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Moody's Downgrades France to Aa1, Maintains Negative Outlook

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Moody's Monday downgraded the credit rating of French sovereign debt to Aa1 from AAA, or one notch, citing a worsened economic outlook with increased exposure to peripheral nations through trade and banking and rising debt-to-GDP levels. France was also kept on negative watch, meaning further downgrades from Moody's could follow should the economic outlook remain bleak, debt levels rise or contingent liabilities on peripheral nations increase.

Back in January, Standard and Poor's downgraded France's credit rating and Moody's becomes the second ratings agency to do so. Fitch still has a AAA rating on France but Egan-Jones, the noted rating agency that tends to preempt the "big three" in downgrading sovereigns, has already placed France at BBB+, only three notches above junk.

French bond yields rose on the news, with the 10-year government bond yield rising 6.5 basis points to 2.126 percent and 2-year bond yields rising 3.4 basis points to 0.14 percent; the rise in 2-year bond yields was a remarkable 30.63 percent following the downgrade. It is important to analyze both benchmark 10- and 2-year bond yields, and 10-year bond yields are a good measure of the long-term solvency of a debtor while the 2-year bond yields are a strong measure of short term liquidity. Although short term yields have risen drastically since the downgrade, they still remain at low levels when compared to those of Spain and Italy.

French finance minister Pierre Moscovici spoke following the downgrade and put most of the blame on the previous administration, led by former Prime Minister Nicolas Sarkozy. He also said that the move should pressure the French government to speed up budget reforms and shrink the deficit to three percent of GDP as soon as possible.

Dietmar Hornung, senior credit officer for the Sovereign Group at Moody's, said that the downgrade occurred because of France's “multiple structural challenges, including its gradual, sustained loss of competitiveness and the long-standing rigidities of its labour, goods and service markets.” Further, he said that the continued negative outlook reflects that the country was tilted to another downgrade over the next 12 to 18 months.

The effects of the downgrade can already be seen on the European economy. The European Financial Stability Facility (EFSF), the temporary bailout fund, was supposed to auction 3-year bonds but delayed the auction due to the downgrade. The EFSF's credit rating was contingent on the AAA ratings of many of its stronger members including France, Germany and the Netherlands, and the downgrade could increase borrowing costs for the fund, making bailouts for nations such as Greece, Ireland, and Portugal more difficult. Also, the recent weakness in the Dutch economy, seen in its recent disastrous GDP report, could lead to further downgrades in the continent and further weaken the borrowing ability of the bailout mechanism.

One positive sign is that, although bond yields are rising, France's 2013 budget only factors in 10-year borrowing costs of 2.9 percent, much higher than current levels. Therefore, even if bond yields continue to rise, so long as the economy does not contract much further, France's finances should remain in tact for the course of the year. However, this is also contingent on spending cuts and tax increases being implemented efficiently and the economy recovering from the pan-European slowdown.

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