Moody's Changes Aaa-Rated Germany, Netherlands, Luxembourg Outlook To Negative

In a first for Moody's, the rating agency, traditionally about a month after Egan Jones (whose rationale and burdensharing text was virtually copied by Moody's: here and here), has decided to cut Europe's untouchable core, while still at Aaa, to Outlook negative, in the process implicitly downgrading Germany, Netherlands and Luxembourg, and putting them in line with Austria and France which have been on a negative outlook since February 13, 2012.The only good news goes to Finland, whose outlook is kept at stable for one simple reason: the country's attempts to collateralize its European bailout exposure, a move which will now be copied by all the suddenly more precarious core European countries.

From the report:

Moody's changes the outlook to negative on Germany, Netherlands, Luxembourg and affirms Finland's Aaa stable rating

London, 23 July 2012 -- Moody's Investors Service has today revised to negative from stable the outlooks on the Aaa sovereign ratings of Germany, the Netherlands and Luxembourg. In addition, Moody's has also affirmed Finland's Aaa rating and stable outlook.

All four sovereigns are adversely affected by the following two euro-area-wide developments:

1.) The rising uncertainty regarding the outcome of the euro area debt crisis given the current policy framework, and the increased susceptibility to event risk stemming from the increased likelihood of Greece's exit from the euro area, including the broader impact that such an event would have on euro area members, particularly Spain and Italy.

2.) Even if such an event is avoided, there is an increasing likelihood that greater collective support for other euro area sovereigns, most notably Spain and Italy, will be required. Given the greater ability to absorb the costs associated with this support, this burden will likely fall most heavily on more highly rated member states if the euro area is to be preserved in its current form.

These increased risks, in combination with the country-specific considerations discussed below, have prompted the changes in the rating outlooks of Germany, the Netherlands and Luxembourg. In contrast, Finland's unique credit profile, as discussed below, remains consistent with a stable rating outlook.

RATIONALE FOR OUTLOOK CHANGE

Today's decision to change to negative the outlooks on the Aaa ratings of Germany, the Netherlands and Luxembourg is driven by Moody's view that the level of uncertainty about the outlook for the euro area, and the potential impact of plausible scenarios on member states, are no longer consistent with stable outlooks.

Firstly, while it is not Moody's base case, the risk of an exit by Greece from the euro area has increased relative to the rating agency's expectations earlier this year. In Moody's view, a Greek exit from the monetary union would pose a material threat to the euro. Although Moody's would expect a strong policy response from the euro area in such an event, it would still set off a chain of financial-sector shocks and associated liquidity pressures for sovereigns and banks that policymakers could only contain at a very high cost. Should they fail to do so, the result would be a gradual unwinding of the currency union, which Moody's continues to believe would be profoundly negative for all euro area members. The rating agency has reflected this risk by raising the score for the "Susceptibility to Event Risk" factor in its sovereign rating methodology from "very low" to "low" for these three countries.

Secondly, even in the absence of any exit, the contingent liabilities taken on by the strongest euro area sovereigns are rising as a result of European policymakers' continued reactive and gradualist policy response, as is the probability of those liabilities crystallising (as Moody's already observed in a recent Special Comment, entitled "Moody's: EU Summit's Measures Reduce Likelihood of Shocks but at a Cost", published on 5 July 2012). Moody's view remains that this approach will not produce a stable outcome, and will very likely be associated with a series of shocks, which are likely to rise in magnitude the longer the crisis persists. The continued deterioration in Spain and Italy's macroeconomic and funding environment has increased the risk that they will require some kind of external support. The scale of these contingent liabilities is of a materially larger order of magnitude for these countries due to their size and their debt burdens; for example, the size of Spain's economy and government bond market is around double the combined size of those of Greece, Portugal and Ireland. Although the rising likelihood of stronger euro area members needing to support other sovereigns has not yet affected Moody's assessment of these sovereigns' "Government Financial Strength" in its rating methodology, the rating agency nevertheless believes that it needs to take some account of the impact that additional financial commitments would have on the assessment of their financial strength, given the material deterioration in these countries' fiscal metrics since 2007. Over the long term, Moody's believes that institutional reforms within the euro area have the potential to strengthen the credit standing of most or all euro area governments; however, over the transitional period (which could last many years), the additional pressure on the strongest nations' balance sheets will increase the pressure on their credit standing.

Accordingly, Moody's now has negative outlooks on those Aaa-rated euro area sovereigns whose balance sheets are expected to bear the main financial burden of support -- whether because of the need to expand the European Stability Mechanism (ESM) or the need to develop more ad hoc forms of liquidity support. These countries now comprise Germany and the Netherlands, in addition to Austria and France whose rating outlooks were changed to negative on 13 February 2012. The credit profile of these sovereigns is most affected by the policy dilemma described above.

Finland, with its stable outlook, is now the sole exception among the Aaa-rated euro area sovereigns. Although Finland would not be expected to be unaffected by the euro crisis, its net assets (Finland has no debt on a net basis), its small and domestically oriented banking system, its limited exposure to, and therefore relative insulation from, the euro area in terms of trade,and its attempts to collateralise its euro area sovereign support together provide strong buffers which differentiate it from the other Aaas.

Today's actions on the four sovereigns' outlooks incorporate the implications of certain euro area developments, such as the rising risk of a Greek exit, the growing likelihood of collective support for other euro area sovereigns, and stalled economic growth. By the end of the third quarter, Moody's will also assess the implications of these developments for Aaa-rated Austria and France, whose rating outlooks were moved to negative from stable in February. Specifically, Moody's will review whether their current rating outlooks remain appropriate or whether more extensive rating reviews are warranted.

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