and Italian 10-year bonds actually fell on the morning of January 16.
Nevertheless, with France and Austria stripped of their top status, the European Financial Stability Facility will struggle to keep its triple-A rating, pushing up funding costs for future rescues. Alternatively, the bailout fund will have to shrink, reducing the euro zone’s crisis-fighting resources. Italy’s lowly rating – S&P now has the country just three steps above junk – will keep funding costs high for its banks and companies.
The decision by Greek bondholders to call off talks over a deal to cut in half euro 200 billion of private debt is also worrying. As the debt swap is a precondition for Greece’s second bailout, the impasse raises the risk of a disorderly default. Even if a deal can be salvaged, Greece’s bailout costs are rising: according to the country’s finance minister, Greek banks will need euro 40 billion in additional capital to counteract a worrying deposit run.
The euro zone could handle the downgrades and a Greek default if it had a compelling plan. But the current scheme has flaws. As S&P pointed out, economic policies that emphasise austerity can be self-defeating. And even this commitment to austerity, enshrined in a “fiscal compact” last December, could be under threat. Joerg Asmussen, an ECB executive board member, has criticised the draft treaty implementing the compact, arguing that it is too easy for governments to breach fiscal rules.
These are not fresh concerns. But after period during which cheap three-year loans to banks from the ECB helped to support Italian and Spanish bond yields, and equity markets rallied, euro zone governments might have believed the crisis was easing a bit. Any optimism emerging from the New Year festivities has now been dashed.
