European debt crisis: Investors’ confidence shows signs of crumbling

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European leaders will continue this week to slowly hammer out new structural measures to shore up the euro currency zone, but market confidence among investors already showed signs of crumbling late last week.

One month after European leaders struck deals over a bailout fund and a debt restructuring for Greece, financial markets are again gripped with pessimism and impatiently looking for more.

Germany is pressing for tighter fiscal discipline through budget controls that would initially draw approval from a few of the 17 nations that belong to the currency union without requiring time-consuming revisions of the union’s treaty. Critics say the plan would effectively create two euro zones, a central one paying lower interest rates and a peripheral one paying higher borrowing rates.

Meanwhile, international investors are holding back, said people familiar with the financial industry, because of uncertainty about the future of the euro zone and worry about how further downgrades of sovereign bonds by credit agencies might hurt banks.

Banks in Europe have also practically stopped lending to other banks, a key task of the financial system that central banks are now performing. And international financial officials fear a self-reinforcing crisis of confidence that could slow down economies — and damage financial institutions and governments alike — just as experienced technocrats are taking charge in Greece and Italy.

“Europe needs to understand that financial markets don’t work on political timelines, and they are already a long way behind the curve,” Australian Treasurer Wayne Swan said in his weekly economic note over the weekend. He said European Union leaders had to act quickly to prevent a “slow-motion train wreck.”

“Over the past month, it seems to have been two steps forward, one step back for Europe,” Swan added. “The region’s policymakers have been frustratingly slow to build on the framework announced on October 27.”

In an interview Sunday on Canal Plus TV, France’s budget minister, Valerie Pecresse, said, “We won’t restore confidence unless we show proof — very quickly — about the unfailing solidity and solidarity of the euro zone.” In contrast with German officials, she said an “overhaul” of European treaties was needed that would include “real regulators, real sanctions” to restore confidence.

German finance minister Wolfgang Schaeuble said in an interview on ARD television Sunday: “We must together set up institutions that secure trust in the euro. Everything that detracts from that is damaging.”

Upcoming tests

European financial ministers meet this week, but next month holds bigger tests on the political and economic front. On Dec. 5, Italy’s new prime minister, Mario Monti, is due to present a new fiscal plan, most likely with the support of the country’s major parties but badly in need of support abroad. On Dec. 9, there will be a summit meeting of the E.U. that could be marred by disputes over euro bonds. Such bonds would be jointly issued by the 17 member states in the euro zone, but German Chancellor Angela Merkel has rejected the idea. Schaeuble called them “dangerous.”

Then on Dec. 20, Spain’s new prime minister, Mariano Rajoy, takes office. He faces large debts in sectors outside the central government — such as corporations and municipal governments — that could turn into large nonperforming loans for the country’s big banks.

And what will happen in the interim?

Late last week, Germany, the continent’s strongest economic power, could not sell all of its sovereign bonds in an auction. And despite the recent selection of Monti, a veteran technocrat with a good grasp of Italy’s financial needs and broad support in domestic opinion polls, Italy had to pay investors 6.5 percent on six-month bonds in an auction Friday, a record in the euro era. In addition, Standard & Poor’s downgraded Belgium’s credit rating.

“The good news is that practically everyone agrees that the sovereign debt market does not properly reflect the true default probabilities,” Erik F. Nielsen, UniCredit Global’s chief economist, said in a letter to clients Sunday. But he said it wasn’t clear “how long one might think they’ll continue before sanity returns to the debt market.”

Fearful of what could happen in financial markets this week, Belgium’s caretaker government, in office since June 2010, held a marathon 19-hour negotiating session and broke a more-than-one-year-old deadlock over its budget. It said it would agree to run a deficit of 2.8 percent of gross domestic product, within the E.U. target range, and to balance the budget by 2015 through a package of austerity measures, according to the Associated Press.

Also last week, Austria took measures to rein in its three largest banks — UniCredit Bank Austria, Erste Group and Raiffeisen Bank International — by ordering higher capital levels and curbs on the growth of their lending in Eastern Europe.

A closer union

Many of the euro-zone countries are moving toward a closer fiscal union that could, down the line, try to prevent future crises by imposing mandatory penalties on profligate countries such as near-bankrupt Greece.

Tighter fiscal discipline might persuade the German government to drop its resistance to the more aggressive tactics that a chorus of economists now say may be needed to quell the crisis.

At the center of the debate is the role of the European Central Bank. The ECB has already waded into bond markets, buying up the debt of troubled euro-zone countries to try to bring down borrowing costs and provide liquidity to banks. But the ECB has been straining as more investors shy away from the debt of countries such as Italy.

Countries such as France are calling for the ECB to effectively print massive amounts of new euros and launch a much larger bond buyback program that could ease the skyrocketing interest rates in countries such as Italy and Spain.

But the Germans have staunchly resisted a beefed-up role for the ECB, in part because of fears of inflation and because such a plan would rob indebted nations of the urgency to undertake major economic policy changes.

“Right now we are very close to the edge,” said a senior European diplomat who requested anonymity to speak freely on the matter. “There needs to be some quick decisions, but I am not yet convinced that the Germans are really willing to change their stance.”

In the meantime, concern is focusing on Italy and Spain, the euro zone’s third- and fourth-largest economies, where borrowing costs are climbing toward levels that would be unsustainable over the long term.

Some analysts have said that Italian officials have privately begun mulling over contingency plans to avoid a default. They include potentially forcing a one-time levy on Italian households, raising enough cash to scoop up Italian bonds now seen as too risky by a growing number of investors.

“You could call it an internal bailout,” said Raj Badiani, economist with IHS Insight in London. “Italy is a country with a large amount of private wealth. It could be tapped if the situation worsens there.”

But other economists say the recent interest rates, as high as they are, would become a crisis for Italy only if they remained high for a period of months.

An Italian newspaper also said that the International Monetary Fund was drawing up a $800 billion assistance package for Italy, but financial sources who spoke on the condition of anonymity said that such a plan was unlikely because Italy does not need such a fund and because the IMF does not have the resources to amass such a package.

Staff writer Michael Birnbaum in Berlin contributed to this report.

Steven Mufson covers energy and other financial news.
Anthony Faiola is The Post's Berlin bureau chief. Faiola joined the Post in 1994, since then reporting for the paper from six continents and serving as bureau chief in Tokyo, Buenos Aires, New York and London.
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