Big 5 economies sliding down

September 4, 2012 (TSR) – Moody’s Investor Service has lowered the EU’s triple A rating outlook to negative, warning it might downgrade the bloc if it decides to cut the ratings on the EU’s four biggest budget backers: Germany, France, UK and Netherlands, which together account for around 45% of the EU’s budget revenue, thus adding pressure on the European Central Bank to provide details of a new debt-buying scheme to help deeply indebted euro zone states at its policy meeting on Thursday (6 September).

The outlook change did not result in a change from the Aaa rating.  The press release from Moody’s provided this explanation:

The outlook change to negative reflects the negative outlooks now assigned to the Aaa sovereign ratings of key contributors to the EU budget: Germany, France, the UK and the Netherlands, which together account for around 45% of the EU’s budget revenue.  Moody’s believes that it is reasonable to assume that the EU’s creditworthiness should move in line with the creditworthiness of its strongest key member states considering the significant linkages between member states and the EU, and the likelihood that the large Aaa-rated member states would likely not prioritise their commitment to backstop the EU debt obligations over servicing their own debt obligations. On 23 July 2012, Moody’s had changed to negative its outlooks for the Aaa ratings of Germany and the Netherlands.

The credit rating agency acknowledges that there are structural features in place that enhance the EU’s creditworthiness, however, they are in Moody’s view not sufficient to delink the EU’s ratings from the ratings of its strongest key member states.

According to Moody’s, the “debt issued by the European Union is backed by multiple layers of debt-service protection: 1) the borrowing country’s promise to repay its loan (the funds raised are lent back to back, and the borrowing country pays down the interest and loan principal; 2) the EU’s budgetary resources; and 3) the European Commission’s right to call for additional resources from member states, if needed.”

They explained that “in the event of a scenario of extreme stress in which Aaa-rated member states would default on their debt obligations, 1) defaults on the loans that back the EU debt would be highly likely, 2) the EU’s cash reserve would likely be stressed, and 3) the EU member states would likely not prioritise their commitment to backstop the EU debt obligations over the service of their own debt obligations.

Hence, they suggested that the EU’s creditworthiness should move in line with the creditworthiness of its strongest key member states.

The EU’s conservative budget management is based on the EU Treaty, which requires the European Union to balance the EU budget, prohibiting any borrowing to cover budgetary shortfalls. In addition, the EU’s Multiannual Financial Framework (MFF) provides the general framework for a seven-year period and establishes a ceiling for total expenditures for the annual budgets during that period.

Back in July, Moody’s changed its outlook for Germany, the Netherlands and Luxembourg to negative as fallout from Europe’s debt crisis cast a shadow over its top-rated countries. The outlook on France and the UK are also negative.

Purchasing Managers’ Index reports from Markit Economics indicate economic contraction for the thirteenth successive month from individual European nations:

Ireland  50.9            4-month low

Netherlands  49.7   6-month high

Austria  46.7           37-month low

France  46.0            4-month high

Germany  44.7       2-month high

Spain  44.0             5-month high

Italy  43.6               10-month low

Greece  42.1           3-month high


Greece’s progress report is also due in September from the troika—the European Commission, ECB, and International Monetary Fund. There are early signals that indicate the report will criticize Greece’s implementation of its austerity program.

Greek Prime Minister Antonis Samaras has asked to delay some of the agreement’s target dates, citing a much deeper recession in Greece than was assumed when the pact was negotiated.

Germany, a key player in the talks, shows no inclination to alter the current deadlines.

This refusal to give Greece more room to address its economic woes could set the stage for Greece’s exit from the euro according to Moodys. Such a scenario is inevitable if Greece fails to meet a target and the EU withdraws its financial support from the government. Without funds from the EU, Greece would default on its loans and be unable to pay state workers in euros, forcing it to leave the union and resume printing its own currency. Moody’s estimates a 45% chance of this occurring within the next two years.

Greece can go but not Spain

While northern European leaders say the euro zone could survive without Greece, the cost could be quite significant, undermining market perceptions about the currency union’s permanence. Spain would most likely suffer first from this change in market psychology, seeing its bond yields rise sharply. If the contagion from Greece’s exit is severe enough, it could spell the end of the single currency.

However, odds are that Europe’s leadership will do what it takes to keep the euro zone together, showing measured but temporary flexibility with Greece while it works through its fiscal problems. At some point, Greece still may have no option other than leaving the euro zone but only after the ECB is certain that the exit will not set off a calamitous chain reaction—meaning not for two years, at least.

Planning for a post-euro world

The euro zone’s political and policy paralysis casts a dark shadow. The U.S. election season and the possibility that the world’s largest economy will stall as fiscal policy slams on the brakes early next year is paralyzing business and household decisions. Worse, emerging economies such as Brazil, China and India are at more risk than they were during the 2008-2009 recession. Room to expand fiscal spending is limited and inflationary fear has constrained monetary policy. In tandem, the high level of uncertainty created by the euro zone crisis and the U.S. “fiscal cliff” is suppressing private investment across the globe.

For European policymakers, a collapse of the currency union is almost unthinkable; litigation over existing euro contracts alone would create a nightmare. The cost of a Greek exit is manageable by comparison. It appears from the drama being played out in Berlin and Brussels that this is the outcome European leaders are anticipating. Nonetheless, legal departments in international corporations and trading companies and even some member nations of the euro zone are quietly making plans in case the currency union falls apart. Negative bond yields in Denmark and Switzerland are the result of investors parking money in safer currencies to hedge against a euro collapse.

For better or worse, punishing Greece for its fiscal profligacy is a popular idea in northern Europe. Doing so will send the message to other peripheral euro zone member countries that membership is not guaranteed and bad behavior will be punished. It also creates a strong foundation for a closer fiscal, political and monetary union in Europe.

Germany under huge pressure

The predominant risk to our outlook is to the downside. While the U.S. government is expected to negotiate a moderate path around the 2013 fiscal cliff, uncertainty will continue to color investor perceptions until Washington’s fiscal course is clear. On the upside, quick definitive action by the ECB to resolve the euro crisis could provide a considerable boost to the global economy. Such a decision will be made mainly on political grounds, and a change in the ruling party in Berlin next year could tip the balance in favor of an activist central bank.

It is important to note that a controversy arose as a result of a leaked comment by European Central Bank President Mario Draghi that the ECB could begin buying three-year bonds from Eurozone countries.  The leak about the bond-buying program would not be announced until Thursday, at the conclusion of an ECB rate-setting meeting was described by an ECB official as a breach of confidence.


Global growth has been tepid and uneven and is expected to remain so through the rest of 2012. A large part of Europe is either in recession or sliding toward it. The recovery in the U.S. is slow but relatively solid. In Asia, performance is uneven, with China and India decelerating while other small East Asian economies experience unexpectedly strong growth. Australia, where the economy is tied closely to China, is slowing in tandem with its largest trading partner. South America’s agricultural commodity exporters are experiencing a boom as agricultural regions in North America and elsewhere experience drought conditions. Metal and nonmetal commodity exporters are seeing prices fall as growth slows in India and China. Oil exporters are enjoying a temporary bump in fortune due to the West’s embargo of Iran.

Moody’s said the outlook for the EU could go back to stable if the outlooks on the four key triple A countries also returned to stable.

The agency also changed to negative the outlook the European Atomic Energy Community (Euratom), on whose behalf the European Commission is also empowered to borrow.

Source: Moodys/Lady MJ Santos


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