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Friday, January 13, 2012

Friday the thirteenth in the eurozone…

Over on the Telegraph blog, we look at today's euro developments:

It all looked so good in euroland after a market rally and successful Italian and Spanish bond auctions this week. However, on Friday the eurozone crisis again took a turn for the worse. Standard & Poor's – the increasingly unpopular credit rating agency – is set to downgrade France and Austria from their AAA ratings. At the same time talks broke down over what losses banks and other bondholders will be forced to accept when Greece writes down its massive debt, injecting another huge dose of uncertainty into the euro mix.

Euro policy geeks are already engaged in fierce debate about which of these two events constitute the worst news for the eurozone. Let’s have a look:

Downgrades: Friday the thirteenth jinx aside, this downgrade could be spotted a mile away with S&P putting the whole eurozone on negative watch before Christmas. Other eurozone downgrades are also taking place, notably of Italy, but the loss of AAA ratings are undoubtedly the most critical. In addition to the symbolism of having one of the EU’s big three economies downgraded, the eurozone’s €440bn temporary bailout fund (the EFSF) – aimed at backstopping fragile euro states – could be soon to follow. The EFSF needs its current AAA rating to continue to dish out cheap loans to Greece, Portugal and Ireland (and any other country that might need help). But as France is a major contributor to the EFSF, a downgrade for the country could result in a corresponding slash to the rating of the EFSF.

The effect would be higher borrowing costs for the struggling countries that tap the fund, reducing effectiveness of the ESFS as a backstop measure. In addition, an EFSF downgrade will make the fund – and the eurozone – even more reliant on German taxpayers. This would further expose the German economy to potentially bad eurozone debt and, at worst, even threaten the country's own credit rating.

It also raises even more questions about an EU plan, currently being negotiated, to increase the lending capacity of the EFSF through a complicated leveraging and insurance scheme (for details, see here). You simply cannot create money out of nothing – and even more so when one of your key players has just suffered injury.

So expect short term market jitters. But so far, we’re only looking at one credit rating agency, with the other two holding their fire – which is probably why the news coming out of Athens is more significant.

Greece: The negotiations over losses for investors in a voluntary restructuring of Greek debt are starting to look like a bad horror movie. For all the grand talk from EU leaders and officials, bondholders (especially smaller firms such as hedge funds) still have a massive incentive not to participate in the voluntary restructuring – either Greece pays back the money they owe them or there is a default, in which case their insurance on Greek debt (known as credit default swaps) are paid out and they recoup their losses at least.

The crux is that Germany and the IMF in particular have made a write down of Greek debt a precondition for paying out the next trance of bailout money, which Athens needs by March 20 to pay off €14 bn in debt due. If neither Greece, the bondholders nor Germany/IMF blink, we may be looking at a forced Greek restructuring (where Greece legally enforces losses on bondholders) or even a full default and, at worst, a eurozone exit. But there’s still plenty of negotiating time before March.

What’s clear is that both the downgrades and the break-down in the Greek restructuring talks could change the face of the eurozone crisis. Though the downgrades seem more dramatic now, the Greek problem could soon begin to hit home. An enforced write-down or uncontrolled default both essentially amount to the same thing in the eyes of the markets and investors will begin to have doubts about the future of other eurozone countries – if a default can happen in Greece, why not in other insolvent eurozone states?

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