euro area economics - implications of s&p downgrade _ rbs dec 2011
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Euro Area Economics11 December 2011
Important disclosures can be found on the last page of this publication.
Analysts
Jacques Cailloux
Chief European Economist
+44 20 7085 4757
Nick Matthews
Senior European Economist
+44 20 7085 0173
Michael Michaelides
Covered Bond/Agency Strategist
+44 20 7085 1806
Harvinder Sian
Rates Strategist
+44 20 7085 6539
Frank Will
Head of Covered Bond Research
+44 20 7085 2091
www.rbsm.com/strategy
Bloomberg: RBSR
Implications of S&P
downgradesFrance loses it and so does AustriaThe market implications of the ratings review are worse than a whole downgrade of the
region owing to the increased political wrangling, questions on the EFSF/ESM firewall
and the fact that flight to quality still has somewhere to go. Germany comes out as a
clear winner and will have its position at the negotiating table strengthened even
further. The French downgrade will complicate future negotiations around fiscal
integration and comes at a delicate time domestically. The loss of the AAA is likely to
be politicised in the run up of the upcoming general elections and could lead to an
increase in popular support for fringe parties.
S&P made its long awaited announcement since placing 15 euro area sovereigns on
CreditWatch with negative implications in early December. Despite warning of the
potential for a blanket downgrade of all sovereigns (apart from Greece, which is already
rated CC), S&P have instead taken a more selective approach.
The ratings of seven countries were left unchanged (Belgium, Estonia, Finland,
Germany, Ireland, Luxembourg, the Netherlands), while there were one notch
downgrades for five countries (Austria, France, Malta, Slovakia and Slovenia). Two
notch downgrades were given to four countries (Cyprus, Italy, Portugal and Spain). The
new ratings and changes are shown below.
All countries were removed from CreditWatch, but 14 countries have negative outlooks
(the only exceptions being Germany and Slovakia), indicating that S&P see at least a
one-in-three chance that the rating will be lowered in 2012 or 2013. The outlook horizon
for investment grade countries is up to two years, but only up to one year for
speculative-grade ratings.
Greece was not part of this exercise and remains CC with negative outlook. S&P
assigned a recovery rating of 4 to Cyprus and Portugal (as they moved into
speculative-grade category), indicating an expected recovery of 30-50% should a
default occur.
Overall, the most notable outcome was the clear differentiation between Germany and
all other AAAs countries. Germany comes out as a clear winner with a stable outlook.
The French downgrade comes at a d time and will likely complicate domestic politics
ahead of the critical general elections. Likewise, Frances position at the European
negotiating table is likely to be weakened vis--vis Germany. This might render future
negotiations surrounding fiscal integration even more difficult.
As was anticipated, S&P mentioned that the key rationale behind the downgrades was
the lack of decisiveness and effectiveness in the European policy response. The
criticism seems to be aiming at the lack of firepower of the fiscal backstops rather than
the ECB itself which was praised for its actions. In this context, it is rather surprising
that the treatment of EMU solidarity contingent liabilities was quite different between
countries, with the harshest words for France and not even a mention for the other
AAAs including most surprisingly Germany. Other factors mentioned relate to the risk offurther fiscal deterioration.
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Although Euro area member states will explore the options to keep the EFSFs triple-
A, we expect S&P will ultimately align the EFSFs rating with that of France and Austria
at AA+. Indeed, in order to maintain the AAA rating of the EFSF, euro area policy
makers would have to accept a reduction in the lending capacity of the EFSF by
Eur169bn. Alternatively they would need to increase their guarantees significantly,
something we believe unlikely at a time that the focus is shifting on the ESM.
The upcoming ESM will however also face a difficult trade-off between higher lending
volume and achieving a AAA rating. With no further increase to the current callable
capital levels, the lending capacity of the ESM would decline by Eur200bn. To maintain
the current lending capacity and its AAA, then member countries would need to double
their level of callable capital into the ESM compared to current commitment. Should
euro area policy makers want to double the lending capacity of the ESM from pre
downgrade times (while maintaining its AAA), then the ESM would need a callable
capital of almost 30% of euro area GDP! Discussions surrounding the potential
increase in the size of the ESM in March will be more difficult post downgrade.
The EIB and EU will most likely be able to avoid a downgrade, with the latter having a
higher likelihood of a rating confirmation. A negative outlook, particularly in the case of
EIB, cannot be ruled out however.
We are alert to a more muted market impact near term by domestic buying (France)
and ECB buying (Italy/Spain) but the negative rating outlooks (ex-Germany and
Slovakia) means risks can quickly return. For instance, the downgrade for France and
Austria will mean technical shifts into better rated markets for collateral purposes. The
Austrian downgrade was not consensus but more generally the negative market
outlook for France also hurts. Italy faces similar collateral demand weakening, and this
continues a trend.
The general EGB flow is buying in domestic markets and buying safety/liquidity and
France will lose some traction on this score and since most of the debt in EMU is held
by EMU residents (and can not be shifted out of Euros wholesale) then Bunds will see
increased structural support towards that will keep short end yields negative andgradually support our (still) bullish view on German bonds. We reiterate that the
German bond view is not the same as a view on the German credit given the flow of
funds.
Italys move to a BBB+ means it is now much closer to Junk status and we agree with
S&P in that austerity is likely to be self-defeating and political risks remain high.
Overall, while the market impact of the downgrades is unlikely to be very significant in
the short term, they serve as a stark reminder that the euro area sovereign crisis is
here to stay. More importantly, these downgrades are likely to solidify expectations that
neither the EFSF nor the ESM will be able to maintain their AAA rating. This in turn is
likely to make any significant increase in the lending capacity of either institution more
difficult. We continue to expect the crisis to deepen eventually leading to further
widening in spreads across countries vis--vis Germany.
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Euro area S&P ratings
Euro areacountry
Old S&Prating
S&P possibledowngrade
limit (5th Dec)
Actualdowngrade
New S&Prating
Outlook Grade
Austria AAA 1 notch 1 notch AA+ Negative Investment
Belgium AA 1 notch unchanged AA Negative Investment
Cyprus BBB 2 notch 2 notch BB+ Negative Speculative
Estonia AA- 2 notch unchanged AA- Negative Investment
Finland AAA 1 notch unchanged AAA Negative Investment
France AAA 2 notch 1 notch AA+ Negative Investment
Germany AAA 1 notch unchanged AAA Stable Investment
Greece CC - - CC Negative Speculative
Ireland BBB+ 2 notch unchanged BBB+ Negative Investment
Italy A 2 notch 2 notch BBB+ Negative Investment
Luxembourg AAA 1 notch unchanged AAA Negative Investment
Malta A 2 notch 1 notch A- Negative Investment
Netherlands AAA 1 notch unchanged AAA Negative Investment
Portugal BBB- 2 notch 2 notch BB Negative Speculative
Slovakia A+ 2 notch 1 notch A Stable Investment
Slovenia AA- 2 notch 1 notch A+ Negative Investment
Spain AA- 2 notch 2 notch A Negative Investment
Source: S&P, RBS
Only four AAA countries in the euro area remain on the S&P methodology (Germany,
the Netherlands, Finland and Luxembourg). While undoubtedly good news for these
countries, we view the decision to not apply a wholesale downgrade to all countries as
the worst possible outcome from a euro area crisis management perspective and might
contribute to shift euro investors into Germany and away from the EFSF and France.
Absence of a wholesale downgrade a surprise to us
While some of the downgrades are unsurprising, our core view was a wholesale
downgrade to all countries given that S&P was highlighting system-wide stresses
stemming from interrelated factors such as: (i) tightening credit conditions across the
euro area, (ii) markedly higher risk premiums on a growing number of sovereigns,
including some that were rated AAA, (iii) continuing disagreements among euro area
policymakers on how to tackle the crisis and ensure greater economic, financial, and
fiscal convergence among euro area members, (iv) high level of government and
household indebtedness across a large portion of the euro area, and (v) the risk of
recession in the euro area this year.
In our post-EU Summit assessment in December (Where is the Fiscal Union?, 11December 2011), we wrote: We see the next leg of this crisis as potentially being
triggered by wholesale rating downgrades by rating agencies as they become (i)
increasingly convinced that a recession is inevitable, (ii) the ECB will not QE the
system, (iii) the leaders are too slow to make the quantum leap into the fiscal union.
We covered extensively our thoughts over the chain reaction that could follow from a
wholesale downgrade of euro area members in Where is the Fiscal Union?, noting at
the time it was a scenario which we now believe to be very likely. We stated at the
time that the ramifications of such a decision by S&P, potentially to be followed in Q1
by Moodys, would be far reaching with supra national organisations such as the World
Bank at risk of downgrades.
To complement this note, we also encourage clients to re-read Section 3 Multiple
Sovereign downgrades are likely in Where is the Fiscal Union?, where we covered in
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detail the implications of downgrades for Supras & Agencies and Government
Guaranteed Debt, the impact on euro area banks and the transmission channels of
sovereign downgrades into banks.
In this note we focus on (i) S&Ps motivations for its ratings actions, (ii) implications of
the ratings downgrades on the EFSF, (iii) ESM, (iv) the negotiating power between
France and Germany, (v) the market impact of ratings downgrades, and (vi) the impact
on European supranationals.
1. S&Ps motivations for its ratings actions
S&P noted that its ratings actions were primarily driven by its assessment that policy
initiatives taken by European policymakers in recent weeks may be insufficient to fully
address ongoing systemic stresses in the eurozone. The stresses were said to include:
(i) tightening credit conditions, (ii) an increase in risk premiums for a widening group of
eurozone issuers, (iii) a simultaneous attempt to delever by governments and
households, (iv) weakening economic growth prospects and (v) an open and prolonged
dispute among European policymakers over the proper approach to address
challenges.
S&P remain unimpressed by the outcome of the EU Summit and subsequentpolicymaker statements and lead S&P to believe that the agreement reached has not
produced a breakthrough of sufficient size and scope to fully address the eurozones
financial problems. In particular, S&P noted its opinion that the political agreement
does not supply sufficient additional resources or operational flexibility to bolster
European rescue operations, or extend enough support for those eurozone sovereigns
subjected to heightened market pressures.
There was criticism of a reform process based on fiscal austerity alone which it said
risked becoming self-defeating. S&P stated refinancing costs for certain countries may
remain elevated, credit availability and economic growth may further decelerate and
pressure on financing conditions may persist. Therefore, external scores were adjusted
down for sovereigns considered most at risk of an economic downturn and deteriorating
funding conditions (eg. due to large cross-border financing needs).
Interestingly, S&P made clear that the ratings downgrades were not caused by any
inaction by the ECB. On the contrary, S&P said the ECB had been instrumental in
averting a collapse of market confidence. They highlighted the ECBs easing of
collateral requirements, an ever expanding collateral pool, the lowering of interest rates
to an all-time low of 1% and most importantly in our view, it has engaged in
unprecedented repurchase operations for financial institutions, greatly relieving the
near-term funding pressure for banks. However, S&P warned that while it currently
assessed the ECBs response as broadly adequate it said our view could change as
the crisis and the response to it evolves. It warned a lowering of the monetary score for
all eurozone sovereigns could have negative consequences for the ratings on a number
of countries.
Sovereigns with unchanged ratings (Bel, Est, Fin, Ger, Ire, Lux, Neth)
S&P highlighted these seven countries are likely to be more resilient in light of their
relatively strong external positions and less leveraged public and private sectors.
These credit strengths were said to remain robust enough to neutralise the potential
ratings impact from the political problems noted above.
Sovereigns with negative outlooks (all except Germany and Slovakia)
S&P believe downside risks persist and a more adverse economic and financial
environment could erode their relative strengths within the next year or two to warrant
further downward revision. The main downside risks affecting sovereigns to various
degrees are related to the possibility of further significant fiscal deterioration as a
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consequence of a more recessionary macroeconomic environment and/or
vulnerabilities to further intensification and broadening of risk aversion among
investors, jeopardizing funding access at sustainable rates. S&P also warned that a
more severe financial and economic downturn it expected could also lead to rising
stress levels in the banking system, potentially leading to additional fiscal costs for the
sovereign through bank workout/recapitalisation programmes. Furthermore, it also
highlighted a risk that reform fatigue could be mounting, especially in countries with
deep recessions and where growth prospects remain bleak, which S&P said couldeventually lead us to the view that lower levels of predictability exist in policy
orientation.
Overview of downside ratings triggers for S&P, covering major EGB issuers that were on ratings watch negative previously
Primary downside drivers to S&P ratings
Germany
Stable outlook reflect robust public finances/prudent budgets.
Downside risk if net govt debt/GDP moves to 100% from 80%
Downside risk from unexpected surge in contingent liabilities from domestic financials.
It curiously does not reference extra EMU solidarity contingent liabilities.
France
Negative outlook based on deviation of budgets from a consolidation path and announced measures may be insufficient ifgrowth falters, and net govt debt/GDP moves to 100% from 80%
Downside risk if heightened financing & economic risks in EMU lead to a significant rise in contingent liability or a materialwidening in external financing conditions. (This looks harsher than German/Dutch/Finnish risk on contingent liability.)
Netherlands
Negative outlook if public finances deviate in a significant and sustained way from the 2012-15 plan due to a prolongeddecline in growth.
If the government net borrowing exceeds 3% per year over the medium term
No reference to extra EMU solidarity contingent liabilities or financial sector contingent liabilities
Austria
Negative outlook given risks Austrian banks' balance sheets from negative developments in major trading and outwarddirect investment partners such that Austrian government needed to recapitalize the banks. This could lead to net generalgovernment debt rising above 80% of GDP, and could also further increase contingent liabilities.
Economic growth is much weaker S&P expect which could undermine budget consolidation and render structural reformsineffective, and see an increase in net general government debt beyond 80% of GDP.
No reference extra EMU solidarity contingent liabilities.
Finland
Negative outlook based on any sustained current account deficits or sustained deviation in public finances from theplanned budgetary consolidation path for any reason.
S&P references sustained net new borrowing of 2.5% GDP a likely to trigger a downgrade.
No reference extra EMU solidarity contingent liabilities.
Spain
Negative outlook based on delays in additional labour market and other growth enhancing reforms, or if the reforms aredeemed in sufficient.
The government does not undertake additional measures to broadly meet 2012 and 2013 of 4.4% and 3% respectively.
Further pressure from the private sector leads to a reassessment of sovereign fiscal performance, particularly if it results inan increased need for additional capital injections from the state or similar interventions.
Italy
Negative outlook on weaker-than-expected macroeconomic environment and deflationary pressures that reduce Italy's percapita GDP; and result in Italy's net government debt ratio continuing its upward trajectory.
Or else, on a prolonged worsening of financing conditions.
If the technocratic administration fails to implement necessary structural reform measures (that boost growth) whether onopposition from special interest groups, other incumbents or if the government's term is cut short before the mandate isfulfilled.
No mention here on additional financial sector contingent liabilities..
Portugal
Negative outlook on a more severe economic contraction resulting in worsening political environment and further negativeadjustment in the S&P political score.
In particular, continued fiscal austerity without improving growth prospects could result in widespread unemployment, whichcould negatively affect social cohesion & political support for the EU/IMF program.
If potential cost of recapitalizing Portuguese banks is likely to increase government debt burdens substantially..
IrelandNegative outlook ifweaker external demand results in lower economic growth undermining the government's strong policy
implementation.
If this was not offset by redoubled efforts to attain fiscal consolidation targets the S&P political score could be lowered.Source: RBS
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2. Implications for the EFSF
Back in July 2011 we stated that the biggest hurdle to a significant upsizing of the
EFSF was the implication of the contingent liabilities for AAA sovereign ratings:
Net/net, there are problems with upsizing the EFSF or ESM in terms of the size of the
contingent liability and the ratings threat to AAA countries and the EFSF itself. If any of
the large AAA countries is downgraded, then the EFSFs own AAA rating will also
be severely threatened and its lending capacity will be curtailed. (Euro areafaces break point | Lessons learned and policy options, 13 July 2011).
We also warned more recently (Where is the Fiscal Union?) that: downgrade of the
EFSF would also be particularly damaging and could affect significantly the ability of
this institution to access the market. Should the EFSF struggle to access markets, a
negative feedback loop would likely be created with the countries in most need of
financial resources likely to suffer most as market participants would start questioning
whether their funding needs could continue being met by the EFSF.
Without any changes to the structure of EFSF, the existing bonds will be downgraded in
line with France and Austria to AA+. This is because under the S&P treatment of EFSF,
all bonds must be fully covered by triple-A guarantees, or by triple-A collateral. This will
no longer be the case following the downgrade- see the impact for each of the
outstanding bonds below.
EFSF Bond-by-Bond Backing
Bond 2.75% Jul-2016 3.375% Jul-2021 2.75% Dec-2016 3.5% Feb-2022 1.625% Feb-2015 Total
Issued February 2011 June 2011 June 2011 November 2011 January 2012
Amount Issued ( mln) 5,000 5,000 3,000 3,000 3,000 19,000
Paid Out ( mln) 3,600 3,700 2,200 3,000 3,000 15,500
Recipient Ireland Portugal Portugal Ireland Ireland/Portugal
AAA Guarantors Left 43.8% 45.0% 45.0% 61.7% 61.7%
France 25.6% 26.3% 26.3% 36.0% 36.0%
Austria 3.5% 3.6% 3.6% 4.9% 4.9%
AAA Collateral 28.0% 26.0% 26.7% 0.0% 0.0%
Shortfall* (%) 29.1% 29.9% 29.9% 41.0% 41.0%
Shortfall* ( bn) 1,454 1,493 896 1,229 1,229 6,299
(*not including any shortfall from AAA collateral) Source: RBS
In essence this leaves the EFSF and the Euroarea member countries with two options:
(a) Provide loan specific buffer to support the existing AAA bonds but accept alower lending capacity going forward
(b) Accept a downgrade to AA+, keeping maximum lending capacity at 440bn
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Try and Defend the AAA
For existing bonds, the EFSF would need to pay in (or raise bond an additional
6.01bn1 to provide collateral to cover the loss of the AAA guarantees previously
provided by France and Austria.
There would also need to be a reallocation of any amounts from the loan specific
buffers from the first three bonds (worth a total of 3.5bn) invested in AAA assets,
which were French or Austrian AAAs. This includes the two sovereigns but also French
and Austrian agencies, such as ASFINAG, CADES, CDC, OKB, OeBB, RFF and SFEF.
Going forward, the EFSFs lending capacity would fall from 440bn to 271bn (a
169bn fall). For future bonds, the EFSF would once again need a loan specific buffer
(i.e. AAA collateral) when raising debt, which would again mean not all of debt raised
could be lent out (as for the first three bonds raised in 2011, see table above). The new
bonds would be 61.7% backed by the existing AAA nations (taking into account their
165% over-guarantees) and the remaining 38.3% would need to be retained as AAA
collateral. So for a new EFSF 5bn bond only 3,083bn could be paid out.
Accept a AA+ rating
The other option is that the EFSF accepts the lower rating of AA+ from S&P, meaning
its lending capacity will not be impacted. This would have the additional benefits of
EFSF keeping maintaining a remaining lending capacity of 396bn which can be used
for (a) the second Greek bailout package (b) support through any of the other flexible
EFSF tools (primary/secondary buying, flexible credit lines, bank recap) and (c) of
course for the leveraging of the EFSF- though we remain particularly sceptical on this
final point given these rating actions.
Losing the AAA could have a number of other drawbacks:
Firstly the spread to bunds (and to the EU/EFSM) is likely to widen. Given the rating
differential this will further consolidate investors preference for bunds, especially non-
European investors and particularly considering the stable outlook on Germany. We
have already seen a declining participation share from Asian investors over the fiveEFSF bonds and an increasing reliance on Eurozone and bank take up.
Secondly, the perception that the bailout funds are the ultimate backstops for the
system (which just need to be beefed up) will diminish even further. The rating
actions show the positive feedback between deterioration in the periphery and
worsening creditworthiness of the sovereigns behind the backstop facilities (i.e. the
high correlation risk).
General Implications for Bail-out facilities
This further highlights the problem in depending on bail-out facilities, which are not
prefunded, but instead rely on tapping wholesale markets at the moment when
sovereigns are under severe stress. If the market instead knows there is already a
stock of available resources, this reduces the likelihood of spreads widening
significantly as investors realise the pressure on the bail-out fund to access the markets
is lesser (much like the benefits of term funding for banks). This further highlights the
need for a war chest to fight the crisis: in this case beefing-up IMF resources or
accelerating paid-in capital for the ESM.
As such we expect the focus to shift to the better-deigned, but not flawless, ESM
structure and less focus being placed on the EFSF and particularly the attempt at
leveraging. Euro area leaders have pledged to explore options for maintaining the
EFSFs rating. However, ultimately we consider it highly unlikely they will be willing to
1This assumes the guarantors states pay in the minimum to maintain the rating, taking into account the small buffer of
collateral in additional guarantees and collateral available (289mln)
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inject funds directly or raise additional bonds solely to defend AAA ratings of the
existing EFSF bonds, particularly given the associated fall in lending capacity for the
facility going forward.
3. Implications for the ESM
The ESM is due to be launched as soon as member states representing 95% of the
capital commitments have ratified it, which is expected in July 2012. The ESM will have
a subscribed capital of EUR 700bn. According to the ESM treaty, the Eurozonecountries will pay-in EUR80bn in five annual instalments of 20% each. The first
instalment shall be paid by each ESM Member within fifteen days of the date of entry
into force of this Treaty which is envisaged for July 2012. Moreover, during the five-year
instalments period, ESM members shall provide, in a timely manner prior to the
issuance date, appropriate instruments in order to maintain a minimum 15 % ratio
between paid-in capital and the outstanding amount of ESM issuances. ESM Members
will be irrevocably and unconditionally committed to pay on demand any capital call
made on them within seven days of receipt.
Before the downgrade of France and Austria, the ESM would have had a 58.1% share
of AAA shareholders. If the six AAA euro area countries had been downgraded, then
this share would have dropped to zero and it would have been highly unlikely for theESM to achieve an AAA. Following the downgrade of France and Austria (and the
confirmation of the ratings of Germany, the Netherlands, Finland and Luxembourg) the
share of AAA holders has dropped to only 34.9%. However, given the high correlation
of the expected assets (i.e. sovereign debt of bailed-out Eurozone countries), there is a
significant risk that the ESM will not be able to be rated above the level of France,
particularly if the lending volume significantly exceeds the paid-in capital. Assuming no
credit is given by S&P for ESMs assets, if the ESM wants to achieve a AAA rating,
then its lending volume would be limited to EUR 296bn (down from Eur500bn
currently), comprising of EUR 80bn of paid-in capital plus EUR 216bn of AAA
guarantees [(700-80)* 34.9%].
If the ESM wants to maintain its AAA rating and its lending capacity at Eur500bn, thensubscribed capital would need to be increased to Eur1.280tr (from Eur700bn currently).
This would lead to doubling in callable capital for all member countries. Should EU
heads of States decide to double the lending capacity of the ESM (they agreed at the
last Summit to reconsider the size of the ESM in March), then this would lead to an
increase of callable capital to Eur2.6tr (or 27% of euro area GDP).
Over recent months, there have been discussions about a potential increase of the
capital from EUR 80bn to EUR 100bn and the acceleration of the instalment payments.
Both measures would improve the credit standing of the ESM. Under S&Ps
methodology, the advantage of paid-in capital over callable capital is that it would be
added to 100% to the narrow risk-bearing capacity of the ESM whilst in the case of the
callable capital only the AAA shareholders, which account for 34.9% of the total, wouldbe added to the broad risk-bearing capacity. Again, assuming that no credit is given by
S&P for ESMs assets, if the ESM wants to maintain its AAA rating, the lending volume
would be limited to EUR 309bn- 100bn of paid-in capital plus EUR 209bn of AAA
guarantees [(700-100)* 34.9%] in this case.
Previous statements from German Finance Minister Wolfgang Schaeuble indicated the
willingness of the German government to accelerate the capital provision, but not on a
unilateral basis. We believe that several Eurozone member states (Portugal, Ireland,
Greece but also Spain and Italy) would struggle raising the higher volumes in the
current market environment, or at an accelerated pace.
If the ESM drops the AAA target, the inclusion of French and Austria support would
allow a significantly higher lending volume of EUR 440bn (in case of EUR 80bn of paid-in capital) and EUR 448.5bn (in case of EUR 100bn of paid-in capital), respectively.
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4. Impact on European supranationals
EIB
Following the downgrade of France and Austria, the share of EIB shareholders rated
AAA by S&P has fallen from 62% to 43%. This does, however, not automatically trigger
a downgrade of EIB. We actually believe that S&P will confirm EIB's AAA (90% chance)
but there is nevertheless a tail risk. A negative outlook for EIB might prove to be
unavoidable.
The downgrades of France and Austria leave Germany, the Netherlands, Finland, and
Luxembourg as well as Denmark, Sweden and the UK as the only remaining triple-A
countries backing EIB. Whilst the loss of two of its AAA shareholder will put pressure on
EIBs AAA rating, there are a number of factors offsetting this negative impact. First,
EIB is an eligible counterparty at the ECB and the only supranational with access to
central bank liquidity, which is highly supportive for the rating. S&P has highlighted
liquidity as one of the key factors in rating EIB. S&P will also take into account EIB's
high asset quality (no direct sovereign exposure) and its preferred creditor status.
S&P's math
One of the most important ratios for S&P is the risk bearing capacity of a supranational
institution in relation to its purpose-related exposure. At year-end 2010, EIB had
adjusted shareholders' equity (own funds) of nearly 40bn. As a consequence, its ratio
of adjusted shareholders' equity plus provisions for losses (narrow risk-bearing
capacity; NRBC) to loans, equity investments, and off-balance sheet items (purpose-
related exposure; PRE) was 10.9%. In addition, EIB had almost 137bn in callable
capital from AAA rated member countries. Accordingly, its ratio of NRBC plus callable
capital from its AAA rated member countries (broad risk-bearing capacity; BRBC) to
PRE was above 48% at year-end 2010.
EU
The European Union is somewhat different from the other supranationals, in so far asits credit quality is derived from the claim it has against the European budget; rather
than on a share of callable capital. Please see below the layers of support outlined by
S&P itself in one of its recent reports:
(1) The EU can use its own cash balances or draw on the assets in accounts it has
with member states, through which member states make "own-resource" payments to
the EU on a monthly basis. These funds can be appropriated for debt service, whether
or not they have been committed elsewhere.
(2) Member states are legally obliged to balance the EU budget. The annual level of
EU payments to member states has been set at 1.07% of EU-27 gross national income
(GNI) over the period 20072013. Member states are committed (under
COM[2010]160) to release funds to cover these budgeted expenditures.
(3) Over and above member states' payments to cover budgeted payment
appropriations, EU sovereigns are legally obligated to make payments up to the own-
resources ceiling, which is expected to average 1.23% of EU-27 GNI over 20072013.
We understand the difference between the own-resources ceiling (1.23% of GNI) and
those budgetary expenditures covered by annual own-resource payments (1.07% of
GNI) to be fiscal headroom available for debt service in case of default under loans
granted or guaranteed by the EU. We expect this fiscal headroom to average around
30 billion in 20112012.
(4) The EU is also empowered by European Council regulation to call on member
states for funds in excess of the own-resources ceiling as the EU's legal obligations areultimately supported by the member states.
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(5) In the event that one or more member states do not meet their legal obligations,
the difference would be divided among the remaining member states in proportion to
the estimated budget revenue from each of them.
In December, S&P said that their review of the EU will focus on the financial ability of
Eurozone member states to support the EU's debt service should the institution face a
period of financial distress. S&P also highlighted that for 2011, budgeted revenues from
Germany and France were 32% of total EU revenues, at 16% and 14%, respectively. In
total, AAA rated member states accounted for almost half of the EU's 2011 budgeted
revenues. The UK, Denmark, and Sweden together they contributed 13% of the EU's
2011 budgeted revenues.
Given the EU's dependency on revenues from national budgets, S&P stated that it
could lower the EU issuer rating by one notch if the AAA ratings on one or more
member states would be lowered, with a special focus on the largest contributors,
France and Germany. A downgrade of all six AAA Eurozone sovereigns would have
most likely resulting in a rating cut of the EU. Following the downgrade of France and
Austria, the support of the remaining AAA rated EU countries within and outside of the
Eurozone will ensure that the AAA of the EU, in our view. However, we see a risk of a
negative outlook.
S&P said in December that if the ratings of all six EIB's AAA eurozone sovereign
shareholders are lowered, the ratio of AAA rated callable capital as a percentage of the
total callable capital (221bn) would fall from 62% to just under 22%. This would result
in a fall in the BRBC to PRE ratio to 24%. Consequently, S&P placed EIB's placed the
issuer rating on CreditWatch negative at the time (indicating a downgrade of EIB by
one notch in such a scenario)
However, given that only France and Austria were downgraded the BRCB to PRE ratio
fell from 48% to 37% making a downgrade less likely, in our view. Moreover, supporting
rating factors include the high quality of EIB's loan book, underpinned by conservative
risk-management policies (as stated by S&P)
S&P said that it will resolve EIB's CreditWatch placement within 90 days once they
have completed the review of EIB's eurozone shareholders currently rated AAA. S&P
also said that if they view the reduction in AAA callable capital as not being sufficiently
offset by EIB's asset quality, they could lower the EIB rating by one notch, if any. We
see a risk that EIBs rating outlook will be changed to negative reflecting the negative
outlook for several of its AAA shareholders.
5. Political implications of the French downgrade
5.1 Implications for domestic politics
The French downgrade takes place at a politically charged time in France which is just
about to enter in the general election campaign (first round: April 22nd, Second roundMay 6th). The rating downgrade has already been seized upon by the opposition to
blame Sarkozys policies. Finance Minister Baroin on French Television tonight was
quick to stress that the main reasons for the downgrade was due to the lack of
effectiveness in the European policy response to the crisis rather than to French
policies per se, something mentioned by S&P in its statement: the downgrade reflects
our opinion of the impact of deepening political, financial, and monetary problems within
the eurozone.
Up until recently, Sarkozy had made it a priority to defend the French AAA. The
downgrade will likely weigh significantly on the political debate in the run up of the
French elections. His recent pro active stance on the crisis had resulted in an increase
in popular support which led to a narrowing gap with Hollande from 5.5 points at thebeginning of December to 3 points in the most recent polls. The downgrade could result
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in some erosion in Sarkozys position. It is also possible that the downgrade could
benefit extreme right candidate Le Pen who has enjoyed a significant increase in
popular support over the last few weeks (see chart). She has recently released her
economic programme which includes among other things a return to the French Franc,
the dismantlement of the European Union and the enactment of trade barriers. Despite
these extreme views, most recent polls put her only 2.5 points below Sarkozy at 21.5%.
A repeat of the 2002 elections when her father famously made it to the run off cannot
be excluded (at the time her father got 17.8% of votes).
Le Pen enjoying a significant increase in popular support
10
15
20
25
30
35
12/9/2011 12/15/2011 12/21/2011 12/27/2011 1/2/2012 1/8/2012
Hollande Sarkozy Le Pen
Source: RBS
With a clear risk that Le Pen makes it to the second round, the spectre of such an
outcome could have some impact on mainstream parties which might feel the need to
adjust their rhetoric (towards a more nationalistic political agenda) to avoid losing more
votes to the extremes.
Overall, the downgrade will complicate somewhat the domestic political debate in
France at such a sensitive time. It might also provide the opportunity for the extremes
to seize upon populist themes such as euro exit as Le Pen seems to be determined in
doing. While this is no doubt going to create some noise over the coming months, it is
unlikely in our view, to change the outcome of the elections in a fundamental way with
the next President to be either from the centre right or centre left party.
5.2 Implication at the negotiating table with European peers
We have been arguing for some time that a wholesale downgrade of all euro area
AAAs would have probably created less frictions at the European negotiating table
putting everyone in the same boat. The French downgrade in the absence of aGerman downgrade might strengthen the German position regarding negotiations
around the fiscal compact and might prompt a last minute attempt from German
officials to inject additional automaticity in the sanction mechanisms. Interestingly, the
FT reported today that ECB Asmussen had sent a letter to the negotiators working on
the Treaty where he expressed his concerns about the recent dilution of the Treaty:
These revisions in my view clearly run against the spirit of the initial general agreement
on an ambitious fiscal compact. While this is hardly surprising given the watering down
of the Treaty under its latest draft, it will no doubt help Germany making its case heard.
The difficulty of course is that any aggressive sanction mechanism would be
interpreted in France as a potential loss of sovereignty which could benefit the
extremes. This leaves very little room for manoeuvre for Sarkozy and does complicatein our view the future crisis resolution negotiations. Of note as well, S&P specifically
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mentioned in its outlook on France that it could face a further downgrade should it face
a significant increase in contingent liabilities.
6. Market impact of ratings downgrades
The outcome of the ratings review is worse than a whole downgrade of the region. Be
alert to a more muted market impact near term by domestic buying (France) and ECB
buying (Italy) but the negative rating outlooks means risks can quickly return,
especially over new concern for EFSF/ESM funding.
The downgrade for France and Austria will mean some technical shifts into better
rated markets for collateral purposes. The Austrian downgrade was not consensus
but more generally the negative market outlook for France also hurts. Italy faces
similar collateral demand weakening, and this continues a trend.
The general EGB flow is buying in domestic markets and buying safety/liquidity.
France will lose some traction on this score and since most of the debt in EMU is held
by EMU residents (and can not be shifted out of Euros wholesale) then Bunds will
see increased structural support towards that will keep short end yields negative and
gradually support our bullish view on German bonds. We reiterate that the German
bond view is not the same as a view on the German credit given the flow of funds.
Italys move to a BBB+ means that it is now much closer to Junk status. Italian linkers
are not yet out of the Barclays index. This is a real risk as austerity is likely to be self-
defeating and political risks remain. This is a problem for the markets as the firewall
of the EFSF/ESM are hurt by ratings downgrades.
Portugal is now Junk for all three major rating agencies. Ireland is now the same
rating as Italy for S&P.
Other impacts to watch include CSAs with French and Austrian agencies such as
CADES and the LCH margin calculation.
What to expect near termFrance: The ratings downgrade was largely expected in the case of France but it was
not clear whether all EMU AAAs would be lost (with France 2-notches) or France would
lose its AAA while Germany retained her status. In the event, it is the latter and for
reasons we outline below, this is more negative medium term for France, but the near
term impact can be muted.
That is, rating action itself is not a huge surprise, and funds that are sensitive to such
matters would be getting underweight French paper (a consensus anyway). The key
reason we do not expect a huge moves in French rates/slope is however largely on the
back of likely concerted action to support the debt market by domestics.
Austria: The downgrade here will have come as more of a surprise to consensus but isnot shocking in the context of CEEMA exposure via the banking system. The room to
coordinate domestic buying is likely more limited (given the downgrade risk was seen
as in line with Germany) and for this reason there may be more underperformance than
France initially, though we see France as the weaker credit.
Italy: The move to BBB+ moves Italy closer to Junk but there will be some funds unable
to hold paper below A ratings levels now. This is likely to force selling pressure (index
moves do not have to be done immediately) but the key point here is that even if
LCH.Clearnet widen margins (see below) there is a backstop of support at some point
inthe short end from the ECB 3y LTRO and the ECB further on the curve. Italian linkers
will continue to cheapen but the Barclays index for instance using the middle rating and
it is only when another agency drops Italy in the BBB-handle that technical selling will
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be seen. So summarise, here: expect selling but there will be a mop up via domestics
at the short end and the ECB more generally.
A narrower set of quality names for collateral and index and AAAcurves
One of the reasons that a ratings downgrade in France/Austria is more damaging for
these countries than wholesale loss of AAA in the Euro area is that the flight to quality
still has somewhere to go.
Not all investors are affected but there are a couple of areas where ratings are
important, including for instance in collateral for tri-party repo. The tables below show
the results from the last ICMA survey results and highlight that the bulk of the collateral
pool is in AAA and unlike the U.S downgrade there are competing same currency
assets that are deemed safe/safer. (Tri-party uses references ratings first before drilling
into other detail.)
In the case of Italy, with the drop to BBB+, the use of this paper in tri-party was we think
diminishing after the ICMA survey but is still important.
Tri-party repo collateral by credit rating
Jun-11 Dec-10 Jun-10
AAA 49.8% 46.6% 51.4%
AA 21.8% 19.7% 15.2%
A 13.1% 20.1% 20.9%
BBB 6.9% 4.3% 6.7%
sub BBB- 2.2% 5.1% 2.2%
A1/P1 4.7% 3.8% 3.4%
A2/P2 0.0% 0.0% 0.0%
Non-Prime
0.2% 0.0% 0.0%
Unrated 1.5% 0.4% 0.1%
Source: ICMA, RBS
Collateral from
Jun-11 Dec-10 Jun-10
Germany 22.4% 24.3% 21.3%
Italy 10.0% 10.3% 9.5%
France 9.9% 9.4% 8.6%
Belgium 2.2% 2.3% 1.8%
Spain 7.1% 5.2% 4.0%
Other EMU 6.6% 6.5% 6.0%
UK 11.1% 11.6% 9.9%
DKK, SEK 2.4% 2.3% 2.2%
US 2.4% 3.1% 3.1%
Accession 0.8% 0.5% 0.3%
Japan 4.2% 2.5% 2.0%
Other 11.9% 13.7% 22.8%
Other 8.0% 7.6% 7.4%
Equity 0.9% 0.7% 1.0%
Source: RBS
For index investors the trend is towards reducing exposure by changing mandates
and often this is led by the end-user client who wants a rates product rather than a
credit product. This is most significant for Italy which is closer now to junk and non-
residents will attempt to shy away from the market as far as possible because the sheer
size of the market means that there is not exit door big enough for investors en masse.
That said, the current ratings thresholds do not have very material index investor move
risk but there will be some funds that invest only in single A-ratings and above, and in
the context of the low market liquidity this is likely to see selling pressure in BTPs.
Otherwise, the amount of AAA only index trackers is limited enough to suggest that
the fallout should not be very marked from this source, a point that was also evident
in the short lived reaction for Spain. In this case, the move was also widely
anticipated and saw 10y SPGB/Bund spread only 3bp wider from the close of 19th
Jan-09, when S&P was the first to downgrade, to 23rd Jan-09.
This is why there is greater risk to Austria where the downgrade was rather less
consensus, and allowed less scope for pre-positioning.
There are also other investors that track EGB AAAs, for instance, Dutch insurance
which references the ECB AAA curve to discount liabilities. We always thought that
German, Netherlands and Finland were the more secure AAAs and so have been well
prepared for French & Austrian downgrades. Prior analysis, from Neal Hegeman at
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RBS Insurance Solutions gave the results in the charts below. The results suggest
some extra long end weakness from these investors.
The ECB AAA our calculation on the curve effects
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
3.5%
1 2 3 4 5 6 7 8 9 101112131415161718192021222324252627282930
ParYield
current ECB AAA curve (lhs)
swap curve
post Austria + France downgrade (lhs)
Years
Source: RBS
The curve delta is large for hedgers using this curve
-4%
-3%
-2%
-1%
0%
1%
2%
3%
4%
1 5 9 13 17 21 25 29
ParYield
-0.70%
-0.50%
-0.30%
-0.10%
0.10%
0.30%
0.50%
0.70%
D
elta
delta (rhs)
current ECB AAA curve (lhs)
post Austria + France downgrade (lhs)
Source: RBS
The great debt shuffle: more home bias and more bias to safety/liquidity (Germany)
The table below shows holders of government debt at end 2010. The key development
is that debt ownership is unwinding a decade of integration with a bias towards more
domestic sovereign support. Given that roughly 80% of denominated debt is bought
by EMU residents then this debt shuffle is largely intra-EMU. Nevertheless, private
sector ex-EMU residents will likely be less willing, at the margins, to hold riskier debt,
while we expect large official sector holders to maintain exposures as they have done
through the crisis.
Holders of general government debt, 2010 (% of total government debt)
Total residents Central BanksResident Other
MFIsOther Fin. Corp Other residents Non residents
Belgium 43.7 1.4 23.5 14.7 4.1 56.3
Germany 51.0 0.2 31.5 9.2 10.1 49.0
Ireland - - - - - -
Greece 30.4 3.2 23.9 0.3 3.1 69.6
Spain 58.5 3.4 28.4 7.9 18.8 41.5
France - - - - - 66.2*
Italy 55.4 3.6 27.0 15.6 9.1 44.6
Luxembourg 69.9 - 47.5 - - 30.1
Netherlands 31.7 0.3 18.2 10.6 2.6 68.3
Austria 23.6 0.4 12.0 6.9 4.2 76.4
Portugal 36.7 0.8 22.4 5.8 7.8 63.3
Finland 28.9 - 12.5 1.2 15.2 71.1
Euro area47.9 1.7 26.5 11.9 7.8 52.1
* French data is from the Tresor Source: ECSB, RBS
As such a crucial point is that while it is common to hear of non-EMU resident selling of
EGBs, it is not clear that an exit from EMU debt markets is feasible for many holders.
For instance, official sector holders such as central banks have wider goals than theprivate sector and many of the Swiss and UK holdings will be effectively offshore Euro
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centric funds that also cannot exit Euro exposure completely. Clearly that leaves room
for large selling by other Non-EMU residents and this is expected to continue
pressuring the Euro debt markets. The charts below attempt to tell a story that it is the
intra-EMU debt that tends to be the dominant flow and therefore driver of the markets.
That makes the analysis flow risk in the following order most important:
1 Debt shifts between EMU members (= increasing home bias)
2 Debt shifts to safer EMU debt by those investors (EMU and non-EMU) because someEuro area economic exposure is hard to avoid.
3 Debt shifts out of Euro area debt by all investors, most prominently by non-EMU
investors.
Non resident debt holdings in tn (private & public) debt
-
2.0
4.0
6.0
8.0
10.0
12.0
14.0
2002 2003 2004 2005 2006 2007 2008 2009 2010
Official sectors
UK, US, Japan, Swiss
EMU to non-resident other
EMU country debt
Source: IMF, RBS
as a % of the total non-resident debt exposure.
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
2002 2003 2004 2005 2006 2007 2008 2009 2010
EMU to non-resident other EMU country debt UK, US, Japan, Swiss
Source: IMF, RBS
Where is the money going?
The charts below show ownership trends in AAA sovereigns for European and non-
European banks, which highlights the demand for safety and liquidity and the ratings
moves embellish the trend that has been in place already for several months.
European banks exposure non resident exposure to the publicsector debts of .
3515
94
209
423620
106
245
464123
130
262
46
0
50
100
150
200
250
300
Austria,
Public sector
Finland,
Public sector
France,
Public sector
Germany,
Public sector
Netherlands,
Public sector
Dec.2010 Mar.2011 Jun.2011
Source: BIS, RBS
Non European banks exposure non resident exposure to thepublic sector debts of .
4 3
55
122
156 5
55
127
166 5
61
118
20
0
20
40
60
80
100
120
140
Austria,
Public sector
Finland,
Public sector
France,
Public sector
Germany,
Public sector
Netherlands,
Public sector
Dec.2010 Mar.2011 Jun.2011
Source: BIS, RBS
Where is this buying of debt moving on the curve? The charts below show the results of
the latest EBA stress test disclosures and show the stock of debt held in French and
German sovereign paper. The chart on the right shows the distribution of the debt by
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bucket held across the EMU-11. There is a large proportionate holding at the short end
(3m to 3y, at 48%) but there is also a large amount of duration held too.
German and French sovereign debt held by banks in the EBAstress tests
0
20
40
60
80
100
120
3M 1Y 2Y 3Y 5Y 10Y 15Y
Germany FranceEUR bn
Source: RBS
Sovereign debt held by banks in the EBA stress tests, bybucket
10%
14%
11%8%
15%
22%
19%
0%
5%
10%
15%
20%
25%
3M 1Y 2Y 3Y 5Y 10Y 15Y
EBA stress test data on EMU-11 debt owndership by bucket
Source: RBS
All this helps to explain why German debt has continued to rally despite the clearer
contingent liability for German as investors cannot ignore a region as large as the
Euro area for commercial reasons such that some EMU debt exposure is necessary
and going forward we expect agreater skew to the German debt markets and one
which has been a key pivot in our ongoing bullish Bund market outlook.
The ratings action mostly solidifies this tendency but there will be some new flows to
further this bias and France and Austria become relative losers.
Other considerations
The EFSF/ESM: Ratings threats make the already tough funding conditions for the
much harder especially given the negative outlooks, and this will influence on the idea
that the firewalls are less robust when most needed and this can impact as soon as the
next weeks on likely Greek PSI failure.
LCH margin trigger level versusthe AAA reference spread
200
250
300
350
400
450
500
Sep-11 Nov-11 Jan-12
Italian 10y over AAAbenchmark450bp threshold
Source: RBS
There may be areas where agencies of Sovereigns have CSAs that require extra
collateral to be posted, perhaps such as French CADES.
The LCH.Clearnetmargins for Italy were hiked today but this is not related to wide
spread levels (a credit story) but is instead related to the volatility of the market. The
bigger anticipation is a general increase in the margin requirement which can have a
detrimental affect on BTPs (which in turn will be fought by the ECB). LCH.Clearnet
could have already executed these margin hikes as the Italian spread has been above
the 450bp general threshold in late December and earlier this month.
The fact LCH.Clearnet has not moved highlights its flexibility to watch the markets to
ensure such a move is permanent. On the basis of a AAA only reference rate (ex-France and Austria) for the margins, Italian 10y is again above the 450bp margin at
464bp but again there is no immediate implication.
A factor to consider is that the narrower reference now to only Germany, Netherlands
and Finland, may see a change in methodology where an average rating is used, or
else continue to use the same names regardless as they are still considered core EMU.
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Error! No text of specified style in document | 11 December 2011
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