Quantity not quality

France/euro zone: A French downgrade would rock the euro zone’s bailout fund. France’s triple-A status is the weak link in the soon-to-be-expanded European Financial Stability Facility. But while a lower rating would push up borrowing costs, it need not be a disaster.

The EFSF is guaranteed by the euro zone's 17 members. But it is assurances from the six triple-A rated countries that have enabled ratings agencies to give the fund their top grade. Euro zone countries have just agreed a plan to expand the EFSF's borrowing capacity from around 255 billion euros to about 450 billion euros. They have also promised to pass on the facility's low borrowing costs to bailed-out countries such as Greece and Ireland. France will underwrite about 158 billion euros of the EFSF - equivalent to 35 percent of the fund's triple-A guarantees. All three ratings agencies have recently confirmed the country's status.

But, following S&P’s decision to strip the US of its top rating, many investors believe France may be next. A French downgrade would make life tricky. To maintain the EFSF's size and rating, the five remaining triple-A countries would have to increase their guarantees - in turn possibly endangering their own ratings. The burden would largely fall on Germany, which in France's absence would have to boost its guarantees to around 325 billion euros - equivalent to almost 15 per cent of the country's GDP. Fierce public opposition to the existing bailouts means that is probably a non-starter.

An alternative would be to allow the EFSF's rating to drop a notch. That would also allow the fund to become bigger: The EFSF currently has guarantees from double-A rated nations worth about 575 billion euros. Even if it excluded Spain, which has a double-A rating but may need some kind of support, the fund would still have around 480 billion euros of lending capacity. True, dropping to double-A would lift the EFSF's funding costs. The fund's triple-A rated 10-year bonds currently yield about 80 basis points more than German bonds. A lower rating might add as much as 100 bps to the premium, according to Credit Suisse.

That in turn would boost bailout costs for Greece, Ireland and Portugal, making it tougher for them to get their debts under control. But that may be the price to pay for a bigger fund. A benign scenario is not guaranteed: A French downgrade may prompt jitters across the euro zone, especially around Italy which would still be too big for even an expanded EFSF to rescue. At that point, policymakers may need to consider more radical steps, like issuing common euro zone bonds. But for now, EFSF looks like the best available plan.