LONDON - Proposals to beef up Europe's bailout fund by offering to guarantee portions of the debt owed by the region's weaker governments threaten to trash France's top credit rating.

The nation's 10-year notes are the third-worst performers this quarter - behind only Greece and Belgium - as traders speculate the European Financial Stability Facility (EFSF) will be used to insure the first portion of losses in the event of a sovereign default. France's rating is under pressure, Moody's Investors Service said on Monday, and investors now demand to be paid a record 93.2 basis points more to hold its bonds rather than German notes, up from 29 basis points in April.

"France is the key factor here," said Bob McKee, chief economist at Independent Strategy Ltd in London. "Offering insurance increases France's contingent liability, and that puts pressure on its rating. If France loses its AAA status, that in turn increases the pressure on Germany."

French bonds are being hurt as policymakers consider using the guarantee to ensure Italy, the world's third-largest bond issuer, and Spain can continue to access markets as contagion spreads from Greece. A downgrade of France will also limit the EFSF's ability to hold a top grade, according to Moody's.

Default swaps

The cost of insuring French bonds using credit-default swaps has soared to 183 basis points, from an average of about 84 in the first half of the year. They are the most expensive to protect among the top-rated nations in Europe and more costly than for nations rated AA- by Standard & Poor's, including China, Estonia and the Czech Republic.

"Looking at the numbers, France is no longer a AAA credit," said Nicola Marinelli, who oversees $153 million in funds at Glendevon King Asset Management in London. "They're talking about guaranteeing trillions of euros of bonds but if France isn't a AAA then even guaranteeing one more euro might not be sustainable."

French bonds have lost 2.85 percent this quarter, according to indexes compiled by Bloomberg and the European Federation of Financial Analysts Societies. Belgian bond returns are down 4.06 percent in the period and Greek notes have lost 7.68 percent, the indexes show.

Moody's warning

European leaders will meet in Brussels on Sunday to determine a recapitalization of the region's banks as they face the prospect of higher losses on Greek debt, an increase in the effectiveness of the EFSF as well as ways to tighten economic and financial policy. The meeting won't provide a complete fix for the crisis, German Chancellor Angela Merkel's spokesman Steffen Seibert said on Monday, and the work will extend well into next year.

"The deterioration in debt metrics and the potential for further contingent liabilities to emerge are exerting pressure on the stable outlook of the government's AAA debt rating," Moody's said in a report late Monday. "The French government now has less room for maneuver in terms of stretching its balance sheet than it had in 2008."

Moody's said it will monitor and assess its "stable" outlook on the nation's debt over the next three months.

In a separate statement on Tuesday, Moody's said that Europe's central banks have "substantial capacity" to support lenders and sovereign debt markets.

The so-called Eurosystem, headed by the European Central Bank, will continue to meet the liquidity needs of solvent eurozone banks, Moody's said.

French 10-year borrowing costs increased to about 3.06 percent from 2.6 percent at the end of September. Italy's 10-year borrowing costs, as low as 4.93 percent on Aug 17 after the European Central Bank started buying its bonds, have soared to 5.8 percent.

Spain, Germany

Spain's 10-year bond yields, currently 5.3 percent, were 5.14 percent at the end of September and as much as 6.32 percent on July 18. German 10-year yields also jumped this month, rising to 2.1 percent from 1.73 percent on Oct 4.

The need to lever the EFSF stems from the size of the potential calls on its limited resources, said Sony Kapoor, managing director of London-based policy group Re-Define Europe.

The facility is backed by so-called overguarantees of about 780 billion euros ($1.07 trillion) from its member states, allowing it to claim a AAA rating, according to Bloomberg calculations.

The EFSF's firepower drops to about 230 billion euros when the countries that have already received bailouts are excluded, Italy and Spain drop out of the tally, and the cost of a second Greek bailout is deducted.

'Political signal'

Italy and Spain alone must refinance more than 420 billion euros of bonds that come due next year, Bloomberg data show. By offering to take the first loss on some portion - the part mooted is 20 percent - of new issuance, the eurozone states can show they are standing behind the issuer and persuade private investors to step in.

"You're sending a very strong political signal that all the member states believe that Spain and Italy are solvent and they are willing to demonstrate that by putting themselves in harm's way," said Kapoor at Re-Define. "They have a very narrow space for maneuver in terms of the leverage. They're between the devil and the deep blue sea."

French banks tumbled in the past three days with BNP Paribas SA, the biggest of the nation's lenders, dropping more than 12 percent and Societe Generale SA down almost 14 percent on concern they would be downgraded along with the government.

"Given the sheer size the French banking system it may end up being singled out as the most vulnerable country to a rating agency downgrade," said Marchel Alexandrovich, an economist at Jefferies International in London.

Bloomberg News

(China Daily 10/19/2011 page16)