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Moody's downgrades Spain by two notches

Pallavi Aiyar  |  Brussels 

Europe’s economic roller-coaster ride continued with Moody’s downgrading Spain’s credit rating by two notches against the backdrop of the countdown to Sunday’s EU summit.

Spain is the euro zone’s fourth largest economy, and if fiscal contagion were to spread here there are serious concerns that the country may be too big to bail out. Moody’s cut Spain’s bond rating to A1, from Aa2 late on Tuesday. Its move followed similar downgrades by the other two big ratings agencies, Standard & Poor’s and Fitch.

And the euro zone’s worries continued their centripetal direction from periphery to core with Moody’s also warning France that it may lose its triple A credit rating. Although the French government immediately rushed to assuage fears, were this in fact to happen it could potentially destabilise the European Financial Stability Fund (EFSF), the euro zone’s bailout fund.

Moody’s statement on Spain referred to the country’s large sovereign borrowing needs, heavily indebted banking system and challenging growth outlook, which left it vulnerable to further downgrades.

And for those who remain optimistic of Sunday’s EU summit producing a ‘big bazooka’ with which to dazzle markets, the Moody’s assessment makes for sobering reading.

“Since placing the ratings under review in late July 2011, no credible resolution of the current sovereign debt crisis has emerged and it will in any event take time for confidence in the area’s political cohesion and growth prospects to be fully restored,” the agency said.

Spain is currently paying more than twice what Germany does on 10-year bonds, even after the European Central Bank stepped in to prop up its bond market on August 8. Moody’s has now cut its growth forecast for Spain to one per cent in 2012, from a previous estimate of 1.8 per cent.

As with the rest of Europe’s beleaguered PIIGS (Portugal, Ireland, Italy, Greece and Spain) economies, slower growth in Spain will make it harder to reduce budget deficits.

On France, whose economy is the second most powerful motor of the euro zone, Moody’s warned that by backing a European rescue fund, its own credit rating could be at risk.

The very nature of the EFSF is circular since it will rely on borrowed money, using the strong credit standing of France and Germany to get low interest rates. But if the programme stretches France’s finances enough to provoke a credit ratings downgrade, the success of the bailout fund would be at risk.

France is responsible for about one-third of the euro 440 billon EFSF an amount equivalent to 8.5 per cent of France’s annual economic output.

Amidst all the bad news, hope flared briefly late yesterday after a report in the UK’s Guardian newspaper claimed France and Germany had arrived at a deal, ahead of Sunday’s summit, to increase the EFSF’s funding to a whopping euro 2 trillion. In the meantime, FT Deutschland has reported a similar plan, but for a smaller, euro 1 trillion. However, officials in Brussels are attempting to tamp down expectations of such massive increases in the EFSF’s firepower.

Germany’s Chancellor Angela Merkel has also been calling for ‘realistic’ expectations for the summit saying that while it will be an ‘important step’ towards solving the current crisis, it will not be the final one.

Sunday’s meeting is expected to unveil a ‘comprehensive package’ to tackle the region’s fiscal woes using a three pronged approach: substantially increasing the size of the EFSF, recapitalising Europe’s banks and forcing banks to take sizable losses on their holdings of Greek debt to help the country get back on its feet.

What’s almost certain is that while markets might initially rally on the back of whatever announcement is forthcoming at the summit, it’s unlikely to bring long-term respite. Given the complicated structure of the euro zone quick implementation of any decisions reached will be difficult. This was evidenced by the slow passage of July’s expansion of the EFSF to its current euro 440 billion, which was held up by, amongst other problems, a Slovakian veto.

With France’s credit rating under pressure, the recent downgrades of Spain, Italy and Belgium, the collapse of Dexia bank and slowing growth across the eurozone, most analysts fear that Sunday’s summit will only produce yet another bandage for a broken arm.

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First Published: Thu, October 20 2011. 00:05 IST