Bloomberg News

Bond Woes to Worsen as Austerity Suffocates Growth: Euro Credit

September 20, 2011

(See EXT4 for more on the European debt crisis.)

Sept. 20 (Bloomberg) -- Borrowing costs may rise even further for Europe’s most indebted nations as slower growth at home combines with a weakening global economy to subvert deficit-reduction plans, measures in the bond market show.

“The market is afraid of a lack of growth that will make debt rebalancing quite a challenging task,” said Koen Van De Maele, global head of fixed income at Brussels-based Dexia Asset Management, which oversees the equivalent of about 83 billion euros ($114 billion). “As an investor, if you know that the growth will be lower then it’s definitely a concern in terms of the debt sustainability. You have to balance the risk and the return.”

Greece, Portugal, Ireland, Spain and Italy -- which saw its credit rating downgraded today by Standard & Poor’s -- are implementing austerity packages to bring down their debts and restore confidence after investors demanded record premiums to hold their bonds instead of benchmark German bunds. The growth assumptions underpinning those plans are under threat after the European Central Bank and the European Commission cut their economic forecasts for this year and next.

The ECB began buying Spanish and Italian bonds on Aug. 8 to curb a surge in yields as contagion from the debt crisis spread to the region’s third- and fourth-largest economies. Spain’s 10- year bond yield climbed to a euro-era record 6.46 percent on Aug. 2, while similar-maturity Italian yields reached an all- time high 6.40 percent on Aug. 5. Italian 10-year yields were at 5.67 percent today, while Spain’s were at 5.36 percent.

ECB Forecast

The ECB cut its euro-region growth forecast for 2011 to 1.6 percent from 1.9 percent and that for 2012 to 1.3 percent from 1.7 percent on Sept. 8. The European Union said on Sept. 15 the euro-area economy may come “close to standstill at year-end.” There’s “a serious risk” of recession in the U.S. and Europe, Nobel-prize winning economist Joseph Stiglitz said Sept. 16.

Greece became the first of Europe’s most indebted economies to need outside aid in May 2010, forcing it to implement austerity programs after its borrowing costs surged to records, locking the nation out of the debt markets. It now faces economic contraction of 5.5 percent this year, borrowing costs near records and a default probability of 95 percent, according to credit-default swaps prices.

‘Not Positive’

“It’s clearly not positive for any country that’s trying to sort out its debt dynamics,” said Padhraic Garvey, head of developed debt-market strategy at ING Groep NV in Amsterdam. “Italy and Spain really need to have decent global growth to prevent their deficit situations from getting worse. In all cases, slower global growth will have a negative effect.”

Italy’s 54 billion-euro austerity package seeks to balance the budget by 2013 and relies on an expansion of gross domestic product of 1.1 percent this year and of 1.3 percent in 2012. Confindustria, the Italian employers’ association, predicts Italy’s $2.3 trillion economy will expand 0.7 percent this year and 0.2 percent next year. The premium investors demand to hold its 10-year securities instead of benchmark German bunds widened to 387 basis points.

S&P cut Italy’s credit rating to A from A+, citing concern that weakening economic growth and a “fragile” government mean the nation won’t be able to reduce the euro-region’s second- largest debt burden.

Spain’s Finance Minister Elena Salgado said she couldn’t rule out that slower growth affecting Europe may have an impact on the Spanish economy.

Ireland, Portugal

Yields on 10-year bonds from bailed-out Ireland and Portugal are above the average for the past two years, even after falling from records. Ten-year Irish bonds yield around 8.75 percent while rates on similar-maturity Portuguese securities are more than 11 percent.

Ireland’s 10-year yield spread was at 696 basis points. That compares with a record 1,154 on July 15. Portugal’s 10-year bonds yielded 983 basis points more than German bunds, versus a record 1,071.

“A slowdown in global growth could weigh on the feasibility of the bailout packages agreed for Portugal, Ireland and Greece,” said Norbert Aul, a European interest-rate strategist at RBC Capital Markets in London. “Weak growth in the stronger euro-area economies could spark resistance for further aid commitment.”

Default Bets

Economic decline has prevented Greece from reaching its deficit targets, as the fiscal gap ended at 10.5 percent of gross domestic product last year, exceeding the goal of 9.5 percent. Finance Minister Evangelos Venizelos said yesterday the nation’s economy will shrink 5.5 percent this year and will also contract “notably” next year. That’s greater than the 3.8 percent forecast by the European Commission, as austerity measures deepen a three-year recession.

“It’s clear they’re in an austerity trap,” said Duncan Sankey, head of research and partner at Cheyne Capital Management LLP in London, a hedge fund that manages more than $7 billion in assets. “Greece is heading towards meltdown. If that happens, the question is how to stop contagion to Italy and Spain.”

Greek two-year bond yields soared above 80 percent last week as traders increased bets the nation will default on its debt. The 10-year yield was at 23 percent today and the spread with German bunds was little changed at 2,121 basis points and reached a euro-era record 2,482 basis points on Sept. 15.

Eighteen months of crisis-fighting, 256 billion euros in loans for Greece, Ireland and Portugal and 143 billion euros of bond purchases by the ECB have failed to stabilize markets and stop the debt crisis spreading.

Luxembourg Prime Minister Jean-Claude Juncker, who heads the group of euro-area finance ministers, said last week that the demands of budget cutting make any plan to spur growth through fiscal measures impossible.

“Policy makers don’t have the firepower to deal with the crisis like they did at the start of the crisis,” said John Davies, a fixed-income strategist at WestLB AG in London. “It is difficult to see what more they can do.”

To contact the reporters on this story: Keith Jenkins in London at kjenkins3@bloomberg.net; Emma Charlton in London at echarlton1@bloomberg.net.

To contact the editor responsible for this story: Mark Gilbert at dtilles@bloomberg.net.


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