Saturday, April 9, 2011

Euro Crisis: No Rest for the Indebted

European officials are trying to convince Ireland to take financial aid to prevent its problems from infecting other, larger indebted countries like Spain and Italy. So far, it’s not working that well.

After five straight days of speculation about an imminent Irish rescue by the E.U. and International Monetary Fund, Ireland, European finance ministers and the European Central Bank are still locked in a stand-off. European ministers are talking to Dublin about a potential aid package for the country’s rickety banks, probably totaling some €50 billion ($67.45 billion), but so far, Irish officials continue to say they have not requested any aid.

So, how has Europe’s bond market responded? Well, some of the recent turbulence has halted, but things aren’t really improving, which means debt-laden countries like Spain and Italy are still facing elevated interest rates to refinance their debts.

Let’s start with Ireland itself, which has said it won’t borrow from the market until next year to avoid paying high costs. The interest rate on Ireland’s benchmark 10-year government bond, which moves inversely to its price, is 8.56% on Wednesday compared with 8.58% on Tuesday. After falling Friday and Monday, Irish borrowing costs are again rising. The reason: Dublin has agreed to have European Central Bank, IMF and European Union officials visit to take a look at the country’s banks, starting Thursday. But markets still aren’t sure this will mean a new Irish bank bailout, even though Ireland-based banks are more dangerously reliant on emergency ECB funds than institutions in Greece, Portugal or Spain.

Looking elsewhere, the bond markets of Portugal, Spain and Italy haven’t gotten rid of their Ireland-related infection.

On Wednesday, Lisbon sold €750 million of 12-month Treasury bills, but paid investors a painfully-high interest rate of 4.8% compared with 3.3% earlier this month. Interest rates don’t usually jump that much in, like, two weeks.

Were it to borrow for 10 years, Portugal, a small European economy with weak growth prospects, would probably have to pay an interest rate of 6.87%, based on market prices, compared with 5.86% in early September.

Spain, Europe’s fourth-biggest economy, would have to pay 4.62% to borrow for 10 years compared with 4.06% two months ago.? It will be in the market selling long-term debt on Thursday. And let’s not forget Europe’s No. 3, Italy: It would have to pay 4.15% compared with 3.76%. (Greece’s borrowing costs are jumping higher too, but it’s locked out of the capital markets and will be mostly using bailout money for the next few years.)

Many euro club members bear heavy debt loads, which is why it’s important for them to keep their interest costs low. Higher interest payments just put more debt on their pile. The worry among European officials is that a sudden spike in borrowing costs will make these countries’ debt burdens unsustainable.

Meanwhile, Spain has suffered a banking and property crunch much like Ireland’s and has probably been less transparent about the value of the property loans in its financial system. That is leading some investors like Cambiz Alikhani at London-based asset manager Iveagh Ltd. to worry that Ireland is a side-show and that a potential Spanish crisis is the elephant in the room.

A third act to Europe’s debt saga, following Greece and Ireland, would further test the durability of what has arguably been Europe’s greatest political success over the last half-century, the euro itself. Since the euro-dollar exchange rate is the most important in the world – the euro is the second-most traded currency – a currency collapse could have catastrophic consequences for markets.

On Wednesday, the euro is continuing to struggle amid Europe’s debt woes, having fallen to $1.35 from nearly $1.43 a few weeks ago – a 6% drop – though some of the drop is investors unwinding bets against the dollar in light of rising U.S. interest rates. In a comforting sign, the euro remains above the $1.18 level we hit during Greece’s spring crisis, but everyone’s now wondering whether it has further to fall if Europe’s latest sovereign-debt fire isn’t put out.

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