"The market has already raided three countries..."

The European Union's grand experiment with a common currency has been a bumpy ride and has appeared to have hit a major pothole. Human society is precariously balanced in virtually every arena and on just about every conceivable level. (GW)

Europe's Crisis Widens

Italy, Spain See Bonds Sink, Portugal Faces Rating Cut as Faith in Rescue Ebbs

By Marcus Walker and Brian Blackstone
Wall Street Journal
November 30, 2010

Investors dismissed European leaders' latest attempt to restore market calm, raising doubts about whether governments can rebuild confidence in the region's common currency amid signs that the debt crisis is creeping deeper into the Continent.

The euro fell to a 10-week low, and was below $1.30 in late New York trading. Bond markets across Europe's vulnerable fringe sank, as the "risk premium" investors demand for lending to Spain and Italy hit record highs. Standard & Poor's said after European markets closed it is considering a downgrade on Portugal's credit rating, citing economic pressures and increased risks to the government's creditworthiness.

The bond selloff extended Monday's declines, suggesting that Sunday's agreement by European governments to bail out Ireland and set up a permanent rescue fund has left investors cold.

Germany and other European governments hoped the twin announcement would end the near-panic that has gripped debt markets in recent weeks. Instead, a crisis of confidence that began last year in Greece has continued to spread.

Particularly worrying to Europe's leaders are early signs the market turmoil is spilling into countries thought to be less at risk: Italy and Belgium. "Tension is very high, in part because the market has already raided three countries," said Luca Cazzulani, deputy head of fixed-income strategy at Italy's Unicredit bank.

Economists generally agree Europe's current bailout fund is sufficient to rescue Spain, should that be necessary. But if Italy, Europe's third-largest economy, teetered, a rescue would test both Europe's economic resources and the will of healthier countries such as Germany to shoulder the costs.

Italy is faring better economically than some neighbors and its budget deficit is among the lowest in the euro zone. But Italy also has the region's second-largest debt burden, and half of it is financed abroad.

In addition to the huge government debt of some countries, especially on Europe's periphery, investors worry banks could face big losses. If problems among banks are greater than disclosed, that would have effects on these countries' budgets—and the size of any bailout they might need.

That concern is driven partly by a lack of trust in the integrity of "stress tests" of euro-zone banks earlier this year. Ireland's passed, yet it was the weakness of those same banks that forced Ireland to seek a bailout.

Now European officials are planning a new round of stress tests next year. While some leaders are pushing for these to be broader and more transparent, the agency that will oversee them says it might opt not to publicly disclose the results.

Germany stands accused by critics, ranging from financial markets to European capitals, of fueling the current anxiety by insisting Europe's future bailout fund include rules that could see bondholders take a hit in government rescues.

Chancellor Angela Merkel pushed hard for that principle, saying it is unacceptable that investors make profits from lending to governments while taxpayers cover all of the losses. Even some economists who believe she is right in principle say the timing was terrible, because it undermined fragile confidence in European debt markets.

German officials maintain the rules would affect only future bonds, not existing euro-zone debt, which would be repaid in full. But merely talking about the issue of lenders taking a so-called haircut has shattered the assumption that Western European governments never default. By raising the cost of borrowing for Portugal and Spain, this has made it more likely they may need a bailout, economists say.

"By their actions, the Germans have unsettled the markets and brought about what they're hoping to prevent," said Simon Tilford, chief economist at the Center for European Reform, a London think tank.

One reason the prospect of bailouts of weaker governments is no longer enough to win back investor confidence, economists say, is that they don't solve the underlying problem: Several countries have more debt than their economies can cope with.

Their rising cost of borrowing bodes ill for their plans to issue hundreds of billions in new bonds in the coming years. Ireland, Portugal, Spain and Italy need to issue close to €900 billion of government bonds over the next three years—about €500 billion in Italy alone—according to Citigroup estimates.

Some observers say the euro zone will eventually have to choose between unraveling or creating a deeper union that includes financial transfers from strong countries to weaker ones. But creating the central budget authority that the euro-zone now lacks would be a hard sell in countries such as Germany that would have to foot the bill.

On the other hand, giving up on the euro would undermine 60 years of political efforts to build a united Europe, and could cause unpredictable economic and financial disruption in a region whose trade and banking systems have become deeply intertwined since the euro was created in 1999.

A paradox of the debt crisis is that the 16-nation euro zone, as a whole, has a budget deficit of around 6% of its gross domestic product and total public debts of around 84% of GDP. While not exactly low—6% is twice what's supposed to be the maximum in euro-zone countries—that is healthier than in the U.S., which is running a budget deficit of over 11% and has total debts of around 92% of GDP.

Germany is forcing Ireland and Southern European countries to pursue painful fiscal austerity policies, in the hope that slashing deficits will win back investors' trust. But many in financial markets doubt the strategy will work, saying that without better economic growth, the euro zone's weaker members will struggle to pay down their debts even with fiscal austerity. That makes many analysts believe the ultimate resolution will involve either a restructuring of debts in some countries or a financial transfer, such as by forgiving rescue loans.

Such transfers wouldn't solve a growing problem that threatens the cohesion of the currency area—economic divergence.

The gaps among countries are widening, suggesting that robust recoveries in northern European nations such as Germany aren't spreading south or to Ireland. Jobless rates are relatively low in Germany, at 6.7%, and below 5% in the Netherlands. But Spain's is over 20%, according to the EU. Others in Europe's periphery have double-digit rates, making deficit reduction hard to do without triggering a backlash.

In a currency union with a single monetary policy and 16 different fiscal policies—and, critically, 16 distinct sovereign bond markets—such gaps matter a lot, economists say.

"These divergences give the markets something to sink their teeth into by attacking individual countries and their bond markets," says Jonathan Loynes, an economist at the consultancy Capital Economics. The divergences mean tiny countries like Ireland and Greece, which combined account for just 4% of the region's output, "are almost becoming pivotal to the financial stability of the region as a whole," he adds.

—Stephen Fidler and Alessandra Galloni contributed to this article.

Write to Marcus Walker at marcus.walker@wsj.com and Brian Blackstone at brian.blackstone@dowjones.com