Eurozone warned of credit downgrades after Germany and France strike deal
Merkel and Sarkozy spark relief in markets after agreeing package of measures to take to EU summit
The grand bargain struck by Germany and France to save the euro and restore confidence in the single currency was facing its first challenge within hours of being negotiated, after 15 eurozone nations were warned that their credit ratings could be downgraded.
Just after crunch talks in Paris seen as vital to preventing the collapse of the euro, France and Germany were among the countries warned that Standard & Poor's was considering whether to reduce their ratings.
The German chancellor, Angela Merkel, and the French president, Nicolas Sarkozy, had earlier brought relief to the markets after agreeing a package of measures to take to an EU summit on Thursday, at which the deal is likely to be contested, but will probably be blessed.
Merkel and Sarkozy called for the Lisbon treaty to be reopened to facilitate the new eurozone deal but both agreed that if it ran into insuperable resistance, the 17 countries of the eurozone would themselves forge a new euro pact.
Although the announcement in Paris brought instant relief for the beleaguered euro, the pressure on the currency was short lived as rumours of the S&P action swirled just before the US markets shut. The Dow Jones closed up 78 points, giving up much of a 167-point gain it had made earlier in the day.
Until then, the costs of borrowing for Italy and Spain fell by half a percentage point or more, while the stock markets rallied and the euro strengthened against the dollar.
Earlier, Mario Monti, the new Italian prime minister, had unveiled his radical austerity package entailing €30bn (£26bn) of savings and warned Italy would be the next Greece without the drastic action.
S&P is reviewing 15 of the 17 eurozone credit ratings, and has promised to conclude its review as quickly as possible after this week's summit. Much of the market's focus will be on the six top-rated countries, particularly Germany, whose AAA status had not been thought to be in doubt before Monday night.
Merkel and Sarkozy said the new eurozone regime would be punitive, with automatic sanctions levied against countries breaching budget deficit limits. This was a concession for Sarkozy, who risks howls of criticism in France that he is surrendering parliamentary and governmental sovereignty over the French budget.
Eurozone leaders mustering a qualified majority of 85%, however, would be able to block the sanctions, Sarkozy said. That will allow him to claim that national democratic legitimacy has prevailed, although this looks unlikely.
The Franco-German pact presents David Cameron with a dilemma: whether to support treaty change at the summit of all 27 countries so the UK has a say in what happens, or let the 17 get on with it and face being marginalised. If the Lisbon treaty is reopened, Cameron has to tread carefully between Tory backbenchers who could exploit the opportunity to refashion the UK relationship with the EU, and most of the rest of the EU, who are wary of getting bogged down in a row about what Britain wants. In Brussels, however, officials speculated that the changes might be possible within the framework of the Lisbon treaty.
The German victory on automatic penalties for deficit sinners came on top of a joint call, also a German demand, for legally enshrined debt brakes in all eurozone countries, geared to ensuring balanced budgets, with the European court of justice charged with ruling on individual governments' practices. This appeared to be a more restrictive role for the court than Merkel had wanted, however.
In yet another U-turn by France, Sarkozy said there was no case for pooling eurozone debt and issuing collective debt instruments known as eurobonds – a German red line. "What a strange idea – harmonising the debt," said Sarkozy.
The summit was preceded in France by a chorus of bitter anti-German rhetoric from the left and the far right, putting Sarkozy in a difficult position six months before he bids for a second presidential term. "Those who speak like that are in opposition," said Merkel. "Let's be happy it's us in government and not them."
While both leaders agreed for the first time to rule out eurobonds, they were also poised to turn a blind eye to expanded intervention in the crisis by the European Central Bank, emphasising they would not comment on what the ECB chose to do.
The ECB's short-term role will be critical to whether the euro can be stabilised and whether the new blueprint for a so-called fiscal union is given the time to work.
While the overall package was largely scripted in Berlin, Merkel delivered one major concession, abjuring losses for private investors in sovereign debt crises. Under pressure from France, the ECB and the European commission, she agreed private investors in eurozone debt would not be forced to accept losses in the event of a default or bailout, with the exception of Greece where "haircuts" for the banks and private investors were agreed last July.
In an unexpected move, Berlin and Paris called for the eurozone permanent bailout fund, the European Stability Mechanism, to be launched next year rather than in 2013 as previously planned.
The package is to be turned into a formal joint proposal to be handed to Herman Van Rompuy, the European Council president, who is chairing the EU summit on Thursday and Friday. It falls to him to twist arms and to get the rest of the EU and eurozone to support the package. A big sticking point will be Merkel's insistence on renegotiating the Lisbon treaty, with many member states fearing that will mean opening a can of worms, sparking a lengthy acrimonious bout of horse-trading.
The Irish government will be particularly anxious as it may have to stage a referendum on the revised treaty, potentially derailing the entire scheme. Ireland faces more heavy cuts in public spending next year, with welfare and health departments taking the brunt of the pain under the country's latest austerity budget outlined on Monday.
Ireland's public expenditure and reform minister, Brendan Howlin, said spending would be cut by 2.7%, amounting to €1.4bn (£1.2bn) of reductions, in the first part of a budget which will continue with announcements on tax increases from the finance minister Michael Noonan on Tuesday.
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