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Implications of S&P European Downgrades RBS

Implications of S&P European Downgrades RBS

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Published by: Khaled Haji Khoori on Jan 15, 2012
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Euro Area Economics
11 December 2011
Important disclosures can be found on the last page of this publication.
Jacques Cailloux
Chief European Economist+44 20 7085 4757 jacques.cailloux@rbs.com
Nick Matthews
Senior European Economist+44 20 7085 0173nick.matthews@rbs.com
Michael Michaelides
Covered Bond/Agency Strategist+44 20 7085 1806michael.michaelides@rbs.com
Harvinder Sian
Rates Strategist+44 20 7085 6539harvinder.sian@rbs.com
Frank Will
Head of Covered Bond Research+44 20 7085 2091frank.will@rbs.com
Implications of S&Pdowngrades
France loses it and so does Austria
The market implications of the ratings review are worse than a whole downgrade of theregion owing to the increased political wrangling, questions on the EFSF/ESM firewalland the fact that flight to quality still has somewhere to go. Germany comes out as aclear winner and will have its position at the negotiating table strengthened evenfurther. The French downgrade will complicate future negotiations around fiscalintegration and comes at a delicate time domestically. The loss of the AAA is likely tobe politicised in the run up of the upcoming general elections and could lead to anincrease in popular support for fringe parties.S&P made its long awaited announcement since placing 15 euro area sovereigns onCreditWatch with negative implications in early December. Despite warning of thepotential for a blanket downgrade of all sovereigns (apart from Greece, which is alreadyrated 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 notchdowngrades for five countries (Austria, France, Malta, Slovakia and Slovenia). Twonotch downgrades were given to four countries (Cyprus, Italy, Portugal and Spain). Thenew 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 aone-in-three chance that the rating will be lowered in 2012 or 2013. The outlook horizonfor investment grade countries is up to two years, but only up to one year forspeculative-grade ratings.Greece was not part of this exercise and remains CC with negative outlook. S&Passigned a recovery rating of ‘4’ to Cyprus and Portugal (as they moved intospeculative-grade category), indicating an expected recovery of 30-50% should adefault occur.Overall, the most notable outcome was the clear differentiation between Germany andall 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 politicsahead of the critical general elections. Likewise, France’s position at the Europeannegotiating table is likely to be weakened vis-à-vis Germany. This might render futurenegotiations surrounding fiscal integration even more difficult.As was anticipated, S&P mentioned that the key rationale behind the downgrades wasthe lack of decisiveness and effectiveness in the European policy response. Thecriticism seems to be aiming at the lack of firepower of the fiscal backstops rather thanthe ECB itself which was praised for its actions. In this context, it is rather surprisingthat the treatment of EMU solidarity contingent liabilities was quite different betweencountries, with the harshest words for France and not even a mention for the otherAAAs including most surprisingly Germany. Other factors mentioned relate to the risk offurther fiscal deterioration.
 Although Euro area member states “will explore the options” to keep the
triple-A, we expect S&P will ultimately align the EFSF’s rating with that of France and Austriaat AA+. Indeed, in order to maintain the AAA rating of the EFSF, euro area policymakers would have to accept a reduction in the lending capacity of the EFSF byEur169bn. 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
will however also face a difficult trade-off between higher lendingvolume and achieving a AAA rating. With no further increase to the current callablecapital levels, the lending capacity of the ESM would decline by Eur200bn. To maintainthe current lending capacity and its AAA, then member countries would need to doubletheir level of callable capital into the ESM compared to current commitment. Shouldeuro area policy makers want to double the lending capacity of the ESM from predowngrade times (while maintaining its AAA), then the ESM would need a callablecapital of almost 30% of euro area GDP! Discussions surrounding the potentialincrease in the size of the ESM in March will be more difficult post downgrade.The
will most likely be able to avoid a downgrade, with the latter having ahigher likelihood of a rating confirmation. A negative outlook, particularly in the case ofEIB, 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 andSlovakia) means risks can quickly return. For instance, the downgrade for France andAustria will mean technical shifts into better rated markets for collateral purposes. TheAustrian downgrade was not consensus but more generally the negative marketoutlook for France also hurts. Italy faces similar collateral demand weakening, and thiscontinues a trend.The general EGB flow is buying in domestic markets and buying safety/liquidity andFrance will lose some traction on this score and since most of the debt in EMU is heldby EMU residents (and can not be shifted out of Euros wholesale) then Bunds will seeincreased structural support towards that will keep short end yields negative andgradually support our (still) bullish view on German bonds. We reiterate that theGerman bond view is not the same as a view on the German credit given the flow offunds.Italy’s move to a BBB+ means it is now much closer to Junk status and we agree withS&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 inthe short term, they serve as a stark reminder that the euro area sovereign crisis ishere to stay. More importantly, these downgrades are likely to solidify expectations thatneither the EFSF nor the ESM will be able to maintain their AAA rating. This in turn islikely to make any significant increase in the lending capacity of either institution moredifficult. We continue to expect the crisis to deepen eventually leading to furtherwidening in spreads across countries vis-à-vis Germany.
Implications of S&P downgrades| 11 December 2011Page 2
Euro area S&P ratings
Euro areacountryOld S&PratingS&P possibledowngradelimit (5th Dec)ActualdowngradeNew S&PratingOutlook GradeAustria
AAA 1 notch1 notch AA+ Negative Investment
AA 1 notchunchanged AA Negative Investment
BBB 2 notch2 notch BB+ Negative Speculative
AA- 2 notchunchanged AA- Negative Investment
AAA 1 notchunchanged AAA Negative Investment
AAA 2 notch1 notch AA+ Negative Investment
AAA 1 notchunchanged AAA Stable Investment
CC -- CC Negative Speculative
BBB+ 2 notchunchanged BBB+ Negative Investment
A 2 notch2 notch BBB+ Negative Investment
AAA 1 notchunchanged AAA Negative Investment
A 2 notch1 notch A- Negative Investment
AAA 1 notchunchanged AAA Negative Investment
BBB- 2 notch2 notch BB Negative Speculative
A+ 2 notch1 notch A Stable Investment
AA- 2 notch1 notch A+ Negative Investment
AA- 2 notch2 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 thesecountries, we view the decision to not apply a wholesale downgrade to all countries asthe worst possible outcome from a euro area crisis management perspective and mightcontribute 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 wholesaledowngrade to all countries given that S&P was highlighting system-wide stressesstemming from interrelated factors such as: (i) tightening credit conditions across theeuro area, (ii) markedly higher risk premiums on a growing number of sovereigns,including some that were rated AAA, (iii) continuing disagreements among euro areapolicymakers on how to tackle the crisis and ensure greater economic, financial, andfiscal convergence among euro area members, (iv) high level of government andhousehold indebtedness across a large portion of the euro area, and (v) the risk ofrecession 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 beingtriggered by wholesale rating downgrades by rating agencies as they become (i)increasingly convinced that a recession is inevitable, (ii) the ECB will not ‘QE thesystem’, (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 inWhere is the Fiscal Union?, noting atthe time it was “a scenario which we now believe to be very likely.” We stated at thetime that the ramifications of such a decision by S&P, potentially to be followed in Q1by Moody’s, would be far reaching with supra national organisations such as the WorldBank at risk of downgrades.To complement this note, we also encourage clients to re-read Section 3 “MultipleSovereign downgrades are likely” inWhere is the Fiscal Union?, where we covered in
Implications of S&P downgrades| 11 December 2011Page 3

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