14th January - 'Au revoir' AAA

On the 14th January, France finally - and officially - lost its AAA credit rating. Had Sarkozy not made such a fuss about the importance of retaining it last year, it might not have been such a big deal. As it is, reports speak of Eurozone doom and little else. In total, nine countries in the Eurozone were downgraded; Italy, Spain, Cyprus and Portugal were cut two notches, with the latter two given "junk" ratings. Austria, Slovakia, Slovenia and Malta were the other countries downgraded. Germany kept its AAA rating.

But what do the downgrades mean? The sovereign debt rating is an instrument designed to gauge the likelihood of a state being able to repay its debts. There are several considerations that come into play here, discussed in another post. But here's where France and the UK differ - if the UK runs into problems repaying debts, the Bank of England can print more money and off we all go. The government has shown that it is not afraid to turn to quantitative easing, and this is an important reason why the UK - even with current debt levels - is much less likely to default that France, regardless of the devaluation that occurs. Germany has repeatedly blocked moves to allow the European Central Bank to print Euros, so France only has a finite supply. Considering Germany's experience with hyper-inflation in the 1920s, this is understandable, but leaves the Eurozone in a difficult situation.

Moreover, considering France was one of the main backers of the EFSF, the loss of a French AAA rating clearly had implications for the future of the fund. Two days later Standard & Poor's downgraded the EFSF from AAA to AA+. The loss of AAA ratings effectively reduced the fund's AAA rated guarantees from €440 billion to €260 billion. Approximately €40 billion of this will go to bailing out the Irish Republic and Greece, while €100 billion had been ear-marked for a second Greek bailout. Due mainly to procrastination and posturing on the part of Eurozone leaders, this latter has now risen to an expected €145 billion, however Greece is currently under huge pressure to implement further austerity reforms before this second bailout will be agreed.

France downgraded due to "technical error"

Standard and Poor's mistakenly downgraded France yesterday due to a "technical error". This was at the expense of France, who, along with the rest of Europe, are still incandescent over the episode. It appears that a message was sent out to some subscribers stating that France's sovereign rating had been downgraded. However less than two hours later the agency withdrew the statement and reconfirm the country's AAA/A-1+ rating. The erroneous announcement caused a surge in French 10-year bond yields by up to 28 basis points, up to 3.456 per cent, although these fell again following the retraction.

Last month, Moody's stated that France was - financially speaking - the weakest economy in Europe to still cling on to its AAA credit rating, and put it on a three-month review period (see earlier post here). French bank exposure to Greek and Italian debt means that this situation has not changed.
The technical error prompted French Finance Minister Francois Baroin to ask market regulators in France and Europe to investigate the "causes and potential consequences" of Standard and Poor's actions. France's stock market regulator, AMF, subsequently opened an investigation into the incident. France's fiscal policy is premised on its AAA rating, and Nikolas Sarkozy has effectively pinned his re-election hopes on retaining the rating. A second package of austerity measures in three months was announced this week by the French prime minister, Francois Fillon.

A downgrade for France would almost certainly entail a downgrade of the EFSF, which could pose big problems for the rest of Europe. However, considering that the Fund is unlikely to be able to cover significant bail out for larger European economies a modest increase in interest rates is unlikely to derail its use for smaller loans. However, the unhappy incident does prompt questions about the internal controls and screening mechanisms in place in the big three ratings agencies, not least how it could take nearly two hours for the CRA to realize its error.

While there is no press release or statement on Standard and Poor's website regarding the mistake, reactions in Europe indicate that the matter is not likely to die down soon. Speaking today, Michael Barnier, European commissioner for the internal market stated how serious the error had been. He emphasized that it was imperative that market players exercise discipline and a special sense of responsibility. Mr. Barnier is due to unveil a new regulatory regime for credit rating agencies on Tuesday.

In other developments, the Isle of Man was downgraded one notch to AA+ from its AAA credit rating by Standard and Poor's today. The agency cited reasons that the economy was small, undiversified and focused on financial services, all of which left it vulnerable to market shocks. The agency stated that by diversifying the economy of the crown dependency, the Isle of Man could regain its AAA rating.