France….in the red and beginning to crack?

French banking sources were claiming that the Sarkozy administration has already accepted the country’s  AAA credit rating will be downgraded – perhaps by two notches. A damage limitation PR exercise is already under way.

There’s been quite a bit of expectation-management and rather studied briefing coming out of the Elysee Palace over the last 48 hours on the subject of the country’s credit rating. Stuff along the lines of “Oh well, it won’t make any difference in real terms” and so on. The very fact that Sarkozy’s Finance Ministry is willing to discuss something which – even three months ago – would’ve been unthinkable, shows just how inevitable the French Government now deems the downgrade to be. And sources in Paris confirmed last night that the mood there is one of grudging acceptance.

But don’t be fooled by the casual Gallic shrug: the downgrade won’t just be a disaster for France’s borrowing costs – it will also scupper any last chance the eurozone has of creating a group of sovereign nations with credibility when it comes to guaranteeing the EU’s increasingly colossal debt. Downgrading French debt is a dagger in the heart of Merkel’s plan for fiscal unity followed closely by joint debt guarantees.

“Right now, the feeling on this floor is that an S&P downgrade for France – among others – is a done deal,” a New York credit manager told me last night. Others based in Europe beyond France were of the same opinion.

“Contagion is a reality,” said one, “there isn’t a nation in the eurozone – Germany included – that isn’t now exposed because of past political sloth and smugness. France is already a real risk. And if that’s confirmed by a downgrade, then the only trustworthy debt guarantor would be Germany. And as Merkel won’t be allowed to even go there, that just leaves Mario Draghi in the Central Bank”.

I posted earlier yesterday about the huge dangers of having the ECB as a last hope. But specifically, a French downgrade damns any Merkelian hope of a small elite group of sovereigns reassuring the markets. After that, only Draghi’s central bank is left.

When French Foreign Minister Alain Juppé said yesterday (Wednesday) that a credit-ratings downgrade wouldn’t be “cataclysmic”, he was protesting far too much. In turn, President Nicolas Sarkozy said two days earlier that a ratings downgrade represented “an added difficulty, but not an insurmountable one”, surely the remark of a man who already knows Madame La Guillotine is about to fall on his neck.

It’s not hard to see why both Juppé and Sarkozy are affecting a sanguine attitude to the certainty: before last week’s Summit, S&P said it would take ‘a quick decision’ based on ‘whether euro-zone countries managed to deliver a common solution to the crisis and limit the impact on their individual economies and creditworthiness’. Unless the S&P guys have been on Jupiter this week so far, they could not but conclude that the downgrade is justified. Worse still for French borrowing (and pride) the rumour mill seems to think the relegation will be two notches, not one.

I opined in these columns a fortnight ago that a major bank failure (probably French) would be the next big catalyst accelerating eurozone meltdown. Whether that proves to be correct or not depends from here on just how much determination the world’s central banks and Treasuries show. The Slog’s prediction would’ve come true in the shape of a Credit Agricole collapse without the Big Six intervention last week – led of course by the Dollar liquidity moves made by the US Fed. But there was only negative news from the States yesterday afternoon GMT, when word leaked out from a Bernanke meeting with Congressional officials, the gist of which was that the Fed plans no additional aid to European banks amid the region’s sovereign debt crisis. This does not rule out further liquidity easing: but it does, yet again, put the glare of all the spotlights on the ECB.

Mario Draghi himself has been back-pedalling over the last week. Having mentioned “other elements” that could follow the Merkozy drive to Fiskalunion, he declared himself “kind of surprised” the words had been interpreted to mean either or both expanded bond buying and QE. But he’s been quiet over the last two days.

He has a lot of thinking to do. Especially as, in private, he probably sees the French AAA loss as a cert.