Ratings agency Moody's gave an emphatic thumbs-down on Friday to Europe's efforts to resolve a debt crisis, slashing Ireland's credit rating as EU leaders took no new action to prevent market turmoil spreading.
Moody's cut Ireland's rating by a stunning five notches during a European Union summit meant to restore confidence in the eurozone by creating a permanent financial safety net from 2013 and vowing to do whatever it takes to protect the euro.
Moody's cut Ireland's rating to Baa1, three notches above junk, with a negative outlook from Aa2 and warned further downgrades could follow if Dublin was unable to stabilize its debt situation, caused by a banking crash after a decade-long property bubble burst.
"While a downgrade had been anticipated, the severity of the downgrade is surprising," Dublin-based Glas Securities said.
The blow to investor confidence came as the 27 leaders failed to agree any specific measure to stop contagion spreading from Greece and Ireland, which have received EU/IMF bailouts, to other high-deficit countries such as Portugal and Spain.
"The recent events have demonstrated that financial distress in one member state can rapidly threaten macrofinancial stability of the EU as a whole through various contagion channels," a final summit statement said.
The leaders spurned calls for immediate practical steps such as increasing the size of a temporary bailout fund or allowing it to be used more flexibly to buy bonds or open credit lines before troubled countries are shut out of the credit markets.
Barclay's Capital analyst economist Fabio Fois called it "another missed opportunity to calm the markets."
German Chancellor Angela Merkel, who led opposition to those options, sought to reassure citizens and markets, declaring: "We are doing everything to make the euro secure."
Merkel said the existing EU rescue fund was sufficient, and she was impressed by reforms announced by Spain and Portugal.
On the sidelines of the summit, non-euro member Britain won support from France, Germany and other countries for a drive to freeze the common EU budget in real terms over the next decade to take account of national spending cuts.
Prime Minister David Cameron said the EU's big three would issue a joint letter on Saturday calling for a lean budget in the seven-year spending plan after 2013, rising only in line with inflation "to stop this budget getting out of control."
"It is unacceptable to spend more and more and more through the EU budget," he said, playing to Eurosceptics in his Conservative Party who have been disappointed that he has not done more to confront Brussels.
Poland, set to become the biggest beneficiary of the 126.5 billion euro annual budget, voiced anger at the move.
The European Central Bank took action to bolster its firepower to fight the debt crisis by announcing on Thursday it would almost double its subscribed capital.
But analysts said this was chiefly to cover the risk of write-downs on the 72 billion euros ($95.83 billion) in eurozone sovereign bonds it has bought so far, not to step up such purchases to support governments in trouble.
At Germany's insistence, the 27 leaders said the long-term crisis-resolution mechanism, to be added to the EU's governing treaty, would only be activated "if indispensable to safeguard the stability of the euro as a whole," making it a last resort.
The premium investors charge to hold Greek, Irish, Portuguese or Spanish bonds rather than benchmark 10-year German Bunds crept up in thin pre-Christmas trading, and the cost of insuring their debt against default also rose.
"European leaders failed to address the issue of debt sustainability and possible insolvency problems prior to 2013," said Carsten Brzeski, senior economist at ING Belgium.
"Debt restructuring, a common eurozone bond or an increase of the EFSF? None of these issues have been addressed. But they have to be," he said.
Italian Prime Minister Silvio Berlusconi told reporters the leaders had discussed a proposal by two veteran finance ministers for common eurozone bonds but it would take time to convince all countries and Merkel was strongly opposed to it.
"I'd by them right away instead of the bonds of a single country — it's Europe that's providing the guarantee," he said. "Merkel is very opposed, but many others are interested, not least because Europe need only provide the guarantees."
The record seventh summit this year approved a two-sentence amendment to the EU treaty at Germany's behest to permit the creation of a European Stability Mechanism to handle financial crises from June 2013.
The ESM, to replace the temporary fund created in May, will be empowered to grant loans on strict conditions to member states in distress, with private sector bondholders sharing the cost of any write-downs after 2013 on a case-by-case basis.
The aim is for all 27 member states to ratify the change by end 2012. European Council President Herman Van Rompuy, chairing the summit, said no country would need to put it to a referendum, removing one potential risk. Decisions will be taken by unanimity, ensuring that EU paymaster Germany retains a veto.
Many analysts expect Greece and Ireland to have to default before then, but ECB executive board member Lorenzo Bini Smaghi dismissed such talk in a Financial Times article, saying the cure could do more harm than the disease.
There has been a relative lull in financial market pressure in the past two weeks as investors and traders close their books ahead of the end of the year, but analysts expect turbulence to resume in 2011 as Spain and Portugal face refinancing crunches and the rating agencies clearly see no diminution of risk.
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