France and Italy Downgraded by the Credit Rating Agencies: a Plot Against the Euro?

The anger was palpable here in Italy as news of the Standard & Poor's downgrade spread this evening, Friday 13th. Anger was perhaps more muted in France and the French Finance Minister Baroin declared on French TV that he had half-expected it. And that in any case the credit agencies could not dictate French policy and that France would not undergo further austerity measures.

Crash-test of a 2010 Hyundai Tucson GLS at the...  Actually, a lot of people had expected the downgrade and to some extent the markets had probably already digested the news because their reaction was relatively subdued. The other two major agencies, Fitch and Moore's, were expected to follow soon. France lost its triple A rating by one notch and Italy was down two notches to BBB+ with a "negative" outlook.  All Euro-zone countries were downgraded except Germany, Belgium, the Netherlands and Luxemburg. Mind you Germany maintained its triple A but got a "negative" outlook.

Commentators across the political spectrum in Italy pointed to Prime Minister Monti's courageous package of austerity measures. You could sense the disappointment: after all, big efforts had been made - in the order of €30 billions.  The downgrading seemed to overlook the fact that Italy has one of the most solid banking sectors in Europe. For example, Italian banks hold some €750 million of "toxic" Greek bonds as compared with several billions said to be held by banks in France, Germany and the UK. Moreover, Italy presently enjoys a healthy public debt situation, with tax revenues reportedly flowing in at a higher rate than current payments on the debt.

Others pointed to another worrying dimension to the downgrading of the French debt: since France was originally one of the triple A rated Euro-zone governments guaranteeing the future European Financial Stability Fund (EFSF) designed to come in aid of Euro-zone governments in difficulty, its downgrading was seen as a bad omen for the future of the Euro.

How important is this? Frankly, I believe not that much. At this point in time, what the European Central Bank does (or doesn't do) is far more important for the health of the Euro than whatever role the EFSF might be able to play in future. More on this in a moment.

Another bad omen is the breakdown of the Greek government talks with private banks to renegotiate its debt. In practice, this could be interpreted as tantamount to a Greek default. This bit of news was overshadowed by the credit downgrading news, but from a practical point of view it is far more worrying. After all, credit rating agencies' reputation is not exactly golden: these are the same agencies that gave a few years ago a triple A to Enron and to American banks in spite of their subprime mortgage activities...And credit rating agencies get paid by their customers (banks etc) for this type of rating whereas the ratings on a country's sovereign debt are given out free. 

One may well wonder about such a business model that is predicated on a rather improbable wall separating the agencies' work on sovereign debt from that on private debt.

By Friday night,  a common statement was expected from Brussels but as I write it hasn't come yet. One can expect the Eurogroup Ministers of Finance to express disdain and contest the downgrading. They might even hint at creating a European Credit Rating Agency. Many see a "European" agency as the proper counter move against the "American" agencies. 

Apart from the chauvinistic satisfaction it might give some people, I don't believe a European credit agency would serve to change the rules of the game. 

First it would need to establish a reputation for independence. If it fails to do so, it would be useless - just as useless as the Chinese credit rating agency is. No one follows what the Chinese agency says because everyone is convinced it is subservient to the Chinese government. 

Second, there would be a need to change investment rules for many if not most big institutional investors (pension funds etc). This is the crux of the credit agency problem: a lot of institutional investors are obliged to follow investment rules that include respecting the ratings given by the "big" three agencies. So when Italy loses its A rating and goes into the B class, it can expect that a whole lot of investors that might have bought its bonds in future won't be able to do so anymore.

The solution? For the Euro, there is an urgent need to make investors AND credit rating agencies understand that the Euro is collectively defended and protected. It makes no sense at all to maintain the triple A credit rating for some countries like Germany and lower it for all the other Euro members. 

Because if France and Italy go down, you can bet that Germany will too. It may well be the biggest European economy and the healthiest in terms of employment and exports, but France and Italy taken together are much bigger than Germany. 

There is no way that Germany can sustain the Euro on its own. Nor for that matter can it get out of the Euro. If Germany tried to get out, leaving aside the cost and logistical mess caused by tearing up the Euro, one can expect the reborn Deutsche Mark to shoot up. It would probably to double the current level of the Euro, effectively killing off all German exports. Whereas, as of now, with a weak Euro with respect to the dollar, it's all to the benefit of German exports.

No, such a mega-scenario is not credible. 

The only problem and the real one is and remains Greece. The reason why talks have broken down with the European big banks (French, German etc) said to be holding Greek toxic bonds is simply that they longer hold these bonds! Rumors have been circulating that they had offloaded their bonds to private hedge funds located in London and elsewhere. So now all those banks look "clean" and the Greek bonds are in private hands somewhere and nobody knows where. But the investors who hold them are savvy types: I'm willing to bet they got them at say around 40% of value (or even less) and expect Greece to pay them at 50% (that's the rate that was reportedly under discussion) or higher. So in a few months they will have made tons of money...while the Greek GNP keeps contracting further and further under the weight of austerity measures.

Is that what Germany wants for its Euro partners? 

It is high time that the European political class stop talking about creating new European institutions such as the EFSF and concentrate instead on allowing the one institution that exists, the European Central Bank (ECB), to function as it should. It is incoherent to expect the ECB to fight inflation when the problem is recession and deflation. The Germans should understand this. 

The ECB chart does say the Bank is to fight inflation but it also says the Bank is supposed to insure the stability of the Euro. That means, regardless of what the Germans think, that the Bank must defend the Euro with all and every means available to a central bank.

When will the European Central Bank become independent from German diktaats?

Model of the ECB's new headquarters, which is ...                                    Model of New ECB Building to be Completed in 2014  
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