Market reaction to S&P’s decision to downgrade several euro-area countries last week has been rather muted, probably because the move was not really a surprise. Still, I think euro-area governments should pay close attention to the rating agency’s reasoning.
Last week, S&P cut the credit ratings of France and Austria from AAA to AA+; it downgraded seven other European countries as well. The rating agency said that these moves were based entirely on the failure of euro-area policymakers to address the crisis at a collective level.
Contrary to criticism from the European Commission, S&P hasn’t ignored the recent developments in individual countries. Indeed, it reserved particular praise for Italy. S&P just thinks that those moves aren’t enough to offset failures at the supranational level.
S&P’s assessment echoes the concerns of most international investors (including ourselves). It believes, rightly in my view, that the European Union summit on December 9 did not do enough to bolster financial firewalls in the euro area and that the crisis cannot be solved by austerity alone.
More generally, S&P argues that the authorities aren’t doing enough to counterbalance the lack of flexibility implicit in euro membership: “Financial solidarity among member states appears to us to be insufficient to prevent prolonged funding uncertainties. Specifically, we believe that the current crisis management tools may not be adequate to restore lasting confidence in the creditworthiness of large euro zone members such as Italy and Spain.” It’s hard to disagree with any of this.
The downgrades will also undermine the ability of the European Financial Stability Facility (EFSF) to support Greece and the other countries most at risk. The rating agencies only take into account guarantees issued by AAA-rated governments when deciding whether to maintain a AAA rating on the EFSF. Using S&P’s new ratings, the EFSF’s effective lending capacity would be reduced to about €270 billion from €440 billion, which was already too small.
There are two ways forward: the remaining AAA-rated countries could increase their guarantees (again) or policymakers could accept a lower credit rating for the EFSF. Since the first option is a nonstarter for the remaining AAA-rated euro-area countries (Germany, the Netherlands, Finland and Luxembourg), a lower credit rating for the EFSF is the most likely way forward. The groundwork for this is already being laid.
Ultimately, last week’s downgrades highlight the flimsy nature of the barriers against contagion in the euro area. This brings us to the worrisome recent developments in Greece. Not only have private sector involvement talks reached an impasse, but recent reports suggest that the interim government isn’t delivering on its promises. The first of these can probably be worked around, but the second cannot.
Throughout the crisis, I’ve argued that other euro-area governments would go to considerable lengths to avoid a disorderly default in Greece, mainly because of the unpredictable chain of events this could unleash. So far, this assumption has been correct. But if Greece can’t deliver this time, there is a real risk of a disorderly default (particularly in March, when a €14 billion bond issue will mature).
Given the grave impact that this could have on the rest of the region, I find it incredible that bigger and more effective firewalls have not yet been built. Perhaps last week’s downgrades will act as a catalyst. If not, the European Central Bank will remain the only effective barrier against widespread contagion in the euro area.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.