European officials seek way out of crisis

Updated: 2010-12-02 09:43


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BRUSSELS - European officials searched urgently for ways to contain the region's debt crisis, amid expectation that a rebound in government bond markets would prove only temporary.

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The EU's monetary affairs chief, Olli Rehn, lobbied Wednesday for further action from the European Central Bank such as government bond purchases to help calm financial markets, a day ahead of a key meeting of the bank's governing council.

Meanwhile, EU regulators loosened rules on bank bailouts for at least another year, while Spain announced additional cutbacks, trying to dispel concerns its economy - regarded as potentially too big to bail out - might falter.

There was a slight recovery on financial markets, with the euro rising above $1.30 and the yields on bonds from vulnerable countries like Portugal, Ireland, and Greece falling slightly. Just as significantly, pressure came off the debt of Spain and Italy, two countries that have stronger finances but which only Tuesday appeared to be facing increased skepticism from lenders like that which pushed Greece and Ireland into needing bailout loans.

Still, bond yields and spreads - signs of financial fear - remained near record highs, signaling concern that the so-called PIIGS (Portugal, Italy, Ireland, Greece, Spain) might eventually default on their massive debts, piling losses onto the balance sheets of banks and investment funds, or need a bailout that would strain the eurozone's resources.

Although investor demand was unexpectedly strong a Portuguese sale of 500 million euro($650 million) in treasury bills, Lisbon had to pay an interest rate of 5.3 percent - up from 4.8 percent two weeks ago.

The official line from EU executives and politicians is that there is no risk Portugal could default within the next year, since a 750 billion euro ($1 trillion) EU backstop stands ready to bail it out.

But in recent weeks, an increasing number of bank analysts and economists have warned that a debt restructuring - reducing the debt load by pushing losses on creditors - appears almost inevitable for some countries. Crucially, the austerity measures meant to cut deficits risk backfiring by slowing state revenues and economic growth.

"As it stands ... a number of member-states are effectively insolvent and caught in a vicious circle," Simon Tilford, chief economist at the Centre for European Reform in London wrote in a note Wednesday. "The collapse of economic growth has devastated tax revenues, while deflation threatens to push up the real value of their debts."

Standard & Poor's Ratings Services said it was considering a downgrade of Portugal's sovereign credit rating due to concerns that the government's austerity measures will choke off economic growth.

By the end of 2012, Greece's debt will stand at 156 percent of gross domestic product, Italy's at 120 percent and Ireland's at 114 percent, according to EU estimates released this week. That means that even if those countries nationalized the economic output of an entire year to pay off their debts it wouldn't be enough to pay off all the debt at once.

The debt loads of Portugal and Spain - estimated to reach 92 percent and 73 percent of GDP respectively by 2012 - are smaller. However, economists are anxious about their weak growth rates, the extent to which foreign investors own the public debt and that an upheaval in their banking sectors could quickly drive government debt through the roof.

Over the past two years, European governments supported their financial sectors with 4.59 trillion euro in state aid, according to figures released Wednesday. While the overwhelming majority of that aid, 3.94 trillion euro, was given as loan guarantees, the case of Ireland has shown how expensive those guarantees can become if banks run into more serious trouble. On Sunday, Dublin accepted 67.5 billion euro($89 billion) in bailout loans after the collapse of its banks drove government deficits to an EU postwar record of 32 percent.

Portugal's central bank warned Tuesday that its financial system was facing "serious challenges," as foreign concerns about public, private and corporate debt have made it harder for Portuguese banks to raise money. It warned that continuing to request financing from the European Central Bank was "unsustainable."

Spanish Prime Minister Jose Luis Zapatero meanwhile cancelled a trip to Latin America later this week to push through new plans to partially privatize the country's national lottery and airports and cut a benefit paid to people who have come to the end of their unemployment pay.

In Brussels, Monetary Affairs Commissioner Rehn heightened analyst expectations of increased bond purchases by the ECB to prop up shaky government finances and liquidity-starved banks.

Austerity measures, paired with the bailout for Ireland and agreement on a permanent crisis mechanism for the eurozone "could provide a sound basis for the continuation of actions of stabilization by the ECB, which has played a key role in ensuring financial stability in the euro area, for instance last May," he said.

The ECB meets Thursday for a monetary policy decision and a press conference by ECB President Jean-Claude Trichet will be the focus of the day.

Markets are looking to see whether Trichet will increase purchases of government bonds - a stabilization program established in May - to stop yields from rising and take the edge off Europe's debt market turmoil. So far, it has splashed out around euro70 billion in direct bond purchases.

European officials have insisted that no government would default on its current debts and with its extensions of more lenient bank bailout rules the Commission signaled its commitment to stabilize markets by supporting the financial sector.

The EU's Competition Commissioner Joaquin Almunia said he was prolonging the temporary state aid rules as "the remaining risk of renewed stress is a valid reason to proceed with care and caution in the exit process."

The commission temporarily loosened some rules on state aid after the collapse of Lehman Brothers in 2008. Almunia said that the EU's competition watchdog would allow governments to continue propping up their banks if necessary, but that firms getting aid from the government that goes beyond loan guarantees from January 1 onwards will have to submit a restructuring plan to show how they can continue to function without additional support in the future.

Almunia said he hoped that the commission could return to the normal rules on state aid for banks by 2012, but warned that it was "still too soon" to give an exact date.

"I cannot anticipate because nobody can assure that the normal conditions in the financial markets will be completely re-established by the end of next year." he said.


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