Eurozone crisis: the key questions answered

What does the downgrade mean for Europe – and Britain?

Katie Allen

January 15 2012

What is S&P?

Standard & Poor's is the oldest of the big credit ratings agencies. It assigns grades –
credit ratings – to countries, institutions and companies that need to borrow money,
to help lenders gauge the risk they are taking. Essentially, the lower the rating from a
ratings agency, the higher the interest a borrower has to pay to compensate for the
possibility of it defaulting.

What has S&P done?

It has cut the credit ratings on nine countries in the eurozone. The most high-profile
casualties were France and Austria, which lost their prized AAA ratings – the top
grade, held by only 14 countries worldwide, among them the UK. Sharp downgrades
to Cyprus and Portugal left them with "junk" ratings on their debt – ranking them as
very risky investments.

A handful of countries escaped Friday the 13th unscathed, notably Germany, which
S&P said had a track record of "prudent fiscal policies and expenditure discipline".

What is S&P worried about?

Essentially, it thinks eurozone policymakers have not done enough to resolve the
region's "broadening and deepening financial crisis". It criticised the latest talks as
failing to come up with "a breakthrough of sufficient size and scope to fully address
the eurozone's financial problems".

Importantly, S&P stresses that governments have been wrong to focus on austerity
measures alone because these can become "self-defeating". It warns the ensuing
worries about jobs and household incomes would damage domestic demand and
consequently national tax revenues.

How vulnerable is the UK to a downgrade?

For now, Britain retains its AAA rating, but policymakers in France and Germany are
already pointing the finger at the UK, saying its relatively high debt and flagging
growth make it equally, if not more, deserving of a downgrade.
But economic indicators and debt levels are not the only factors ratings agencies take
into account. In making the call on how likely a country is to be able to repay its debts,
whether a country is in the euro or not plays a big role. Unlike eurozone members,
Britain should not be forced to bail out struggling European nations, and, more
importantly, it still has monetary autonomy – the Bank of England can (and has) start
printing money to shore up the economy. Finally, ratings agencies look at how soon,
and at what rate, countries must repay their debts. France has to come up with
around £100bn this year, but the UK has to find only around half that.

What difference do the downgrades make?

For those downgraded, the cuts are likely to result in higher interest being demanded
when countries want to borrow. Governments need to auction bonds to pay for state
spending and to cover the cost of repaying older bonds that are maturing (known as
"rolling over" debt). Auctions from crisis-stricken Spain and Italy last week enjoyed a
significant fall in rates, but those are likely to go up again now. In Italy, the cost of
borrowing keeps pushing through the 7% barrier, which is regarded as unsustainably
high. When a country cannot afford even to service its debts, it becomes increasingly
likely to require a bailout.

Does this make bailouts harder to fund?

Yes. The eurozone's rescue fund, the European financial stability facility (EFSF), uses
guarantees from its member countries to raise funds in financial markets. If those
backer countries are seen as less creditworthy, so is the fund – and it could well be
downgraded too. That will make it more difficult and more expensive to raise money
from financial markets and other countries outside the eurozone. The fund has
already committed large sums to Greece, Ireland and Portugal and will need to raise
more money should Italy and Spain need the same kind of help.

What happens next?

S&P has given nearly all the countries it downgraded a "negative outlook", meaning
there is a one in three chance of a further cut in 2012 or 2013. It says refinancing costs
for some countries will stay high, credit will be hard to come by and growth will slow.

The rising borrowing costs that many countries will face in the wake of these
downgrades will have repercussions across the eurozone. There are worries, for
example, that rising borrowing costs for Italy mean it will sooner or later need to
apply for help from the EFSF. If it does – and drops out of the fund as a backer – there
are serious implications for key guarantors Germany and France. Their obligations to
the rescue fund would rise – and put fresh pressure on their credit ratings.