Moody’s Strips France Of Triple-A Rating; But There's A Silver Lining

Moody’s Investors Service one-notch downgrade of France's credit wasn't a particularly big deal, as the decision was at least partly expected: Moody’s put France on negative outlook in February and Standard & Poor's downgraded it in January. The decision, however, should be a welcoming development to Socialist President Francois Hollande, as it will help him convince his compatriots that more reforms are needed, and that the clock is ticking.

Moody’s decision, disclosed Monday, also comes with threats of further downgrades if the government fails to implement reforms to fix France’s public finances.

The ratings firm said the main reasons for its action, which leaves Paris-based Fitch Ratings as the only ratings agency to keep France at triple-A, are the structural economic challenges (losses in competitiveness and labor market rigidities), the overoptimistic economic assumptions that raises the risks of fiscal slippage and the weight of contingent liabilities related to peripheral economies. Moody’s also noted that France does not have access to a central bank, in contrast to “other non-euro-area sovereigns that carry similarly high ratings.”

“This is a gentle reminder of the need for France to pursue fiscal austerity and structural reforms,” writes Michael Martinez, an economist at Societe Generale. “Our view is that the French government has recently sent positive signals on public finance commitments and competitiveness. However, more is required.”

France said Tuesday it would respond to Moody’s downgrade by pushing on with reforms. “Moody's raised concerns about France's capacity to reform, and so it is up to us to show that this time we are going to carry out reforms,” Finance Minister Pierre Moscovici told journalists, according to Reuters.

Hollande may have made the right diagnoses of France’s economic problems. But his reforms, if serious, could create political headwinds and lead to a wave of public anger. Moody’s decision could help Hollande demonstrate the need for reforms.

Described by Hollande as the toughest belt-tightening effort in 30 years, France’s 2013 budget is aimed at cutting the budget deficit from 4.5 percent of gross domestic product this year to 3 percent in 2013, an unprecedented effort at a time of economic stagnation.

The French people remain unconvinced of the need for major changes -- including attempts to reform labor laws -- at a time when the country’s unemployment rate is running at a 13-year high and 30 billion euros ($38 billion) in additional taxes on households and businesses are set to kick in next year.

Near-Term Pain

“While any measures aimed at improving France’s competitiveness might boost growth in the future, they are likely to have a damaging effect in the nearer term,” writes Jennifer McKeown, senior European economist at Capital Economics. “Given this and French banks’ still high exposures to the periphery, we still see the economy shrinking by as much as 2 percent next year.”

France's overoptimistic growth forecast of 0.8 percent for next year, which underpins its plan to meet a public deficit target of 3 percent of GDP, has been widely questioned by economists.

Given the overoptimistic growth assumption, “it seems clear that more austerity measures will be needed if the government is to reduce its borrowing to 3 percent of GDP next year as planned,” McKeown said. “The latest news will increase the pressure for such measures to be announced.”

France has one of the world's highest levels of public spending, at 56 percent of GDP. Moody's warned it could downgrade France again if efforts to free up the rigid labor market and overhaul the economy fail to deliver the desired results.

"We would downgrade the rating further in the event of an additional material deterioration in France's economic prospects or in a scenario in which there were difficulties in implementing the announced reforms," Moody's lead France analyst Dietmar Hornung told Reuters. He said more big shocks from the euro zone debt crisis would also exert downward pressure on the rating.

Although Moody’s maintains France on Negative outlook -- indicating that there is at least a one-third chance that the rating be lowered by one notch in 2013 or 2014 -- the good news is that it did not put France on Credit Watch Negative. Therefore, investors should not expect any new downgrades from Moody’s within the next six months.

In the coming weeks, market attention will focus on a possible downgrade by Fitch as well as the consequences for the euro zone's EFSF and ESM bailout funds in light of the French downgrade.

Moody’s latest move could mean that the lending capacity of the EFSF and ESM will be cut.

In the past, ratings agencies have stated that they will grant the funds top ratings only if the amounts that they lend are matched by guarantees from top-rated governments. The loss of France’s 20 percent contribution to the funds’ remaining lending capacity of about 440 billion euros would be a serious blow, according to McKeown.

“The EFSF and ESM could accept a downgrade, but this would mean an increase in their borrowing costs, which would presumably have to be passed on to troubled nations in the form of less generous loans,” McKeown said.