The high price of saving the eurozone

France's AAA credit rating is at risk because of plans to leverage the eurozone bailout fund. Ben Chu explains why

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The Independent Online

Is France still a AAA nation? Moody's raised an ominous question mark over that status earlier this week when the credit rating agency said that it would be monitoring France's public finances closely for the next three months. Yesterday, the French Finance minister, François Baroin, came out fighting in response to the alert, insisting that there was absolutely no threat on the horizon to France's rock-solid creditworthiness. But as both the US and Italy have discovered in recent months, credit rating agencies tend to make up their own minds about these matters. Like it or not, for the next three months, France's creditworthiness hangs in the balance.

Moody's said its decision to monitor France was partly prompted by reports that eurozone leaders are preparing to announce plans this weekend to "leverage" the €440bn emergency bailout fund. So why would moves to prevent the eurozone breaking apart damage France's credit rating?

To answer that requires an understanding of how the bailout fund might actually be leveraged. There have been three broad plans in circulation. One involves the bailout fund, known at the moment as the European Financial Stability Facility (EFSF), turning itself into a bank with a mandate to lend to distressed eurozone sovereigns such as Italy and Spain. This new bank would, itself, be funded by borrowing from the European Central Bank. It could swap the sovereign bonds it acquires for cash from the ECB. This would, in theory, send a message to private investors that there will always be a buyer for European sovereign debt, thus making them comfortable about investing in the market themselves.

The second plan is more simple: scale up the existing EFSF, allowing it to issue more bonds itself and to buy up distressed sovereign bonds with the proceeds. The third plan is to turn the EFSF into an insurance fund for sovereign bonds issued by member states. The fund would guarantee a certain portion of any losses that private investors experienced on bonds. The idea, again, is to reassure investors in these bonds that they are safe investments.

Only one looks viable. The ECB has made its opposition to the first idea plain on the grounds that it would be the central bank holding the credit risk of a default. The second plan – to extend the scope of the existing EFSF – would likely result in the ballooning of the facility's own borrowing costs. For these reasons, a European policymaker yesterday described the insurance fund idea as the "main contender".

But there are still problems thrown up by turning the EFSF into an insurer. A key question is: how much of the face value of sovereign bonds would be insured? German policymakers are pushing for Greek debt to be written down by more than 50 per cent this weekend. Some analysts say this could be interpreted by investors as the benchmark for future "haircuts" for troubled eurozone periphery states. If so, a guarantee of anything less than 50 per cent of the face value of bonds might not succeed in settling the markets.

Another problem is accounting rules. When a company sells insurance, it does not need to pay out any money up front, but the value of that insurance policy is considered a liability on its balance sheet. The same principle applies when a nation offers insurance. And that is one of the reasons why Moody's is taking a close interest in France's public finances. In 2010, France already had a stock of debt equal to 82 per cent of its annual output. Plus, France, as the eurozone's second-largest economy, is already guaranteeing €158.5bn of EFSF lending. Turning the EFSF into an insurer could increase France's guarantee still further. Moody's – and other credit rating agencies – will have to decide whether these potential new financial liabilities are enough to deprive France of its AAA credit status.

Yet there are other threats to France's public finances. France's banks are estimated to hold some €74bn of Italian sovereign debt and €23bn of Spanish sovereign bonds. If the bond markets pushed up the interest rates of these nations high enough, they could be forced into a default. That would bring down the French banking sector and Paris would have no choice but to rescue its banks to prevent a catastrophic impact on the rest of the economy. Such a rescue would be far worse for France's public finances than turning the EFSF into an insurer.

The reality for France – and also for every other member of the eurozone – is that there are simply no cost-free options on the table . The question is which is the least risky. And French ministers seem to be leaning to the view that, despite Moody's' warning, turning the EFSF into an insurer is the least risky option available. By pledging to insure the debts of its neighbours, France would be, indirectly, also insuring itself.

Plan A: An insurer

What is it? Turn the €440bn stability fund, the European Financial Stability Facility, into an insurer which will guarantee a fixed portion of the face value of every new bond issued by a member of the eurozone.

Benefits Private creditors would be providing the bulk of the financing for eurozone members, satisfying one of the requirements of key figures such as Germany's Angela Merkel and France's Nicolas Sarkozy. Also, no new money would be required upfront from European governments.

Drawbacks The plan might not be enough to convince investors if the level of insurance for new bonds is set too low. The scale of the guarantees might also cause the market borrowing costs of stronger sovereigns, such as France, to rise.

Plan B: A bank

What is it? Give the European Financial Stability Facility (EFSF) a banking licence and mandate it to buy up the debt of any eurozone sovereign that finds its borrowing costs rising to dangerous levels.

Benefits Again, no cash would be required upfront from governments. And by putting the full money-printing resources of the central bank behind all member states, private investors would be left in no doubt of the determination of European politicians to prevent the eurozone from breaking apart.

Drawbacks The European Central Bank (ECB) would bear the risk of default by a member state. The outgoing head of the ECB, Jean-Claude Trichet, has made his opposition to the plan clear on these grounds. The German government has alsom rejected the plan for the same reason.

Plan C: A bigger borrower

What is it? Allow the Luxembourg-based EFSF simply to increase its own issuance of bonds by tapping the capital markets and to use the proceeds to buy up distressed eurozone sovereign debt.

Benefits It would be a relatively simple expansion of the existing EFSF. The deal agreed by eurozone leaders in July allowed the EFSF to buy sovereign bonds in the secondary debt markets, rather than simply extending loans to governments. There would be no complex insurance mechanism or problematic involvement of the ECB.

Drawbacks Since investors would not know how many sovereign bonds an expanded EFSF would end up holding, they would find it difficult to price its own issued bonds. Thus, the EFSF would find its own borrowing costs rising the more debt it bought, potentially interfering with the fund's ability to stabilise sovereign debt markets.