s&p - credit faq - factors behind european downgrades

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Credit FAQ: Factors Behind Our Rating ActionsOn Eurozone Sovereign GovernmentsPrimary Credit Analyst:

Moritz Kraemer, Frankfurt (49) 69-33-99-9249; [email protected] Contact:

Frank Gill, London (44) 20-7176-7129; [email protected]

FRANKFURT (Standard & Poor's) Jan. 13, 2012--Standard & Poor's Ratings

Services today completed its review of its ratings on 16 eurozone sovereigns,

resulting in downgrades for nine eurozone sovereigns and affirmations of the

ratings on seven others.

We have lowered the long-term ratings on Cyprus, Italy, Portugal, and Spain by

two notches; lowered the long-term ratings on Austria, France, Malta, the

Slovak Republic, and Slovenia, by one notch; and affirmed the long-termratings on Belgium, Estonia, Finland, Germany, Ireland, Luxembourg, and the

Netherlands. All ratings on the 16 sovereigns have been removed from

CreditWatch where they were placed with negative implications on Dec. 5, 2011

(except for Cyprus, which was first placed on CreditWatch on Aug. 12, 2011).

The outlooks on our long-term ratings on all but two of the 16 eurozone

sovereigns are negative; the outlooks on the long-term ratings on Germany and

Slovakia are stable. See "Standard & Poor's Takes Various Rating Actions On 16

Eurozone Sovereign Governments," published today for full details.

This report addresses questions that we anticipate market participants might

ask in connection with our rating actions today.

WHAT HAS PROMPTED THE DOWNGRADES?

Today's rating actions are primarily driven by our assessment that the policy

initiatives that have been taken by European policymakers in recent weeks may

be insufficient to fully address ongoing systemic stresses in the eurozone. In

our view, these stresses include: (1) tightening credit conditions, (2) an

increase in risk premiums for a widening group of eurozone issuers, (3) a

January 13, 2012

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simultaneous attempt to delever by governments and households, (4) weakening

economic growth prospects, and (5) an open and prolonged dispute among

European policymakers over the proper approach to address challenges.

The outcomes from the EU summit on Dec. 9, 2011, and subsequent statements

from policymakers lead us to believe that the agreement reached has not

produced a breakthrough of sufficient size and scope to fully address the

eurozone's financial problems. In our opinion, the political agreement does

not supply sufficient additional resources or operational flexibility to

bolster European rescue operations, or extend enough support for those

eurozone sovereigns subjected to heightened market pressures.

We also believe that the agreement is predicated on only a partial recognition

of the source of the crisis: that the current financial turmoil stems

primarily from fiscal profligacy at the periphery of the eurozone. In our

view, however, the financial problems facing the eurozone are as much a

consequence of rising external imbalances and divergences in competitiveness

between the EMU's core and the so-called "periphery". As such, we believe that

a reform process based on a pillar of fiscal austerity alone risks becoming

self-defeating, as domestic demand falls in line with consumers' rising

concerns about job security and disposable incomes, eroding national tax

revenues.

Accordingly, in line with our published sovereign criteria, we have adjusted

downward our political scores (one of the five key factors in our criteria)

for those eurozone sovereigns we had previously scored in our two highest

categories. This reflects our view that the effectiveness, stability, and

predictability of European policymaking and political institutions have not

been as strong as we believe are called for by the severity of a broadening

and deepening financial crisis in the eurozone.

In addition to our assessment of the policy response to the crisis, downgrades

in some countries have also been triggered by external risks. In our view, it

is increasingly likely that refinancing costs for certain countries may remain

elevated, that credit availability and economic growth may further decelerate,

and that pressure on financing conditions may persist. Accordingly, for those

sovereigns we consider most at risk of an economic downturn and deteriorating

funding conditions, for example due to their large cross-border financing

needs, we have adjusted our external score downward.

WHY WERE SOME EUROZONE SOVEREIGNS DOWNGRADED BY TWO NOTCHES AND OTHERS BY ONE

NOTCH?

We believe that not all sovereigns are equally vulnerable to the possible

extension and intensification of the financial crisis. Those we consider most

at risk of an economic downturn and deteriorating funding conditions, for

example due to the large cross-border financing needs of its governments or

financial sectors, have been downgraded by two notches, as we lowered the

political score and/or the external score reflecting our view of the risk of a

marked deterioration in the country's external financing.

Standard & Poors | RatingsDirect on the Global Credit Portal | January 13, 2012 2

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Credit FAQ: Factors Behind Our Rating Actions On Eurozone Sovereign Governments



On the other hand, we affirmed the ratings of sovereigns which we believe are

likely to be more resilient at their current rating level in light of their

relatively strong external positions and less leveraged public and private

sectors. These credit strengths remain robust enough, in our opinion, to

neutralize the potential ratings impact from the lowering of our political

score.

In this context, we would note that the ratings on the eurozone sovereigns

remain at comparatively high levels, with only three below investment grade

(Portugal, Cyprus, and Greece). Historically, investment-grade rated

sovereigns have experienced very low default rates. From 1975 to 2010, the

15-year cumulative default rate for sovereigns rated in investment grades was

1.02%, and 0.00% for sovereigns rated in the 'A' category or higher.

WHY DO THE RATINGS ON MOST OF THESE SOVEREIGNS HAVE NEGATIVE OUTLOOKS?

For those sovereigns with negative outlooks, we believe that downside risks

persist and that a more adverse economic and financial environment could erode

their relative strengths within the next year or two to a degree that in our

view could warrant a further downward revision of their long-term ratings. We

believe that the main downside risks that could affect eurozone sovereigns to

various degrees are related to the possibility of further significant fiscal

deterioration as a consequence of a more recessionary macroeconomic

environment and/or vulnerabilities to further intensification and broadening

of risk aversion among investors, jeopardizing funding access at sustainable

rates. A more severe financial and economic downturn than we currently

envisage (see "Sovereign Risk Indicators," published Dec. 28, 2011) could also

lead to rising stress levels in the European banking system, potentially

leading to additional fiscal costs for the sovereigns through various bank

workout or recapitalization programs. Furthermore, we believe that there is a

risk that reform fatigue could be mounting, especially in those countries that

have experienced deep recessions and where growth prospects remain bleak,

which could eventually lead to lower levels of predictability of policy

orientation, potentially leading to another downward adjustment of the

political score, which might lead to lower ratings.

We believe that important risks related to potential near-term deterioration

of credit conditions remain for a number of sovereigns. This belief is based

on what we see as the sovereigns' very substantial financing needs in early

2012, the risk of further downward revisions of economic growth expectations,

and the challenge to maintain political support for unpopular and possibly

more severe austerity measures, as fiscal targets are endangered by

macroeconomic headwinds. Governments are also aiming to put greater focus on

growth-enhancing structural measures. While these may contribute positively to

a lasting solution of the current crisis, we believe they could also run

counter to powerful national interest groups, whose resistance could

potentially jeopardize the reform momentum and impede the recovery of market

confidence. In our view, it also remains to be seen whether European banks

will indeed use the ample term funding provided by the ECB (see below) to


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purchase newly issued sovereign bonds of governments under financial stress.

We believe that as long as uncertainty about the bond buyers at primary

auctions remains, the risk of a deepening of the crisis remains a real one.

These risks could be exacerbated should renewed policy disagreements among

European policymakers emerge or the Greek debt restructuring lead to an

outcome that further discourages financial investors to add to their positions

in peripheral sovereign securities.

For two sovereigns, Germany and Slovakia, we concluded that downside scenarios

that could lead to a lowering of the relevant credit scores and the sovereign

ratings carry a likelihood of less than one-in-three during 2012 or 2013.

Accordingly we have assigned a stable outlook.

HOW DO WE INTERPRET THE CONCLUSIONS OF THE DECEMBER EUROPEAN SUMMIT?

We have previously stated our belief that an effective strategy that would

buoy confidence and lower the currently elevated borrowing costs for European

sovereigns could include, for example, a greater pooling of fiscal resources

and obligations as well as enhanced mutual budgetary oversight. We have also

stated that we believe that a reform process based on a pillar of fiscal

austerity alone would risk becoming self-defeating, as domestic demand falls

in line with consumer's rising concerns about job security and disposable

incomes, eroding national tax revenues.

The outcomes from the EU summit on Dec. 9, 2011, and subsequent statements

from policymakers, lead us to believe that the agreement reached has not

produced a breakthrough of sufficient size and scope to fully address the

eurozone's financial problems. In our opinion, the political agreement does

not supply sufficient additional resources or operational flexibility to

bolster European rescue operations, or extend enough support for those

eurozone sovereigns subjected to heightened market pressures. Instead, it

focuses on what we consider to be a one-sided approach by emphasizing fiscal

austerity without a strong and consistent program to raise the growth

potential of the economies in the eurozone. While some member states have

implemented measures on the national level to deregulate internal labor

markets, and improve the flexibility of domestic services sectors, these

reforms do not appear to us to be coordinated at the supra-national level; as

evidence, we would note large and widening discrepancies in activity and

unemployment levels among the 17 eurozone member states.

Regarding additional resources, the main enhancement we see has been to bring

forward to mid-2012 the start date of the European Stability Mechanism (ESM),

the successor vehicle to the European Financial Stability Fund (EFSF). This

will marginally increase these official sources' lending capacity from

currently €440bn to €500bn. As we noted previously, we expect eurozone

policymakers will accord ESM de-facto preferred creditor status in the event

of a eurozone sovereign default. We believe that the prospect of subordination

to a large creditor, which would have a key role in any future debt

rescheduling, would make a lasting contribution to the rise in long-term

government bond yields of lower-rated eurozone sovereigns and may reduce their


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future market access.

We also believe that the agreement is predicated on only a partial recognition

of the source of the crisis: that the current financial turmoil stems

primarily from fiscal profligacy at the periphery of the eurozone. In our

view, however, the financial problems facing the eurozone are as much a

consequence of rising external imbalances and divergences in competitiveness

between the EMU's core and the so-called "periphery." In our opinion, the

eurozone periphery has only been able to bear its underperformance on

competitiveness (manifest in sizeable external deficits) because of funding by

the banking systems of the more competitive northern eurozone economies.

According to our assessment, the political agreement reached at the summit did

not contain significant new initiatives to address the near-term funding

challenges that have engulfed the eurozone.

The summit focused primarily on a long-term plan to reverse fiscal imbalances.

It proposed to enshrine into national legislation requirements for

structurally balanced budgets. Certain institutional enhancements have been

introduced to strengthen the enforceability of the fiscal rules compared to

the Stability and Growth Pact, such as reverse qualified majority voting

required to overturn sanctions proposed by the European Commission in case of

violations of the broadly balanced budget rules. Notwithstanding this

progress, we believe that the enforcement of these measures is far from

certain, even if all member states eventually passed respective legislation by

parliaments (and by referendum, where this is required). Our assessment is

based on several factors, including:

• The difficulty of forecasting reliably and precisely structural deficits,

which we expect will likely be at the center of any decision on whether

to impose sanctions;

• The ability of individual member states' elected governments to extricate

themselves from the external control of the European Commission by

withdrawing from the intergovernmental agreement, which will not be part

of an EU-wide Treaty; and

• The possibility that the appropriateness of these fiscal rules may come

under scrutiny when a recession may, in the eyes of policymakers, call

for fiscal stimulus in order to stabilize demand, which could be

precluded by the need to adhere to the requirement to balance budgets.

Details on the exact content and operational procedures of the rules are still

to emerge and -- depending on the stringency of the rules -- the process of

passing national legislation may run into opposition in some signatory states,

which in turn could lower the confidence of investors and the credibility of

the agreed policies.

More fundamentally, we believe that the proposed measures do not directly

address the core underlying factors that have contributed to the market

stress. It is our view that the currently experienced financial stress does

not in the first instance result from fiscal mismanagement. This to us is

supported by the examples of Spain and Ireland, which ran an average fiscal


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deficit of 0.4% of GDP and a surplus of 1.6% of GDP, respectively, during the

period 1999-2007 (versus a deficit of 2.3% of GDP in the case of Germany),

while reducing significantly their public debt ratio during that period. The

policies and rules agreed at the summit would not have indicated that the

boom-time developments in those countries contained the seeds of the current

market turmoil.

While we see a lack of fiscal prudence as having been a major contributing

factor to high public debt levels in some countries, such as Greece, we

believe that the key underlying issue for the eurozone as a whole is one of a

growing divergence in competitiveness between the core and the so-called

"periphery." Exacerbated by the rapid expansion of European banks' balance

sheets, this has led to large and growing external imbalances, evident in the

size of financial sector claims of net capital-exporting banking systems on

net importing countries. When the financial markets deteriorated and risk

aversion increased, the financing needs of both the public and financial

sectors in the "periphery" had to be covered to varying degrees by official

funding, including European Central Bank (ECB) liquidity as well as

intergovernmental, EFSF, and IMF loans.

HOW HAS THE EUROPEAN POLICY RESPONSE AFFECTED THE RATINGS?

We have generally adjusted downward our political scores (one of the five key

factors in our published sovereign ratings criteria) for those eurozone

sovereigns we had previously scored in our two highest categories. This score

change has been a contributing factor to the rating actions on the relevant

sovereigns cited above. Under the political score, we assess how a

government's institutions and policymaking affect a sovereign's credit

fundamentals by delivering sustainable public finances, promoting balanced

growth, and responding to economic or political shocks. Our political score

also captures the potential effect of external organizations on policy

settings.

It is our view that the limitations on monetary flexibility imposed by

membership in the eurozone are not adequately counterbalanced by other

eurozone economic policies to avoid the negative impact on creditworthiness

that the eurozone members are in opinion view currently facing. Financial

solidarity among member states appears to us to be insufficient to prevent

prolonged funding uncertainties. Specifically, we believe that the current

crisis management tools may not be adequate to restore lasting confidence in

the creditworthiness of large eurozone members such as Italy and Spain. Nor do

we think they are likely to instill sufficient confidence in these sovereigns'

ability to address potential financial system stresses in their jurisdiction.

In such a setting, the prospects of effectively intervening in the feedback

loop between sovereign and financial sector risk are in our opinion weak.

HOW DO YOU EXPECT MACROECONOMIC DEVELOPMENTS WILL AFFECT THE REFORM AGENDA?

We believe that the elusiveness of an effective policy response is likely to


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add to caution among households and investors alike, weighing on the growth

outlook for all eurozone members. Our base case still assumes that the

eurozone will record moderate growth in 2012 and 2013, i.e. 0.2% and 1%,

respectively -- down from 0.4% and 1.2% according to our early December

forecast, with a relatively mild recession in the first half of 2012.

Nevertheless, we estimate a 40% probability that a deeper and more prolonged

recession could hit the eurozone, with a likely reduction of economic activity

of 1.5% in 2012. Furthermore, we believe an even deeper and more prolonged

slump cannot be entirely excluded. We expect this weak macroeconomic outlook

if realized would complicate the implementation of budget plans, with

slippages to be expected, which would likely further dampen confidence and

potentially deepen the recession, as funding and credit is curtailed and the

private sector increases precautionary savings.

WHAT IS YOUR VIEW OF THE LATEST DEVELOPMENTS IN GREECE AND WHAT IMPACT DO THEY

HAVE YOUR ANALYSIS?

We did not change the rating on Greece, which had been downgraded to 'CC' in

July 2011, indicating our view of the risk of imminent default. Negotiations

with bondholders have taken longer than originally anticipated and we believe

may now run close to a large redemption of €14.5 billion on March 20, 2012,

raising the specter of a disorderly default. Such an event would in our view

further complicate the restoration of affordable market access for other

sovereigns experiencing market stress. We understand that the main unresolved

issues are related to the treatment of holdouts, the participation of official

creditors, and the coupon of the new bonds that will be offered (which partly

determine the effective recovery, which we continue to expect to lie between

30% and 50%). We do not believe that private-sector involvement will

necessarily be a one-off event in the case of the Greek restructuring and

would not be sought in possible future bail-out packages in a future case of

sovereign insolvency or prolonged loss of market access. All the more so as

official lenders are less likely to bear any future losses as their lending

will be channeled through the ESM, a privileged creditor that is expected to

be senior to bondholders in any future restructuring.

HOW DOES STANDARD & POOR'S VIEW THE ECB's RESPONSE TO DATE?

In our view, the actions of the ECB have been instrumental in averting a

collapse of market confidence. We see that the ECB has eased its eligibility

criteria, allowing an ever-expanding pool of assets to be used as collateral

for its funding operations, and has lowered the fixed rate on its main

refinancing operation to 1%, an all-time low. Most importantly in our view, it

has engaged in unprecedented repurchase operations for financial institutions.

In December 2011, it lent financial institutions almost €500 billion over

three years and announced further unlimited long-term funding auctions for

early 2012. This has greatly relieved the funding pressure for banks, which

will have to redeem over €200 billion of bonded debt (excluding in some

jurisdictions sizeable private placements) in the first quarter alone. By

lowering the ECB deposit rate to 0.25%, we believe that the central bank has

implicitly tried to encourage financial institutions to engage in a carry


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trade of borrowing up to three-year funds cheaply from the central bank and

purchasing high-yielding government bonds. Recent Italian and other primary

auctions suggest to us, however, that banks and other investors may still only

be willing to lend longer term to governments facing market pressure if they

are offered interest rates that, all other things being equal, will make

fiscal consolidation harder to achieve.

Reports indicate that many investors had hoped that a breakthrough at the

December summit would have enticed the ECB to step up its direct government

bond purchases in the secondary market through its Security Market Program

(SMP). However, these hopes were quickly deflated as it became clearer that

the ECB would prefer to provide banks with unlimited funding, partly with the

expectation that those liquid funds in banks' balance sheets would find their

way into primary sovereign bond auctions. This indirect way of supporting the

sovereign bond market may yet be successful, but we believe that banks may

remain cautious when being faced with primary sovereign offerings, as most

financial institutions have aimed at shrinking their balance sheets by running

down security portfolios in order to comply with higher capital requirements,

which become effective in 2012. We believe that the ECB has not entirely

closed the door to expanding its involvement in the sovereign bond market but

remains reluctant to do so except in more dramatic circumstances. In our view,

this reluctance is likely prompted by concerns about moral hazard, the ECB's

own credibility (particularly should losses mount), and potential inflation

pressures in the longer term. We think it may also be the case that the ECB

(as well as some eurozone governments) is concerned that governments' reform

efforts would falter prematurely if market pressure subsides.

We believe that the risk of a credit crunch remains real in a number of

countries as economic conditions weaken and banks continue to consolidate

their balance sheets in light of tighter capital requirements and poor market

conditions in which to raise additional equity. However, the monetary policy

actions described above may mitigate the risk of a more extreme tightening of

credit conditions, which, if it were to come to pass, could put further

pressure on economic activity and employment.

In summary, while the monetary policy reaction has not been as accommodating

as many investors may have anticipated or hoped for, we believe that it has

nevertheless provided significant breathing space during which progress on

policy reform can be made. Furthermore, the ECB may yet engage in additional

supporting steps should the sovereign and bank funding crises intensify

further. Therefore, we have not changed our monetary score on eurozone

sovereigns.

HOW DOES STANDARD & POOR'S ASSESS THE REFORM EFFORTS OF THE NEW GOVERNMENTS IN

ITALY AND SPAIN?

In our view, the governments of Mario Monti and Mariano Rajoy have stepped up

initiatives to modernize their economies and secure the sustainability of

public finances over the long term. We consider that the domestic political

management of the crisis has improved markedly in Italy. Therefore, we have


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not changed our political risk score for Italy because we are of the opinion

that the weakening policy environment at the European level is to a sufficient

degree offset by Italy's stronger domestic capacity to formulate and implement

crisis-mitigating economic policies.

Despite these encouraging developments on domestic policy, we downgraded both

sovereigns by two notches. This is due to our opinion that Italy and Spain are

particularly prone to the risk of a sudden deterioration in market conditions.

Thus, we believe that, as far as sovereign creditworthiness is concerned, the

deepening of the crisis and the risks of further market dislocation that could

accompany an inconclusive European crisis management strategy more than offset

our view of the enhanced national policy orientation.

WHY WAS IRELAND THE ONLY SOVEREIGN AMONG THE SO-CALLED "PERIPHERY" NOT

DOWNGRADED?

We have not adjusted our political score backing the rating on Ireland. This

reflects our view that the Irish government's response to the significant

deterioration in its public finances and the recent crisis in the Irish

financial sector has been proactive and substantive. This offsets our view

that the effectiveness, stability, and predictability of European policymaking

as a whole remains insufficient in addressing the deepening financial crisis

in the eurozone. Excluding government-funded banking sector recapitalization

payments, the authorities have adjusted Ireland's budget by almost 13% of

estimated 2012 GDP since 2008 and plan additional fiscal savings of close to

8% of GDP for 2012-2015. All other things being equal, we view the

government's fiscal consolidation plan as sufficient to achieve a general

government deficit of about 3% of GDP in 2015. In our view, there is currently

a strong political consensus behind the fiscal consolidation program and

policy implementation so far has been extremely strong.

In our view, Ireland has the most flexible and open economy among the

"periphery" sovereigns. We believe that Ireland's economic adjustment process

is further advanced than in the other sovereigns currently experiencing market

pressures. This is illustrated by the 25% depreciation in the trade-weighted

exchange rate since May 2008 and Irish exports growth contributed positively

to the muted Irish economic recovery in 2011. However, in our view this also

leaves the Irish economy and, ultimately, the Irish government's fiscal

consolidation program susceptible to worsening external economic conditions,

which is reflected in our negative outlook on the rating.

WHAT ARE THE IMPLICATIONS FOR THE EFSF AND OTHER EUROPEAN MULTILATERAL LENDING

INSTITUTIONS?

Following our placement of the ratings on the eurozone sovereigns on

CreditWatch in December, we also placed a number of supranational entities on

CreditWatch with negative implications. These included, among others, the

European Financial Stability Fund (EFSF), the European Investment Bank (EIB),

and the European Union's own funding program. We are currently assessing the

credit implications of today's eurozone sovereign downgrades on those


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institutions and will publish our updated credit view in the coming days.

RELATED CRITERIA

Sovereign Government Rating Methodology And Assumptions, June 30, 2011

Criteria For Determining Transfer And Convertibility Assessments, May 18, 2009

Introduction Of Sovereign Recovery Ratings, June 14, 2007

RELATED RESEARCH

Standard & Poor's Takes Various Rating Actions On 16 Eurozone Sovereign

Governments, Jan. 13, 2012

Standard & Poor's Puts Ratings On Eurozone Sovereigns On CreditWatch With

Negative Implications, Dec. 5, 2011

Trade Imbalances In The Eurozone Distort Growth For Both Creditors And Debtors,

Dec. 1, 2011

European Economic Outlook: Back In Recession, published Dec. 1, 2011

Standard & Poor's RPM Measures The Eurozone's Great Rebalancing Act, Nov. 21,

2011

Who Will Solve The Debt Crisis?, Nov. 10, 2011

Ireland's Prospects Amidst The Eurozone Credit Crisis, Nov. 29, 2011

Additional Contact:Sovereign Ratings; [email protected]

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adequacy, or completeness of any information used.

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