Eurozone crisis: signs of hope … then credit agencies strike

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    Larry Elliott, economics editor
  • guardian.co.uk, Friday 13 January 2012

It had all been going so well for the euro before the curse of Friday the 13th struck. Spain and Italy had held successful bond auctions, the Greeks were holding fruitful talks with their creditors, the pressure from the financial markets was abating. There were the first whispers, with fingers firmly crossed, that a turning point had been reached in the crisis that has blighted the single currency for the last two years.

But around lunchtime rumours surfaced that the ratings agency S&P had chosen this singularly inappropriate moment to detonate the bomb that has been waiting to go off for the past five weeks – a debt downgrade of eurozone countries. The fact that the story was datelined Berlin was significant: this was a German source leaking the fact that Europe's most powerful economy was not on the list of shame.

France, though, has lost its coveted AAA status, leaving the state of play in the Anglo-French war of the rating agencies as David Cameron 1 Nicolas Sarkozy 0. The concerted attempts by the French establishment to persuade S&P, Moody's and Fitch that Britain was more deserving of a downgrade have fallen on deaf ears. France will be inconvenienced by having its debt status reduced by one notch but the real effects will be psychological and political.

For Sarkozy, months away from a presidential election, the news that France is being downgraded but Germany and the UK will remain AAA is nothing short of disastrous. Cameron should not be too smug, though. If, as looks entirely plausible, the UK economy is going backwards it will only be a matter of time before the rating agencies contemplate a downgrade on this side of the Channel.

There will, of course, be economic consequences of the S&P decision – most, if not all, of them deleterious. Europe's bailout fund for troubled single currency countries, the European Financial Stability Facility, relied on the AAA status of France for its own top-notch rating. The French downgrade means an EFSF downgrade, which will make it more difficult and more expensive to raise funds from financial markets and sovereign wealth funds.

Unsurprisingly, the European Central Bank was active in the bond markets on Friday afternoon buying Italian debt. One consequence of the downgrade rumour was that Italian bond yields – the interest rate Rome has to pay on the money it borrows – started to climb back towards 7%, but the ECB's intervention capped the rise. Further upward pressure can be expected next week.

Business and consumer confidence, already at a low ebb, will take another hit. The eurozone is already on course for a nasty double-dip recession this year: that downturn is now likely to be that bit deeper and longer.

On the foreign exchanges, the euro fell sharply against the dollar to a 16-month low, providing the one silver lining because a cheaper currency will be a boost for Europe's exporters.

With the global economy slowing, that will not be enough in itself to generate the growth necessary to reduce budget deficits and thus satisfy S&P and the others that eurozone nations are licking their public finances back into shape. An unsustainable mix of austerity, slow growth and rising debt means that this will not be the last downgrade seen in 2012, and although Germany emerged unscathed this time it too will come under scrutiny.

Why? Because Germany's export-led growth is vulnerable to a slowdown in the rest of the eurozone, and Berlin will now come under even more pressure to sign the cheques needed to keep monetary union in one piece. The knowledge of what has happened to Sarkozy will make Angela Merkel even more wary about doing anything that could trigger a German downgrade, and she will take an even more uncompromising approach in negotiations with countries seeking bail-out funds.

There could be some fun and games early next week. The EFSF is trying to raise money in the financial markets, while it was announced yesterday that Greece and its private-sector creditors have so far failed to reach an agreement on a debt-reduction deal. Talks are not due to re-start until Wednesday and although the signs last night were not encouraging some sort of agreement does look probable. At this juncture, nobody – the Greeks, Merkel, the ECB, the private sector creditors – wants Athens to default.

This, then is the start of a crucial six-month period for the eurozone. The final few weeks of 2011 were used productively by the ECB to buy some time, by cutting interest rates and by offering hard-pressed European banks cheap funding for three years. But the S&P announcement demonstrated just how hard it is, given the deep-seated nature of Europe's problems, to secure a breathing space – and why it is far too early to assume the worst is over.