Credit warning gives EU summit last chance on debt

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A shock warning that almost the entire eurozone including Germany is sliding towards a debt downgrade left EU leaders with just three days on Tuesday to bridge big splits over the debt crisis.

It also put an icy hand around confident statements by German Chancellor Angela Merkel and French President Nicolas Sarkozy that they want treaty changes to enforce budget discipline.

However, they skirted around technical aspects of exactly how much federal-style discipline would be imposed on national budgets.

And these two countries, the pillars of the eurozone, did not explain how confidence on financial markets can be shored up during the uncertainty of the many months needed for treaty changes, either at the level of the eurozone or of the 27-member European Union.

The warning that Germany and France and 13 other members of the 17-nation eurozone are now on negative credit watch came from Standard & Poor's credit rating agency overnight, radically raising the stakes of an EU summit on Thursday and Friday.

EU leaders themselves admit that the eurozone is at risk of breaking up and that this in turn could eventually fragment the entire European Union.

S&P said 'major downside risks' included a deep recession in Europe and the United States, higher protectionism and persistent inflation.

In Germany, where the warning of a downgrade is a particularly stark measure of fallen fortunes, the main stock index opened with a drop of about 1.40 percent.

The European bond market, where governments borrow to fund their debt, German and French bonds came under some tension.

The rate demanded to lend to Germany for 10 years rose to 2.257 percent from 2.200 late on Monday and for France to 3.243 percent from 3.123 percent.

Eurozone bonds had rallied strongly in the last three trading days on some optimism that a change of strategy was in the air, mainly politically and then possibly also from the European Central Bank, and also because of tough measures by Italy.

Asian stock markets fell by 1.0-1.5 percent and the euro edged down. On Wall Street lost some gains as reports of the S&P warning leaked out.

In Hong Kong, BBY trader Peter Copeland said: "The S&P move is a reminder that it's not all over."

The S&P warning, coupled with notice that the agency would complete a review of eurozone sovereign ratings 'as soon as possible' after the summit, contrasted with the tone of the declarations by Germany and France, the pacesetters in the European Union, after a meeting on Monday.

Reacting later to the S&P warning, France and Germany 'in full solidarity' confirmed 'their determination to take all the necessary measures, in liaison with their partners and the European institutions to ensure the stability of the euro area.'

On Tuesday, France repeated that the French-German plan announced on Monday was the response to S&P.

But in Washington, the head of the International Monetary Fund Christine Lagarde, while welcoming the joint drive for discipline, warned that the German-French statement was 'not in itself sufficient and a lot more will be needed ... for confidence to return.'

Sarkozy and Merkel appeared united and determined when they offered a new direction for the single currency zone.

The two backed automatic sanctions against any EU member state allowing its public deficit go above 3.0 percent of gross domestic product.

They also called for a 'reinforced and harmonised golden rule' on deficits, which could oblige some states to enshrine the commitment to balance their public finances in their constitution or legislation.

The new rules would be enshrined in a rewritten EU treaty signed by all 27 EU members or, as an alternative, by just the 17 eurozone members with the other nations signing on a voluntary basis.

Sarkozy warned of a 'forced march to reestablish confidence in the euro and the eurozone'.

"The goal that we have with the chancellor is for an agreement to have been negotiated and concluded between the 17 members of the eurozone in March, because we must move quickly," he said.

Hours later S&P raised the stakes when it warned that without strong action, triple-A rated Germany, Austria, Finland, Netherlands, and Luxembourg, and AA-rated Belgium, could all be cut by one notch.

France, also AAA, and eight others with lower ratings faced up to two-notch cuts. S&P said that the summit was 'an opportunity for policymakers to break the pattern of what we consider to have been defensive and piecemeal measures to date'.

It then sent a blunt warning: "If the response of policymakers is not viewed by investors as robust, we believe market confidence could take another, possibly steep, drop downwards."

Negative recent developments had 'significantly raised the stakes for the upcoming summit'.