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Moody’s sees more ratings downgrades ahead for weaker European sovereigns even as European governments increase their levels of mutual support.

In their efforts to resolve the ongoing pressures in the euro-area sovereign debt markets, policymakers are trying to balance the desire to support financial stability with the reluctance to extend further support to weaker euro-area members, says Moody’s Investors Service in a Special Comment published today.

Moody’s believes that the probability of rapid economic growth in the region easing the task of fiscal consolidation now seems very low. Growth within the euro area is projected to be weak at best and vulnerable to a further downturn in global demand. The far-reaching structural reforms planned in many countries — aimed at boosting productivity and competitiveness — should improve the region’s long-term growth prospects; however, these reforms carry sizable implementation risks.

There has been a profound loss of confidence in certain European sovereign debt markets, and Moody’s considers that this extremely weak market sentiment will likely persist. It is no longer a temporary problem that might be addressed through liquidity support, and several euro-area governments are increasingly affected by the loss of confidence. Moody’s believes that the associated credit risks could be severe and potentially abrupt, comparable to the ’sudden stops’ that emerging markets have experienced.

Given this context, Moody’s believes that the current policy framework is unlikely to persist in the medium term. In the absence of a rapid return to growth and market confidence, the euro-area states will at some point have to choose between increasing the level of mutual support and managing further defaults. Moody’s believes that the former option is the one that euro-area policymakers are more likely to adopt.

However, institutional obstacles will likely constrain any rapid changes in euro-area policy strategy. Moody’s considers that the tension between the policy options currently available to the euro-area authorities and those that may be needed to restore investor confidence implies significant risk to euro-area financial markets. The rating agency therefore expects that severe market pressures will likely persist for the foreseeable future, with the potential for higher long-term financing costs and an elevated risk of constrained access to funding.

As a result, all but the strongest euro-area sovereigns are likely to face sustained negative pressure on their ratings. Consequently, Moody’s expects fewer countries below Aaa to retain high ratings.

Those with lower investment-grade ratings face a greater likelihood of downward migration, if the probability of a loss of market access increases. Moody’s believes that there are no immediate pressures that could cause downgrades for Aaa-rated countries.

To reflect the heightened, though still low, risk of an exit from the euro area by one or more sovereigns, Moody’s will revisit the euro area’s single ‘country ceiling’, which currently implies that any euro-area entity, regardless of the country in which it is domiciled, could potentially be rated Aaa.

Source: More Sovereign Downgrades Likely As Euro Area Credit Pressures Yet To Peak