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Analysis: Rescue fund downgrade raises pressure on euro zone

A road sign is seen near a banner of a euro coin on the facade of the European Commission headquarters in Brussels
A road sign is seen near a banner of a euro coin on the facade of the European Commission headquarters in Brussels

By Jan Strupczewski

BRUSSELS (Reuters) - Political resistance is clashing with financial imperatives as the euro zone tries to strengthen its capacity to rescue debt-stricken member states after Europe's temporary bailout fund lost its top-notch credit rating.

Standard & Poor's downgrading of the European Financial Stability Facility to AA+ on Monday raised pressure on the 17-member currency area to end disputes holding up the launch of a permanent rescue fund, and to let both run alongside each other with full lending power from July.

The move cast doubt on whether the permanent 500 billion euro European Stability Mechanism will win a top S&P rating. The ESM will have a stronger structure than the EFSF, but both funds have the same shareholders - euro zone governments - nine of which were downgraded last week. France and Austria both lost their triple-A ratings.

EU paymaster Germany has rejected raising its contribution to either fund, which would require parliamentary approval. The Netherlands, Finland and Luxembourg, which along with Berlin kept their triple-A status, also ruled out putting up more money.

EU officials insisted the S&P action would have little or no impact on the fund's capacity, since the two other major credit watchdogs, Moody's and Fitch, still rate the EFSF as triple-A.

"As long as it is only one rating agency there is no need to do anything really," EFSF chief Klaus Regling told reporters during a trip to Singapore to meet investors.

"You had the same situation when S&P downgraded the U.S.. The others did not follow. There was no market impact."

To boost their firepower in case Spain or Italy need financing programs like Greece, Ireland and Portugal, euro zone leaders pushed forward the launch of the ESM by one year to July 2012. They agreed to let it run in parallel with the EFSF for one year rather than immediately replacing it.

They also said they would review in March the limit on lending by both the EFSF and ESM, which had been set at 500 billion euros, signaling they may raise this combined ceiling.

ESM VOTING DISPUTE

But there are political obstacles to finishing work on the ESM, including strong Finnish opposition to efforts by euro zone leaders Germany and France to take ESM decisions by qualified majority vote rather than unanimity to prevent small states blocking urgent action.

Since the idea was announced in December there has been no progress in resolving the dispute with Finland, where the government would need the backing of two-thirds of parliament to accept the change - a majority it does not have.

"There is hope, but others have to understand Finland's problems and give in a little," one euro zone official involved in talks between Helsinki and euro zone capitals said.

The EFSF relies on guarantees from euro zone governments to borrow cheaply and lend the money on to countries cut off from the markets to give them time to reform.

Its maximum lending capacity, based on the guarantees, is 440 billion euros, assuming bonds issued by the EFSF have the highest credit rating.

Credit Suisse analysts said the demotion of France and Austria meant the fund's effective AAA lending capacity was now just 110 billion euros, compared to 183 billion euros before the downgrade.

With the EFSF's firepower diminished, fellow leaders are more likely to overcome German objections and remove the combined lending limit, officials suggest.

"We will see pressure towards that, rather than some new steps inside the EFSF," the euro zone official said. "It would be easier politically to do this, than to say 'we will need more guarantees from the remaining AAAs and others'."

MARKET PRESSURE SEEN KEY

But another euro zone source said Germany was unlikely to budge unless there was strong market pressure in March.

"All will depend on how the markets are moving. If there is no sense of drama, I really doubt that the cap will be removed, particularly because of one very important country (Germany). If there is drama on the markets, this might change."

Euro zone politicians believe the ESM will be a stronger institution than the EFSF, because it will have paid-in capital of 80 billion euros and 620 billion euros of callable capital, making it more like a bank and less dependent on ratings.

But callable capital also depends on the creditworthiness of those that are meant to supply it on demand, and Royal Bank of Scotland said in a research note the ESM may need double the initially foreseen callable capital to secure a AAA rating.

"If the ESM wants to maintain its AAA rating and its lending capacity at 500 billion euros, then subscribed capital would need to be increased to 1.28 trillion euros (from 700 billion currently). This would lead to doubling in callable capital for all member countries," the bank said.

Officials said there has been no discussion so far of increasing the amounts of paid-in or callable capital.

German leaders say the EFSF's current resources have not been exhausted, and apart from a planned second bailout package for Greece, which is within its means, no further financial rescues are expected.

In contrast to U.S. and British officials, who argue that the euro zone urgently needs a bigger headline number to prevent market contagion, Berlin contends that increasing the rescue funds would be seen as a sign of panic, or encourage Italy and Spain to let up on painful economic reforms.

"There is no sense of panic or drama," the euro zone official said.

(Reporting By Jan Strupczewski; Editing by Paul Taylor and Stephen Nisbet)

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