Sizing up the implication of S&P's downgrades in Europe

This is a good analysis - hitting the high points , Germany comes out with the strongest hand . Perhaps we should refer to the Merkel - Sarkozy duo and MERkozy moving forward ? And what will happen with the EFSF and ESM movong forward - will they lose lending capacity ( as well as the ability to leverage ) moving forward or will Europe opt to offer greater guarantees to maintain the AAA fiction for the EFSF and ESM ? Anyway , here are some thoughts from an RBS analyst below ....

Overall, the most notable outcome was the clear differentiation between Germany and all other AAAs countries. Germany comes out as a clear winner with a stable outlook. The French downgrade comes at a d time and will likely complicate domestic politics ahead of the critical general elections. Likewise, France’s position at the European negotiating table is likely to be weakened vis-à-vis Germany. This might render future negotiations surrounding fiscal integration even more difficult.

As was anticipated, S&P mentioned that the key rationale behind the downgrades was the lack of decisiveness and effectiveness in the European policy response. The criticism seems to be aiming at the lack of firepower of the fiscal backstops rather than the ECB itself which was praised for its actions. In this context, it is rather surprising that the treatment of EMU solidarity contingent liabilities was quite different between countries, with the harshest words for France and not even a mention for the other AAAs including most surprisingly Germany. Other factors mentioned relate to the risk of further fiscal deterioration.

Although Euro area member states “will explore the options” to keep the EFSF’s triple-A, we expect S&P will ultimately align the EFSF’s rating with that of France and Austria at AA+. Indeed, in order to maintain the AAA rating of the EFSF, euro area policy makers would have to accept a reduction in the lending capacity of the EFSF by Eur169bn. Alternatively they would need to increase their guarantees significantly, something we believe unlikely at a time that the focus is shifting on the ESM.

The upcoming ESM will however also face a difficult trade-off between higher lending volume and achieving a AAA rating. With no further increase to the current callable capital levels, the lending capacity of the ESM would decline by Eur200bn. To maintain the current lending capacity and its AAA, then member countries would need to double their level of callable capital into the ESM compared to current commitment. Should euro area policy makers want to double the lending capacity of the ESM from pre downgrade times (while maintaining its AAA), then the ESM would need a callable capital of almost 30% of euro area GDP! Discussions surrounding the potential increase in the size of the ESM in March will be more difficult post downgrade.

The EIB and EU will most likely be able to avoid a downgrade, with the latter having a higher likelihood of a rating confirmation. A negative outlook, particularly in the case of EIB, cannot be ruled out however.

We are alert to a more muted market impact near term by domestic buying (France) and ECB buying (Italy/Spain) but the negative rating outlooks (ex-Germany and Slovakia) means risks can quickly return. For instance, the downgrade for France and Austria will mean technical shifts into better rated markets for collateral purposes. The Austrian downgrade was not consensus but more generally the negative market outlook for France also hurts. Italy faces similar collateral demand weakening, and this continues a trend.

The general EGB flow is buying in domestic markets and buying safety/liquidity and France will lose some traction on this score and since most of the debt in EMU is held by EMU residents (and can not be shifted out of Euros wholesale) then Bunds will see increased structural support towards that will keep short end yields negative and gradually support our (still) bullish view on German bonds. We reiterate that the German bond view is not the same as a view on the German credit given the flow of funds.

Italy’s move to a BBB+ means it is now much closer to Junk status and we agree with S&P in that austerity is likely to be self-defeating and political risks remain high.

Overall, while the market impact of the downgrades is unlikely to be very significant in the short term, they serve as a stark reminder that the euro area sovereign crisis is here to stay. More importantly, these downgrades are likely to solidify expectations that neither the EFSF nor the ESM will be able to maintain their AAA rating. This in turn is likely to make any significant increase in the lending capacity of either institution more difficult. We continue to expect the crisis to deepen eventually leading to further widening in spreads across countries vis-à-vis Germany.