20 December 2013

Paul N Goldschmidt: Downgrade of the EU's rating - Incoherence or incompetence?

On 20th December 2013, the ratings agency Standard & Poor's (S&P) announced that it was reducing the EU's long term rating from AAA to AA+. However S&P does not intend to change the mid-term rating since the Union's perspective is stable. The agency said that "the EU's budgetary negotiations had become tenser, proving a rise in risk concerning support to the Union on the part of some Member States".

The European Union’s authorities, and in particular the heads of State and Governments meeting at the Summit, have been mistaken to shrug off the announcement of the downgrading of the EU’s credit rating. Even if similar downgrades have affected other important issuers, including the USA, with minimal repercussions on the rates at which they refinance their outstanding debt, the announcement last Friday by Standard and Poor’s should draw the attention of the authorities and investors alike.

Indeed, either the Agency has concluded – after an in depth analysis – that the outlook for the EU is less solid than heretofore, in which case it is incoherent not to have downgraded simultaneously the ratings of the EIB as well as of Germany, Finland and Luxemburg; or it has been grossly incompetent in the analysis of the credit risks supported by the investors in debt securities issued by the Union.

The issues in question, the outstanding amount of which is limited, benefit from an unconditional EU budget guarantee and are, as a result, a “joint and several” liability of the 28 Member States; this means that, if necessary, the solvent Members must, according to the provisions of the Treaty, provide the budget with the necessary means to meet all its obligations. This should be distinguished from the obligations of the EFSF (already downgraded) and of the ESM that only benefit from a “several” guarantee of the signatories to the “intergovernmental” treaties that establish them.

The decision of the rating Agency implies it considers that Germany (and the other AAA-rated sovereigns) is no longer capable of fulfilling “unconditionally” its obligations or, alternatively, might refuse to do so. In the event, a downgrade of the German rating seems logical because it is absurd to give a better sovereign rating to a country than to a debt to which it has provided an unconditional guarantee.

A similar reasoning applies to the rating of debt securities of the EIB whose shareholders are the identical 28 Member States. Even if the legal construction by which these shareholders underpin the obligations of the institution are slightly different from those supporting the EU budget, the implication of a “joint and several” liability is identical. It is therefore difficult to comprehend why the EIB’s rating has not been put into question.

A further incoherence in the S&P’s announcement stems from the qualification of the outlook as “stable”. Indeed, it is understandable that the Agency is preoccupied by the slowness of progress and the unsatisfactory compromises that preside over the implementation of the Banking Union. They increase the uncertainties surrounding the survival of the single currency in the event of a new crisis, of whatever origin, that would imperil the solidity of the banking sector or the solvency of a eurozone Member State. The lack of momentum towards the establishment of a federal structure within the eurozone together with the growing appeal of nationalist/populist political parties, are reasons enough to question the future prospects of the EU’s solvency. If this is the reason that underpins the rating decision, it should be made clear explicitly and it would then become evident that it should be applied mutatis mutandis to all European Institutions and Member States. Such a justification would, however, be difficult to reconcile with the “stable” outlook of the rating.

In conclusion, I would lean towards the explanation that points to the incompetence of the Agency and to the fundamental errors committed in its analysis. I am writing these lines with the benefit of my personal experience, having been, during my tenure at the Commission between 1993 and 2002, responsible for dealing with the ratings of the EEC, Euratom and the ECSC, a period during which the legal foundation of the joint and several budget guarantee by Member States was never challenged.

It is of the highest importance that the authorities react vigorously and firmly to these developments to avoid their tepid reaction being considered by investors as proof of the uncertainties presiding over the Union’s future.

See article, 20.12.13

Paul N Goldschmidt, Director, European Commission (ret); Member of the Advisory Board of the Thomas More Institute

Tel: +32 (02) 6475310 / +33 (04) 94732015 / Mob: +32 (0497) 549259

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© Paul Goldschmidt