Q&A: Downgrade warnings

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Why has Standard & Poor's threatened to downgrade Spain, Portugal and Ireland, and carried out its threat with respect to Greece?

Public- and private-sector debts have reached high levels in these countries, raising the risk that they might have difficulty paying it off. Greece was seen as most at risk. Its current account deficit, at 14 per cent of gross domestic product, is the highest in the eurozone.

What does it mean for governments?

Most immediately, a lower rating increases the cost of funding debt – putting more strain on budgets. More broadly, the prospect of a downgrade should act as a warning that debt levels have to be addressed and public spending controlled.

Is this good news or bad news?

For public-sector workers hoping for a pay rise in these countries it is not good news. Nor is it going to help governments as they attempt to use tax and spending policies to boost economic growth.

The events of the past week have also exposed weaknesses in the operation of the 16-country eurozone, of which all four countries are members, exposing diverging economic performances and lax fiscal discipline.

The good news is that market mechanisms are functioning. ”A criticism of Europe’s monetary union in its first nine years or so was that member states escaped being punished by markets for fiscal indiscipline. If that process is reversing it would be a positive development in terms of incentives,” said Marco Annunziata, chief economist at UniCredit.

How does that work?

Divergences in bond yields between Germany and other eurozone economies are now greater than at any time since the launch of the euro in 1999. In other words, German bond prices, which have an inverse relationship to yields, have risen faster than other government bonds. Germany is seen as the least risky economy in times of uncertainty.

So are markets doing the job of politicians?

Sort of but financial markets have also become noticeably more sensitive about risks in general.

Are bond yield divergences worse inside the eurozone than outside?

German yields have diverged more sharply against other eurozone economies than against, say, the UK because if investors are worried about UK prospects they can sell sterling.

But eurozone economies share the euro, so investors instead sell government bonds of those countries they believe have become riskier.

Is there really a risk of a government defaulting?

Jean-Claude Trichet, European Central Bank president, said last week he would “totally exclude” such a possibility. What worries financial markets is that it is unclear what would happen in such an extreme scenario. Eurozone governments have a mutual “no bail-out” arrangement, and it is not obvious what role the ECB could play. But in a worse case scenario, a rescue by a multinational institution such as the International Monetary Fund would probably be arranged.

Is there a risk of the eurozone breaking up?

This remains extremely unlikely in the foreseeable future. A country such as Greece would gain little advantage financially because the debt that investors held in Greek assets would immediately be devalued, causing huge losses.

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