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S&P warning puts screws to euro zone ahead of summit

The news that Standard & Poor's is mulling a mass downgrade of the euro zone countries came at a critical stage of Europe's debt crisis. It was leaked shortly after French President Nicolas Sarkozy and German Chancellor Angela Merkel revealed their grand plan Monday to enforce vigorous fiscal discipline on the region, and three days before the Brussels leaders' summit that promises a "comprehensive package" to solve the debt crisis.

The formal announcement that S&P has put 15 of the 17 euro zone countries on credit review "with negative implications" is being dismissed as politically motivated by senior European officials and central bankers. Their suspicions are understandable; the United States' nascent recovery probably would go into reverse if the euro zone, already sliding into recession, fails to snuff out the two-year-old debt crisis.

Adding to the impression that the timing of the S&P move was more than coincidental was the arrival in Europe of U.S. Treasury Secretary Timothy Geithner, and the rating agency's announcement that it expects to conclude its review of the euro zone sovereign ratings "as soon as possible following the EU summit," which finishes Friday.

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Mr. Geithner has been begging the euro zone leaders to take decisive action to end the debt crisis, as have Canadian Prime Minister Stephen Harper and his Finance Minister, Jim Flaherty. Reinforcing his message Tuesday, Mr. Geithner said: "I am here in Europe to emphasize how important it is for the United States and the global economy as a whole that Germany and France succeed, alongside the other nations, in building a stronger Europe."

To be sure, some euro zone officials did not recoil when S&P revealed that the triple-A credit ratings of France, Germany and four other apparently healthy countries, along with nine lower-rated countries, were at risk. (Typically, there is a 50-per-cent chance of a downgrade after a "negative" review is announced.)

Speaking in Vienna, German Finance Minister Wolfgang Schaeuble said that the markets no longer trust the euro zone leaders after so many false starts – the Brussels summit is the fourth this year – and that S&P's statement will prompt them "to do what we've promised, namely to take the necessary decisions, step-by-step, and win back the confidence of global investors."

Many other senior officials were annoyed, apparently believing the S&P move was orchestrated by the U.S. government, alarmist, and unwarranted given the euro zone's fiscal cleanup effort so far. On Tuesday, the European market rally stalled and sovereign bond yields, which fell in recent days as Italy's new government rolled out an aggressive new austerity and growth plan, climbed again for the most part.

The criticism was blunt. Christian Noyer, president of the Bank of France, accused S&P of weighing political factors more than economic and fiscal factors. "The ratings agencies were one of the motors of the crisis in 2008," he said. "One can ask if they are not playing that role again today."

Ewald Nowotny, the Austrian central bank governor who sits on the European Central Bank's governing council, said S&P took a "very politically motivated action." And Jean-Claude Juncker, the Luxembourg Prime Minister who is chairman of the euro zone finance ministers group, called the agency's move "a wild exaggeration and unfair."

Some analysts and economists said the S&P warning would be productive if it scares politicians into ensuring that the Brussels summit succeeds. The research team at Credit Suisse Equity Research also noted that the warning "may spook the ECB into greater action." The central bank has been reluctant to ramp up its purchases of distressed sovereign debt, even though they have been proven effective in bringing down yields.

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Could the downgrade threat backfire? Marshall Auerback, portfolio strategist with Denver hedge fund Madison Street Partners, thinks the long-standing fear of a downgrade, especially among France and the other triple-A-rated countries, is already damaging the recovery. In order to preserve the high rating, they are rolling out increasingly tough austerity programs, which are hurting growth and preventing budget deficits from disappearing. "Paying obeisance to the shrine of Moody's, Fitch and S&P via fiscal austerity is the economic equivalent of seeking to negotiate a peace treaty with al-Qaeda," he said in a note.

A downgrade might also doom Europe's bailout fund, the European Financial Stability Facility (EFSF), whose credit rating is also under review, S&P said in a surprise announcement on Tuesday. The EFSF's rating relies wholly on the six triple-A countries – France, Germany, Austria, Finland, the Netherlands and Luxembourg. If the EFSF loses its creditworthiness it may also lose the support of China and Japan, which had bought EFSF issues in the past.

One thing is for sure: The S&P warning raises the stakes for the Brussels summit. Credit Suisse said it "reminds politicians that they are at the last-chance saloon."

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