Monday, January 16, 2012

France Downgrade and the EFSF

Just as with their downgrade of America last year Standard and Poor’s downgrade of France, Austria and others doesn’t tell us anything we didn’t already know: Europe is suffering under the weight of elevated risk premiums, tight credit conditions and weak growth prospects.

S&P save their toughest criticism for the policymakers who have “...not produced a breakthrough of sufficient size and scope to fully address the eurozone’s financial problems.” We half agree with that: the political process has certainly been arduously slow, but we think some progress has been made.

We are in more fulsome agreement with S&P’s broader assessment, in particular that there is only “partial recognition” of the source of the crisis. On top of financial profligacy at the periphery of the eurozone, they add rising external imbalances and the divergence in competitiveness between the core of Europe and the periphery. Yep.

Like them we have also been concerned that the response to the crisis so far has been ever more stringent fiscal austerity that loses the balance between fiscal consolidation and economic growth. That makes an enduring solution to what will be a long-term problem, more difficult. A focus on economic growth, in particular improving productivity, is an essential part of the equation.

In the near-term the implications of the downgrades of two (France and Austria) of its six AAA-rated guarantors on the AAA-rated European Financial Stability Facility (EFSF) are more interesting. This will reduce the amount of AAA-rated debt it can issue (unless the four remaining AAA-rated guarantors agree to step up the quantum of their guarantees, which is unlikely).

Of course the EFSF issuing AA-rated debt is an option and is not necessarily a bad outcome. Borrowing from the EFSF would still be preferable for countries which rely on the fund (currently Greece, Ireland and Portugal) than raising debt in their own name. The same point holds if the EFSF is itself downgraded. All will be revealed in the next few days.