S&P downgrade threat a clarion call for euro reform

A threat by Standard & Poors to slash credit ratings across the euro zone has sounded a clarion call, which could help Nicolas Sarkozy and Angela Merkel force through a change to the European Union treaty at a summit this week.

The French president and German chancellor are determined to change European rules to impose mandatory penalties on countries that exceed deficit targets, aiming to restore market confidence and prevent a sovereign debt crisis spiraling out of control.

Citing “continuing disagreements among European policy makers on how to tackle the immediate market confidence crisis,” S&P threatened to cut the credit ratings of 15 countries, including Germany and France, by 1-2 notches.

It also warned of slowing growth amid so much austerity, predicting a 40 percent chance of a fall in euro zone output.

A downgrade could automatically require some funds to sell bonds of affected states, making those countries’ borrowing costs rise still further.

Merkel brushed off the threat.

“What a ratings agency does is its own responsibility,” she said, promising that European leaders would make decisions at this week’s summit that would restore confidence.

Her party’s budget spokesman, Norbert Barthle, put an optimistic gloss on the S&P action.

“I actually see a positive effect, because now everyone must be aware of how serious the situation is,” he told Reuters. “This will help with the implementation of the proposals laid out by Chancellor Merkel and President Sarkozy to help stabilize the euro zone.”

Jean-Claude Juncker, chairman of the 17 euro zone finance ministers, said he was “astonished” by S&P’s announcement.

He described it as “a wild exaggeration and also unfair” and said it failed to take into account a new austerity plan for Italy, which pulled borrowing costs for the biggest of the euro zone’s ailing countries back from the brink.

In Paris, Sarkozy’s office said S&P had taken its decision last Tuesday, before both the Italian budget and the Franco-German plan for stricter budget rules.

U.S. Treasury Secretary Timothy Geithner arrived in Frankfurt to confer with several key European policymakers ahead of the summit on Thursday and Friday, a sign that Washington shares the view that the event will be a make-or-break moment for the global economy.

He will meet the leaders of Germany, France, Italy, Spain, the EU institutions and the European Central Bank to press for decisive action to arrest the crisis on his fourth trip to the troubled region since early September.

Sarkozy and Merkel’s plan to force states to cut deficits would be accompanied by an early launch of a permanent bailout fund for euro states in distress.

That could provide the political cover that the European Central Bank needs to buy more bonds of ailing countries as a short-term stopgap, preventing countries from running out of money if they cannot sell bonds on the open market.

INVESTORS CHEER

ECB chief Mario Draghi, who conferred with Geithner on Tuesday, has signaled that a euro zone “fiscal compact” could encourage the central bank to act more decisively on the crisis. It has been reluctant to buy up debt from distressed euro states more aggressively, arguing doing so would take pressure off governments to fix their finances.

Just last month, that fate appeared to be approaching for Italy after the interest rate demanded by investors to lend to it soared above 7 percent. But investors cheered a plan announced on Monday by new technocratic prime minister Mario Monti, slashing Rome’s borrowing costs.

Were it not for his 30-billion-euro austerity plan, Monti declared, “Italy would have collapsed, Italy would go into a situation similar to that of Greece.” Yields on Italian 10-year bonds fell to 6 percent, a full percentage point lower than last week.

Sarkozy and Merkel say they want treaty changes to be agreed in March and ratified after France wraps up presidential and legislative elections in June.

“We need to go fast,” Sarkozy said.

S&P said it would conclude its review “as soon as possible” after the summit, making clear that it wanted to see political as well as financial solutions.

It said ratings could be lowered by one notch for Austria, Belgium, Finland, Germany, the Netherlands and Luxembourg, and by up to two notches for the remaining nine placed under review, including currently AAA-rated France. Cyprus was already on downgrade watch and Greece already has a ‘junk’ CC-rating.

European stocks, bond futures, and the euro were hit by the shock warning, halting a rally in global equities that began last week as the MSCI world equity index fell 0.6 percent.

Bond yields across the euro zone rose, with top-rated German and French bonds underperforming peripheral debt as a recent flight to quality began to unwind.

After two hours of talks with Merkel in Paris on Monday, Sarkozy told a joint news conference: “What we want … is to tell the world that in Europe the rule is that we pay back our debts, reduce our deficits, restore growth.”

Merkel added: “This package shows that we are absolutely determined to keep the euro as a stable currency and as an important contributor to European stability.”

Sarkozy and Merkel said they would send their plan to European Council President Herman Van Rompuy on Wednesday, in time for Friday’s summit. The Belgian, who will chair that crucial meeting, would have preferred to avoid treaty change but has been sounding out other governments on their receptiveness.

If countries such as euro outsider Britain blocked a treaty change for all of the 27 EU members, the 17 states that use the common currency could proceed with an agreement on their own, Merkel and Sarkozy said .