EFSF downgrade could affect Ireland

AN UNPRECEDENTED potential mass downgrade of European countries, and in turn the European Financial Stability Facility (EFSF), is likely to have only a limited impact on the euro zone. However, an increase in the cost of funding for the EFSF could have a knock-on effect for Ireland.

On Monday night, Standard & Poor’s (S&P) put 15 euro area members, including Ireland, on “credit-watch negative”, citing, among other things, higher risk premiums, disagreement at a political level and the rising risk of recession in the euro zone in 2012.

The rating agency followed this with an announcement yesterday that it had put the EFSF’s AAA rating on review for a possible downgrade, depending on the outcome of this week’s EU summit.

“We could lower the long-term credit rating on EFSF by one or two notches if we were to lower the AAA sovereign ratings, which are currently on credit watch, on one or more of EFSF’s guarantor members,” S&P said.

However, analysts suggest that, even if the downgrades go ahead, the impact is likely to be limited as markets have already factored in such moves.

“The market has been anticipating this for some time,” said Goodbody Stockbrokers chief economist Dermot O’Leary.

“As we’ve learned, markets move in anticipation of rating agencies’ changes – not when they do them.”

However, a downgrade may push up the cost of funding for Ireland. According to Mr O’Leary, a 1 per cent increase in the cost of funding for the EFSF could result in a € 200 million increase in the cost of funding for Ireland.

But it is not certain that a downgrade will push up the cost of funding for the EFSF.

Davy stockbrokers chief economist Conall MacCoille said the cost of funding for the US had continued to fall, despite it losing its AAA status in August.

Moreover, if the European Central Bank is charged with a more aggressive bond-buying programme, this in turn could put downward pressure on yields.

On Monday, French president Nicolas Sarkozy and German chancellor Angela Merkel backtracked on the decision to include private-sector involvement, which was used in the Greek sovereign debt writedown, in any future bailout deals. This could pave the way for a more involved role by the ECB in European bond markets.

By taking private-sector involvement out of the European Stability Mechanism (ESM), it means that if Ireland cannot get back to the market in 2013 as planned, it will be able to get some sort of additional funding from the ESM, the launch of which may be brought forward to 2012.

“It is now more likely that Ireland will be able to tap into the ESM for funds should market funding not be available at sustainable rates by that stage,” said Mr O’Leary.

The assertion on private-sector involvement does, however, also make a restructuring of Irish sovereign bonds less likely, although the possibility of renegotiating the €30 billion in promissory notes, which accounts for about 20 per cent of Ireland’s total outstanding debt, remains open.

“In some senses we’re lucky that a large proportion of our debt is in promissory notes, as it means that you can restructure a large element of debt without debt writedowns,” said Mr MacCoille.

S&P’s announcement has also called into question the role of such agencies, according to Mr MacCoille.

“Rating agencies now merely reflect market sentiment rather than giving an independent review,” he said.

If Ireland is downgraded again, a maximum two-notch downgrade would still mean Ireland’s rating will remain in the investment-grade category at BBB.