S&P may downgrade Europe bailout fund

A rating agency'sthreat to downgrade 15 eurozone countries, including Germany, as well as Europe's bailout fund has added pressure on the region's leaders to find a lasting solution to their crisis at a summit this week.

Chancellor Angela Merkel on Tuesday downplayed Standard & Poor's warnings, but the possibility that a downgrade of eurozone countries could weaken the creditworthiness of Europe's bailout fund complicates the region's fight against the crisis.

The first warning came just hours after Merkel and French President Nicolas Sarkozy urged changes to the European Union treaty that would centralize decision-making on spending and borrowing for the 17 countries that use the euro. Tighter political and economic co-ordination among euro countries is seen as a precursor to further financial aid from the European Central Bank, the International Monetary Fund, or some combination.

The threat to cut Germany's prized AAA rating was particularly surprising. Its bonds are considered among the safest in the world and are the basis upon which Europe finances its bailout fund. S&P warned in a follow-up report that it could cut the AAA rating of Europe's bailout fund by up to two notches if it decides to downgrade one of the eurozone's top-rated countries.

The bailout fund needs the AAA rating to cheaply raise money on markets. Losing it would mean it would cost billions more to fund bailouts, hurting the rescued countries that ultimately have to pay the higher interest rates.

Investors mostly took the S&P warnings in stride on Tuesday. European stocks and bonds held onto the gains they made Monday.

"What a rating agency does is the responsibility of the rating agency," Merkel told reporters in Berlin, refusing to elaborate further.However, she added she expected a meeting of European leaders in Brussels on Friday would help restore markets' confidence.

She and Sarkozy on Monday outlined sweeping plans to change the EU treaty in an effort to keep tighter checks on overspending nations. The proposal is set to form the basis of discussions at an EU summit in Brussels on Friday.

The financial markets of Italy and Spain rallied after Merkel and Sarkozy unveiled their proposals, suggesting investor are more confident Europe can survive the crisis.

Late Monday night the euro fell to $1.3330 US from $1.3460 US, unwinding much of the gains made after Merkel and Sarkozy's proposals. By Tuesday, however, it was back up to $1.3420 USbuoyed in part by a report showing a massive rebound in German industrial orders due to a double-digit increase in demand from eurozone countries.

Stock and bond markets largely overlooked S&P's threat, remaining stable on Tuesday. The bond yields for countries like Italy and Spain remained at the one-month lows they hit on Monday.

French Foreign Minister Alain Juppe said it appeared to him that S&P had made its decision before Merkel and Sarkozy released details of the new plan, so hadn't been able to factor that into its considerations.

The leaders' proposal is "exactly the response to one of the major questions from the ratings agency, which talks about insufficient European economic governance," Juppe said on RTL radio.

Sarkozy and Merkel are proposing several broad changes for the EU treaty, including the introduction of a penalty for any government that allows its deficit to exceedthree per cent of gross domestic product. The penalty would be automatic unless a majority of nations opposed it, a loophole that drew sharp criticism from analysts.

Some analysts also feel the proposal, which demands strict austerity measures, misses the mark and will only worsen much-needed growth in already feeble economies.