Standard & Poor's has warned it may carry out an unprecedented mass downgrade of euro zone countries, including Germany and France, if EU leaders fail to deliver a convincing agreement on how to solve the region's debt crisis in a summit on Friday.
The ratings warning sent markets reeling and drew a rebuke from Eurogroup Chairman Jean-Claude Juncker, who said he was astonished by S&P's statement, describing it as a wild exaggeration and also unfair.
The agency's warning it may downgrade 15 countries came hard on the heels of a Franco-German initiative to enforce budget discipline across the 17-member zone through EU treaty changes.
President Nicolas Sarkozy and Chancellor Angela Merkel told reporters that their plan, to be discussed at Friday's summit, included automatic penalties for states that fail to keep deficits under control, and an early launch of a permanent bailout fund for euro states in distress.
They said they wanted treaty change to be agreed in March and ratified after France wraps up presidential and legislative elections in June. We need to go fast, Sarkozy said.
U.S. Treasury Secretary Timothy Geithner arrives on Tuesday to add to pressure on European policymakers to convince markets they have a viable plan to stabilize the euro zone's debt-ridden countries.
Meetings at the European Central Bank in Frankfurt and with Germany's finance minister in Berlin kick off Geithner's fourth visit to the continent since September, underlining Washington's interest in averting a euro zone meltdown and its worries about Europe's woes weighing down the U.S. and the global economy.
Italy, the biggest euro zone nation in trouble, offered a glimmer of hope that the bloc could halt a crisis that is threatening the survival of the common currency. Its borrowing costs tumbled after its new technocrat government announced an austerity program.
S&P's statement made no mention of that program, and French Finance Minister Francois Baroin said it did not take into account Sarkozy and Merkel's announcement.
He said France for its part did not plan to expand the austerity measures it had already announced.
I am not unsettled by this, Juncker told German radio on Tuesday. But I am astonished after the significant efforts in recent days to overcome the crisis, such as savings programs in Italy and Ireland.
S&P said it would conclude its review as soon as possible after the summit, making clear that it wanted to see political as well as financial solutions.
It highlighted continuing disagreements among European policy makers on how to tackle the immediate market confidence crisis and, longer term, how to ensure greater economic, financial, and fiscal convergence among eurozone members.
In its statement, it said that ... 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.
ONE NOTCH OR TWO
It said ratings could be lowered by one notch for Austria, Belgium, Finland, Germany, the Netherlands and Luxembourg, and by up to two notches for the remaining nine placed under review, including currently AAA-rated France. Cyprus was already on downgrade watch and Greece already has a 'junk' CC-rating.
European stocks, bond futures, and the euro were sent reeling by the shock warning, halting a rally in global equities that began last week as the MSCI world equity index fell 0.6 percent.
S&P also threw into relief the difficulty that euro zone countries face in trying not to strangle growth with so much austerity, saying there was a 40 percent chance that the output of the euro zone as a whole would shrink next year.
After about two hours of talks with Merkel in Paris, Sarkozy told a joint news conference: What we want ... is to tell the world that in Europe the rule is that we pay back our debts, reduce our deficits, restore growth.
Merkel added: This package shows that we are absolutely determined to keep the euro as a stable currency and as an important contributor to European stability.
In response to S&P's action, they said they were united in their determination, along with their European partners, to take all measures to secure stability in the euro zone.
ECB chief Mario Draghi has signalled that a euro zone fiscal compact could encourage the central bank to act more decisively on the crisis. It has been reluctant to buy up debt from distressed euro states more aggressively, arguing doing so would take pressure off governments to get their finances in order.
LACK OF PROGRESS
The S&P warning could well have a positive effect by helping Merkel and Sarkozy push through their proposals, Norbert Barthle, the budgetary expert in Germany's ruling conservatives said on Tuesday.
However, ECB governing council member Christian Noyer took a dimmer view, questioning if S&P was adding fuel to the crisis.
The agencies were one of the motors of the crisis in 2008. Are they becoming a motor in the current crisis? he said at a conference in Paris.
Merkel and Sarkozy both had wanted a system of more coercive discipline for euro zone governments that fail to keep down their budget deficits.
But they had been under unprecedented pressure to see eye to eye in a crisis that has split them on issues such as the role of the ECB in lending to troubled states, and whether the bloc should issue jointly guaranteed euro bonds.
Sarkozy and Merkel said they would send off their plan on Wednesday, in time for Friday's summit, and made clear their determination to drive through an EU treaty change despite objections from some member states.
If countries such as euro outsider Britain blocked a treaty change for the 27 EU members, the euro zone would proceed with an agreement among its 17 states, they said.
In this extremely worrying period and serious crisis, France believes that the alliance and understanding with Germany are of strategic importance, Sarkozy said. Risking a disagreement would be risking the euro zone exploding.
Several governments, notably Britain, Ireland and the Netherlands, oppose treaty change because it might not win public backing if put to a referendum.
Both Italy and Ireland have announced fresh austerity measures.
Italian Prime Minister Mario Monti declared that if it was not for his 30-billion-euro austerity plan, Italy would have collapsed, Italy would go into a situation similar to that of Greece.
Ireland also unveiled a tough budget with new spending cuts accounting for nearly 60 percent of next year's 3.8 billion euro fiscal adjustment.
(Additional reporting by Reuters bureaus: Writing by David Stamp; Editing by Paul Taylor and Kevin Liffey)