Leaders call S&P's cuts to sovereign bonds 'disappointing' yet expected

BERLIN / PARIS - European leaders will this week try to rescue under-fire efforts to deliver new fiscal rules and cut Greece's debt burden as they urge investors to ignore Standard & Poor's eurozone downgrades.

Greek officials will reconvene with creditors on Wednesday after discussions stalled last week over the size of investor losses in a proposed debt swap, raising the threat of default. German Chancellor Angela Merkel and French President Nicolas Sarkozy will also meet as the European Central Bank (ECB) warns governments against "watering down" a revamp of budget laws.

The talks - alongside sales of French and Spanish bonds - may serve as tougher tests of the tentative recovery in investor sentiment than S&P's decision to cut the ratings of nine eurozone nations, including France. History suggests fallout from the downgrades may be limited. JPMorgan Chase & Co research shows that 10-year yields for the nine sovereigns that lost their AAA status between 1998 and last year's US downgrade rose an average of 2 basis points the next week.

Efforts to toughen budget laws and make Greek debt more sustainable "deserve far more attention than these rating changes, which as usual are lagging fundamental developments", Joachim Fels, chief global economist at Morgan Stanley in London, said on Sunday.

Investor reaction

Investor reaction to the downgrades last week was muted. As news of the downgraded leaked on Friday, the yield on France's equivalent 10-year debt rose just 3 basis points to 3.055 percent. Italy's 10-year yield climbed 1 basis point to 6.596 percent.

Policymakers fanned out over the weekend to seize back the initiative. Merkel said S&P's decision and criticism of "insufficient" policy steps reinforced her view that leaders must redouble efforts to resolve the two-year crisis. Germany is now alone in the eurozone with a stable AAA.

Reacting to Spain's downgrade to A from AA-, Spanish Prime Minister Mariano Rajoy pledged spending cuts and a banking-system cleanup, as well as a "clear, firm and forceful" commitment to the euro's future. French Finance Minister Francois Baroin said the reduction of France's rating to AA+ from AAA was "disappointing" yet expected, and markets were "muted" in response.

Bailout fund

Speaking over the weekend at a meeting of her party, Merkel played down the risk that weaker French creditworthiness saps potency from Europe's 440-billion-euro ($557.9 billion) bailout fund. The European Financial Stability Facility (EFSF), which is funding rescue packages for Greece, Ireland and Portugal partially with bond sales, owes its AAA rating to guarantees from its sponsoring nations.

"I was never of the opinion that the EFSF necessarily has to be AAA," Merkel said.

Luxembourg Prime Minister Jean-Claude Juncker said the EFSF's shareholders will explore ways to maintain the top rating of the fund, which is scheduled to sell up to 1.5 billion euros in six-month bills this week. In the meantime, Merkel and other European leaders have pledged to move quickly toward setting up its permanent successor, the European Stability Mechanism, this year - one year ahead of the original plan.

In a Bloomberg interview on Monday in Hong Kong, UK Chancellor of the Exchequer George Osborne said he sees some reason for optimism in Europe, while acknowledging that this year is set to be a challenging year.

Grounds for optimism

"Obviously people are anxious about the year ahead, and I understand that, but I would say there are some grounds for optimism," Osborne said, citing recent liquidity measures by the ECB.

Merkel will meet with Sarkozy and Italian Prime Minister Mario Monti in Rome on Friday to flesh out details of crisis-rescue efforts before a European summit 10 days later. Dealing with Europe and whether to boost the resources of the International Monetary Fund to do so will also top the agenda when deputy finance chiefs from the G20 meet in Mexico this week.

Budget rules

The leaders are gathering as the ECB warns governments against diluting a December pact to toughen budget rules designed to avoid a repeat of the crisis.

Recent changes in a text aimed at translating the agreement into an international treaty "imply a substantial watering down" and "run against the spirit" of the original plan, ECB Executive Board member Joerg Asmussen said in a letter last week. Leaders have said they may complete the rulebook by Jan 30, a month earlier than scheduled.

A more immediate threat may come from Greece, where investors have warned of a collapse of the financial system. Failure to strike a deal with creditors could imperil the ability of the government in Athens to pay back 14.5 billion euros maturing on March 20 and force it to seek even more aid from governments.

"A Greek default would have a major impact on the euro as it would spread contagion to other bond markets in the eurozone," Mansoor Mohi-uddin, Singapore-based head of foreign exchange strategy at UBS AG, said on Saturday.

Bloomberg News