ANALYSIS: Investors hold key after eurozone bailout fund downgrade

By Alexandra Mayer-Hohdahl Jan 17, 2012, 15:04 GMT

Brussels - It may have been the day after the eurozone's bailout fund was downgraded by a major credit rating agency, but Tuesday turned out to be mostly business as usual.

The fund, the European Financial Stability Facility (EFSF), auctioned off 1.5 billion euros (1.9 billion dollars) in six-month bills, encountering 'very strong demand.'

The euro remained relatively stable against the dollar, trading slightly up by the afternoon.

And European Union officials stuck by their position that the move by the Standard & Poor's rating agency was merely a technical adjustment - in line with its downgrade of nine eurozone countries on Friday - rather than a sign of a loss of trust in the fund.

Even traditional critics of the bloc's fight against its enduring crisis were less vociferous than usual.

While describing the downgrade as a 'milestone on the eurozone's descent into a downward spiral,' Sony Kapoor, the head of the international think tank Re-Define, also acknowledged that 'this is more of a reputational blow for the EU... than anything with much economic significance.'

Behind the shield of anonymity, EU sources said the effect of the Standard & Poor downgrade from AAA to AA+ ultimately lies in the hands of the EFSF's investors.

The fund borrows on the financial markets, backed up by 780 billion euros in guarantees from eurozone countries. The money is then used to fund bailouts for stricken member states, such as Ireland and Portugal - up to a maximum 440 billion euros.

The fact that the EFSF bonds no longer have a top-level credit score means that investors can demand higher interest rates - thus technically limiting the fund's lending power.

Some observers have also pointed to the fact that some investors may have rules in place that prohibit them from lending to parties that do not have a top-notch rating.

That might pose a problem, since the fund is not only expected to provide bailouts to the likes of Portugal and Ireland, but also act as a lender of last resort for bank recapitalizations and buy bonds of distressed eurozone governments.

That expanded mandate is yet to be applied to the EFSF, which in recent months has also struggled to attract interest from the likes of China and Brazil in complex financial arrangements that were supposed to stretch out its firepower to up to 1 billion euros.

Both EFSF manager Klaus Regling and the chairman of the eurozone finance ministers, Jean-Claude Juncker, insisted on Monday evening that the downgrade 'will not reduce EFSF's lending capacity of 440 billion euros.'

'EFSF has sufficient means to fulfill its commitments under current and potential future adjustment (bailout) programmes,' they said, with Juncker noting that it would also 'continue to be backed by unconditional and irrevocable guarantees by euro area member states.'

European Central Bank President Mario Draghi meanwhile suggested that the only way to do that would be for the remaining AAA euro area countries - Germany, Luxembourg, Finland and the Netherlands - to chip in 'additional contributions.'

The chief economist of the Organization of Economic Cooperation and Development, Pier Carlo Padoan, told dpa on Tuesday that eurozone policymakers should either accept that the EFSF will have less money or 'increase the resources provided (to it) by those countries which have kept their AAA.'

Officials have made a point, however, of noting that the EFSF is only temporary. It was originally meant to be replaced in 2013 by a permanent bailout fund, the European Stability Mechanism, that will be less reliant on credit ratings.

The eurozone is working on moving up its launch to July. Padoan has urged the currency bloc to speed up the process even further.

'We will not change our agenda because of that (Standard & Poor's) rating,' Amadeu Altafaj, a spokesman for EU Economy Commissioner Olli Rehn, told reporters in Brussels on Tuesday. 'We know very well what has to be done. We don't need a rating agency to tell us.'

The issue is likely to be on the agenda of eurozone finance ministers when they meet on Monday, ahead of a closely watched summit of EU leaders on the eurozone debt crisis on January 30.