Moody's threat to downgrade the outlook on France's rating will affect the outcome of the October 23rd summit from which we all expect "the beginning of the end" of the European crisis.
While Italy is the country that cannot be saved, France is the Country that cannot save the euro. Taking on explicit guarantees for the debt of others, even through one's own banks, would make Paris loose the "triple A" rating and would prevent the bail-out fund to have the size and credibility to finance bail-outs.

The fact that markets still consider gross debt just for Europe, and not for the US where it would be just shy of the Greek one, proves that the Euro area still pays the price for doubts on its survival: in exchange for the aid there are important assets, even clearer in the case of banks, that would leave the net debt unchanged, but the value of the assets remains in doubt until it is certain that the Countries hit will be defended to the end by the others.

France's weakness, the incomplete commitment in favor of the euro are all construction faults of the State bail-out fund (EFSF) that are bringing to its ongoing transformation. In these days the idea that is gaining ground is that of making the fund work like an insurer on the risk of losses on securities issued by countries undergoing a crisis. As Allianz CFO Paul Achleitner suggested to the German government a few months ago, the fund would cover 20% to 40% of the risk of losses of the bonds issued.

The resources already available, at least 200 billion euros left in the EFSF, would guarantee up to 1000 billion euros in bonds. "Reassured" investors would therefore require lower yields from Greece or Italy, but they would continue to demand discipline from these Countries. When Achleitner told me about his plan last May, I had all sorts of reservations, to which he rebutted with convinced pragmatism.

The proposal was a bit similar to the creation of a credit default swap that was more solid than the ones on the market, but still had the risk of prompting contagion. It seemed a bit contradictory by the Germans to have imposed losses on Greek bonds to investors, with destabilizing effects, and then proposing insurance on those same losses. The objections in principle regarded however the philosophy of a mechanism that makes the idea of the State bail-out fund take a step back as an embryo of a European government, that lends money in exchange for political conditions, and transforms it into a system to calculate losses. I think I undervalued the need to be pragmatic.

Seen from Berlin, the solution has several advantages because it allows calculating the financial risks of saving the euro, as imposed by the latest ruling of the Constitutional Court. Furthermore, it concerns all countries, and not just those with a "triple A" rating. It also keeps the pressure on those countries undergoing difficulties but it rules out the risk that they pull out of the euro. Finally, it frees the ECB from the fiscal assistance that it is giving. To protect the ECB, Berlin rejected a more advanced proposal to transform the fund into a bank supported by the unlimited liquidity of the central bank. In front of evidence that France, the most important partner, altered growth forecast on which it based its fiscal objectives for 2012, an election year, one can understand Angela Merkel's prudence towards solutions that are too binding and the appeal to what she calls the "art of the possible".

Only in the next few hours we will know with certainty which will be the key proposal for Sunday's summit. If it were the insurance option, one would understand why in these hours Merkel has forecast a turnaround, but not a decisive solution for the crisis.
Since the use of the fund as an insurance is clearly a short-term solution, useful to reduce the fever on the market, it will have to go hand in hand with a more "political" commitment that will require time. Not by chance Merkel yesterday announced the re-opening and reform of European treaties.

Readers will find again in this scheme that "policy of uncertainty" that Merkel likes: full of reassurances on the future of the euro, but leaving to the markets the duty to impose on partners that discipline that no one still has the political authority to exercise.
Insuring losses relieves a bit that uncertainty and the brutal function of the markets. If the risk coverage for investors were at least doubled, also Italy would benefit. The debt servicing costs would remain high, but, as long as markets are happy with the outcome of the summit, yields on Italian bonds would stay within levels that are not pathological. However, the underlying situation would not change. The clock would move back by a few months and the doubt on whether the country can keep up the pace of other countries of the euro area would arise day after day.

translated by Yael Schrage

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