PARIS/NEW YORK (Reuters) ? Standard & Poor's has warned it may carry out an unprecedented mass downgrade of euro zone countries if EU leaders fail to deliver a convincing agreement on how to solve the region's debt crisis in a summit on Friday.
The ratings agency's threat to downgrade 15 countries all the way up to AAA-rated Germany and France came hard on the heels of a Franco-German initiative, to be discussed on Friday, to enforce budget discipline across the 17-member zone through EU treaty changes.
President Nicolas Sarkozy and Chancellor Angela Merkel told reporters that their plan included automatic penalties for states that fail to keep deficits under control, and an early launch of a permanent bailout fund for euro states in distress.
They said they wanted treaty change to be agreed in March and ratified after France wraps up presidential and legislative elections in June. "We need to go fast," Sarkozy said.
Italy, the biggest euro zone nation in trouble, offered a glimmer of hope that the bloc could halt a crisis that is threatening the survival of the common currency. Its borrowing costs tumbled after its new technocrat government announced an austerity program.
S&P's statement made no mention of that program, and French Finance Minister Francois Baroin said it did not take into account Sarkozy and Merkel's announcement.
He said France for its part did not plan to expand the austerity measures it already has announced.
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Interactive timeline: http://link.reuters.com/rev89r
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S&P told the governments it would conclude its review "as soon as possible" after the summit, making clear that it wanted to see political as well as financial solutions.
It highlighted "continuing disagreements among European policy makers on how to tackle the immediate market confidence crisis and, longer term, how to ensure greater economic, financial, and fiscal convergence among eurozone members."
In its statement, it said that "... systemic stresses in the eurozone have risen in recent weeks to the extent that they now put downward pressure on the credit standing of the eurozone as a whole.
ONE NOTCH OR TWO
It said ratings could be lowered by one notch for Austria, Belgium, Finland, Germany, the Netherlands and Luxembourg, and by up to two notches for the remaining nine placed under review, including currently AAA-rated France. Cyprus was already on downgrade watch and Greece already has a 'junk' CC-rating.
S&P also threw into relief the difficulty that euro zone countries face in trying not to strangle growth with so much austerity, saying there was a 40 percent chance that the output of the euro zone as a whole would shrink next year.
U.S. Treasury Secretary Timothy Geithner arrives on Tuesday to add to the pressure on the summit to convince markets that EU leaders have a viable plan to stabilize the finances of the euro zone's most debt-ridden countries.
Meetings at the European Central Bank in Frankfurt and with Germany's finance minister in Berlin kick off his fourth visit to the continent since September, underlining Washington's interest in averting a euro zone meltdown and its worries about Europe's woes weighing down the U.S. and the global economy.
After about two hours of talks with Merkel in Paris, Sarkozy told a joint news conference: "What we want ... is to tell the world that in Europe the rule is that we pay back our debts, reduce our deficits, restore growth."
Merkel added: "This package shows that we are absolutely determined to keep the euro as a stable currency and as an important contributor to European stability."
Later, the two leaders swiftly responded to S&P's action with a joint statement saying they were united in their determination, along with their European partners, to "take all measures to secure stability in the euro zone.
Confidence that European leaders will come up with a credible plan lifted world stocks on Monday, with European shares hitting a five-week high.
Investors and policymakers hope a summit deal on closer euro zone integration, combined with strict deficit reduction moves by heavily indebted states, will induce the European Central Bank to act decisively to stop bond market turbulence spreading.
ECB policymakers have been reluctant to buy up debt from distressed euro states, as this would take the pressure off governments to get their finances in order. But ECB chief Mario Draghi has signaled that a euro zone "fiscal compact" could encourage the bank to act more decisively on the crisis.
"This agreement probably will give the ECB the political cover for intervening more actively on a temporary basis," said Uri Dadush, senior associate at the Carnegie Endowment's International Economics Program in Washington
"The bad news is that this is all temporary. It is difficult to see how a deal like this hangs together without a quid pro quo in terms of some movement towards (jointly guaranteed) euro bonds or some form of long-term fiscal support for the countries in trouble."
LACK OF PROGRESS
Brian Dolan, chief strategist at Forex.Com in Bedminster, New Jersey, said S&P might be "signaling to the EU this is it, that they've got to get something done now."
"If they are trying to send a message, now is a good time."
Merkel and Sarkozy both had wanted a system of more coercive discipline for euro zone governments that fail to keep down their budget deficits.
But they had been under unprecedented pressure to see eye to eye in a crisis that has split them on issues such as the role of the ECB in lending to troubled states, and whether the bloc should issue jointly guaranteed euro bonds.
Sarkozy and Merkel said they would send off their plan on Wednesday, in time for Friday's summit, and made clear their determination to drive through an EU treaty change despite objections from some member states.
If countries such as euro outsider Britain blocked a treaty change for the 27 EU members, the euro zone would proceed with an agreement among its 17 states, they said.
Sarkozy said the economic policy mistakes that led to the euro zone crisis must never happen again, accepting that France and Germany, the euro zone's two biggest economies, bore the biggest responsibility for finding a solution.
"In this extremely worrying period and serious crisis, France believes that the alliance and understanding with Germany are of strategic importance," he said. "Risking a disagreement would be risking the euro zone exploding."
Several governments, notably Britain, Ireland and the Netherlands, oppose treaty change because it might not win public backing if put to a referendum.
AUTOMATIC SANCTIONS
The revised treaty would permit automatic sanctions against states that breach an existing deficit limit of no more than 3 percent of total economic output, unless a "supermajority" of states voted against the penalty.
That would reverse the current system where a majority of states must vote to launch a disciplinary procedure.
It would also enshrine a budget-balancing rule in national constitutions across the euro zone, although Merkel and Sarkozy gave no detail of the proposed wording.
In deference to French concerns about sovereignty, they agreed the European Court of Justice could rule on whether euro zone states had implemented the fiscal rule properly in national law, but would not be able to reject national budgets.
Merkel appeared to have prevailed in her opposition to the issuing of bonds in theory guaranteed jointly by all euro zone countries, but in practice by the bloc's strongest member, Germany. "We reject the idea of euro bonds," she said.
Sarkozy rallied behind her, saying it would be absurd for France and Germany to cover the debts of countries over whose debt issuance they had no control.
In return, Merkel gave ground on the rules of a future permanent rescue fund for the euro zone, the European Stability Mechanism, which have been cited as a deterrent to investors.
One of the most startling market moves was in Italian bonds.
Prime Minister Mario Monti declared that but for his 30-billion-euro austerity plan, "Italy would have collapsed, Italy would go into a situation similar to that of Greece."
Italy's technocrat cabinet approved the combination of tax rises, pension reforms and incentives to boost growth in a three-hour meeting on Sunday.
Markets reacted enthusiastically, with the yield on Italian two-year bonds plunging 85 basis points to 5.78 percent. This was far below yields of over 7 percent last month, a level at which Greece, Ireland and Portugal had to take international bailouts.
But unions immediately called a strike to protest against the "Save Italy" package.
Ireland also unveiled a tough budget with new spending cuts accounting for nearly 60 percent of next year's 3.8 billion euro fiscal adjustment.
(Additional reporting by Geert De Clercq, Daniel Flynn, Vicky Buffery, Nicholas Vinocur, John Irish, Paul Taylor and Astrid Wendlandt in Paris, Gavin Jones and Steve Scherer in Rome, Luke Baker and Julien Toyer in Brussels, Michele Kambas in Nicosia, Andreas Rinke and Alexandra Hudson in Berlin and Walter Brandimarte in New York; Writing by David Stamp; Editing by Paul Taylor and Kevin Liffey)
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