S&P's Euro pressure point

At a practical level Standard and Poor's decision to place 15 eurozone member nations on credit watch means relatively little other than to confirm the obvious. The embarrassment in prospect for the six AAA-rated countries, however, will help focus their minds on Friday's European Union summit.

The reasons cited by S&P for putting 15 of the 17 core eurozone members on negative credit watch, which means they could be downgraded within 90 days, are very familiar to the markets, which had acted pre-emptively as it became apparent that the eurozone authorities were struggling to respond to the escalating crisis.

The ratings agency referred to tightening credit conditions across the eurozone. Credit conditions have been tight for months, to the point where European debt markets are effectively shut and bank lending has shrivelled.

It didn't need S&P to tell anyone interested that there are "markedly higher” risk premiums on a growing number of sovereign issuers, including some rated AAA. When even Germany is struggling to raise funds at acceptable prices, everyone knows lenders are pricing in the real possibility of a catastrophe in Europe.

The continuing disagreements between policymakers about how to tackle the crisis and ensure fiscal convergence in the longer-term has been the central factor in the market's increasing fear and loathing of all things euro, although at least the agreement between Germany and France overnight provides a pathway towards the longer-term objective, with a mechanism for binding members to fiscal discipline and sanctioning those who stray.

The eurozone, as S&P noted, is awash with debt at both the government and household level, a situation compounded by the near-inevitability of a region-wide recession. It is that combination, and the apparent freezing under pressure of eurozone policymakers unable to respond to the complexity of the crisis, that caused the markets to take fright months ago.

While the prospect of the ratings downgrades – even Germany has been placed on credit watch – does highlight the severity of the eurozone's plight, it also complicates it.

There is little new money flowing into the eurozone, and a lot of ‘old' money fleeing it, so in that sense any action on the ratings front has little consequence. It could, however, impact intra-eurozone holdings of sovereign debt and the pricing of any new debt issued. There are institutions that can, or will, only hold AAA-rated paper.

It may also affect the ability of the European Financial Stability Facility – which the eurozone authorities are hoping to leverage to help bail out and support sovereign debt refinancings – to raise funds itself. It would certainly adversely impact the EFSF's cost of funds.

With the clock ticking on the downgrades, those attending the summit will know that, unlike previous forums, they have to produce something concrete and convincing.

The pact between Germany and France does provide a blueprint for a different and more effective pan-European fiscal regime in future, but doesn't address the near-term issues and the need to reassure markets that the authorities have a plan to stabilise Italy and Spain, to re-open credit markets, stabilise the eurozone banking system and maintain some level of economic growth to blunt the severity of the austerity policies being imposed on the more indebted nations.

In the absence of a compact that deals directly with the immediate issues, the crisis will only deepen, destabilising not just the eurozone but the global economy and financial system in the process.