Crisis deepens in the euro zone

S&P’s downgrade of nine european economies reignites concerns over fiscal sustainability of the region.

Standard & Poor’s (S&P) downgraded the credit ratings nine European countries on Friday, a move that may have more symbolic than fundamental financial impact but which serves as a reminder that Europe’s economic woes were far from over.

While the long-term ratings on Cyprus, Italy, Portugal, and Spain were lowered by two notches, sovereign ratings on Austria, France, Malta, Slovakia, and Slovenia were lowered by a notch each.

Another memory jog came from Greece, the original source of Europe’s debt troubles, as talks hit a snag between the new government and banks and other private investors who Athens hopes would agree to take losses on their debt so that Greece can avoid a default.

Together, those developments underscore that even as Europe’s debt turmoil enters its third year, no clear solutions are yet in sight, despite recent signs that a new lending programme by the European Central Bank might be easing financial market pressures.

S&P had warned in December about downgrading many of the 17 nations that share the euro, largely because it felt European politicians were moving too slowly to strengthen the monetary union and the euro zone’s problems were propelling Europe toward its second recession in three years.

European politicians, in turn, criticised S&P’s downgrade plans as providing no meaningful new information to investors but simply stoking a sense of crisis.

To some extent, the prospect of rating downgrades had already been priced into the recent bond auctions by Italy, Spain and other countries. Italy, in fact, completed another fairly successful bond auction on Friday, even as rumours of the downgrades had begun to swirl.

But, the downgrades may now add to the borrowing costs of the nations affected. Some commercial banks required to hold only the highest-rated government securities will have to replace French bonds with other assets, like bonds of Germany.

And, the downgrades cannot help but add to the gloom pervading Europe’s economic climate.

“Today’s actions are primarily driven by our assessment that the policy initiatives taken by European policymakers in recent weeks may be insufficient to fully address the ongoing systemic stresses in the euro zone,” S&P said.

French Finance Minister François Baroin said the loss of his country’s pristine AAA rating, cut a notch to AA+, was “not good news”, but also “not a catastrophe.” He insisted the country was headed in the right direction and no ratings agency would dictate the policies of France, the second-biggest economy in Europe, after Germany.

However, the downgrades pose fresh challenges for Europe’s political leaders, particularly French President Nicolas Sarkozy, who is expected to run for re-election this spring and had long cited his country’s AAA credit rating as a badge of honour.

In August, when S&P cut the US a notch from its top-rank AAA rating, markets briefly plunged. But, bond investors have continued to flock the debt of US, which, as the world’s largest economy, has retained the perception of a financial safe haven. That has kept the US government’s interest rates at very low levels. But, none of the countries downgraded on Friday can necessarily count on such a reaction.

The only euro zone nations retaining their top AAA ratings now are Germany, the Netherlands, Finland and Luxembourg. Italy and Spain, considered the two big euro zone economies most vulnerable to an escalation of debt problems, were both downgraded two notches — Italy to BBB+ and Spain to A.

“It will make it harder to erect firewalls around struggling euro zone economies and convince investors that things are more sustainable,” said Simon Tilford, chief economist for the Center for European Reform in London.

Stocks were down broadly, if not deeply, in Europe and the US on Friday, as rumours of the downgrades preceded S&P’s announcement, which came after the close of trading on Wall Street. And, the euro fell to a 16-month low against the dollar.

Just as significant as the ratings downgrades may be Friday’s suspension of the creditor talks in Greece — whose debt has been awarded junk status by S&P long ago.

In October, the EU pledged to write off ^100 billion ($127.8 billion) of Greece’s debt if bondholders agreed to voluntarily accept 50 per cent losses on their Greek holdings. Such an arrangement, known as private-sector involvement, has been pushed by German Chancellor Angela Merkel as a way of forcing banks, not only European taxpayers, to foot the bill for bailing out Greece.

But, talks broke down between Greece and the commercial banks on Friday.