Eurozone Crisis: Ratings Threat Sees Markets Slip Back As EU Summit Approaches

Markets Slip As Ratings Agency Punctures EU Summit Optimism

Day two of a critical week for the euro saw markets turn negative after the rating agency Standard & Poor's (S&P) threatened the ratings of first the eurozone's sovereigns - even Germany - and then the bailout fund that they are backing, the European Financial Stability Facility (EFSF).

S&P's announcement knocked the building sense of optimism ahead of Friday's EU summit, where leaders are set to debate a plan to rewrite the core treaty of the union to create a legal framework to maintain fiscal discipline within the eurozone. The proposal, released on Monday after a meeting between French President Nicolas Sarkozy and German Chancellor Angela Merkel, includes introducing automatic sanctions for countries that breach strict targets on fiscal stability; reduce the majority needed to pass reforms; and introduce a European Monetary Fund to prop up struggling economies.

The FTSE-100 was flat on Tuesday afternoon, while the CAC-40 had fallen nearly 0.7% by the close. In Germany, where the threat of a downgrade was least expected, the DAX ended down 1.27%.

The falls went some way towards reversing the gains realised on Monday, and sounded a warning that there are still very real risks heading into Friday's summit.

"Systemic stresses in the eurozone have risen in recent weeks to the extent that they now put downward pressure on the credit standing of the eurozone as a whole," S&P said in a statement.

Jean-Claude Juncker, the head of the Eurogroup - the committee of eurozone finance ministers - told German radio that the agency's concerns were "wild exaggeration".

However, while the Franco-German solution does propose to tie up a number of the loose ends that caused the economic imbalances within the single currency's members in the first place, analysts have been quick to remind investors that it does little to solve the problem as it stands. Assuring the markets that the euro has a long-term future would most likely relieve some of the pressure on peripheral countries by reducing the amount of interest that investors demand on their bonds.

Creating the right framework - the "fiscal compact" envisioned by Germany, also frees up other institutions and mechanisms to deploy their capital in support of those stricken peripheral countries. This is particularly true of the European Central Bank (ECB), which to date has been unable to intervene beyond its current, limited bond buying programme. Some analysts believe that the agreed Franco-German proposal implicitly cleared the way for the bank to expand its programme and do more to support countries whose debt is coming under pressure from markets and give them the breathing room to reform and clamber back towards solvency.

US Treasury Secretary Timothy Geithner arrived in Germany on Tuesday for meetings with European leaders. Geithner's visit underlines the global significance of Friday's meeting. While the crisis was contained in Greece, Ireland and Portugal it was principally a European problem, but having expanded to include Italy, Spain and possibly even France, as well as banks across the world, failure this week could cause another credit crunch in developed markets.

Last week, the world's largest central banks injected more cash into the financial system by dropping the cost of borrowing dollars, in response to fears that the crisis, which had prompted European banks to pull back on lending and hold onto cash - known as deleveraging - was causing credit to dry up. The action drove a major rally in world markets.

Even previously pessimistic analysts have raised their expectations ahead of Friday. In a note to clients on Tuesday morning, Eurasia Group analyst Mujtaba Rahman wrote that the summit will be a "turning point" in the crisis, as leaders appear to have engineered workarounds to many of the possible democratic or institutional pitfalls to the plan.

The last "critical" summit, in November, saw a 4am deal cut between leaders to give Greece debt relief, reinforce the bailout mechanisms and seek capital from emerging market sovereign wealth funds, but the entire plan was thrown into chaos by a decision by then Greek Prime Minister George Papandreou to put the package to a referendum. That vote never happened, and Papandreou's government fell, but the damage was done and the crisis, far from being resolved, rolled into a more dangerous phase.

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