The Euro crisis roars back

The euro zone’s debt crisis holiday is over.

As its sovereign bond spreads hit new records, making it punitively expensive to obtain new financing through normal channels, Portugal is under fierce pressure to take a bailout orchestrated by the European Union and the IMF. It would become the third euro zone country in eight months to be flattened by a crushing debt burden.

Yields of 10-year bonds reached 7.44 per cent Monday morning – a record high since the euro’s launch 12 years ago – before retreating slightly on reports that the European Central Bank (ECB) is aggressively buying Portuguese debt to provide support. Euro zone officials are insisting that Portugal is in no need of a bailout.

Portugal’s painful debt yields are a grim reminder that the euro zone’s debt woes are far from over, despite improving growth rates in the region and efforts to tackle budget deficits through austerity programs.

The fear is also one of contagion. If Portugal requires a bailout, many worry that neighbouring Spain, the euro zone’s fourth-biggest economy, can’t be far behind.

Concern is mounting that a spreading crisis could force Europe’s sovereign rescue fund to seek another capital injection. The European Financial Stability Facility has €440-billion ($570-billion U.S.) in financial firepower, though it is able to lend no more than about €255-billion without risking its triple-A credit rating, according to Deutsche Bank.

But the ECB is already running out of Band-aids and fast losing credibility by playing “the extend and pretend” financing game, according to some analysts.

The central bank’s very survival depends on a successful defence of the embattled euro, and it has been buying up large quantities of sovereign bonds since last year. By mid-December, it held €72-billion worth of Greek, Irish and Portuguese debt. But it is on the hook for much larger amounts, held as collateral in exchange for funnelling cheap financing (at about 1-per-cent interest) to desperate banks in those three countries, as well as Spain.

The closed circle of financing has worked well so far. The banks buy up new debt issued by the deficit-ridden governments, which would pronounce their bond auctions a huge success. These bonds would then be used to secure financing from the ECB that would keep the banks afloat – and even enable them to make a tidy profit on the difference between the interest on the government bonds and the ECB financing – thus saving governments from dealing with the fallout of soaring financing costs and massive bank failures.

This strategy “assumed that the problem was temporary liquidity, not solvency,” said noted risk analyst Satyajit Das. “The solution was to ensure that the troubled countries could continue to finance. The restoration of confidence would enable a rapid return to market financing and the status quo.”

But the problem is indeed one of solvency, Mr. Das said. “Extend and pretend” refinancing measures of the sort being pursued within the EU “would allow orderly default or debt restructuring by some countries over time,” Mr. Das he said.

“It minimizes losses, controlling the timing and form of restructuring. It would also minimize disruption to financial markets and solvency issues for investors and banks with large exposures.”

Still, defaults and restructurings are likely unavoidable, he said.

The escalating debt problems might convince Germany to soften its opposition to boosting the size of Europe’s rescue fund. In December, German Chancellor Angela Merkel ruled out the option, apparently on the belief that her voters would retaliate against the cost of more bailouts – Germany is the single biggest contributor to the fund. On Sunday, however, the Chancellor’s chief spokesman declined to reiterate Germany’s refusal to boost the bailout fund, according to a Bloomberg report. On top of the European Financial Stability Facility’s \€440-billion, the IMF has agreed to contribute another €250-billion.

Investors said Portugal’s ability to fund itself will become clearer as early as Wednesday, when it will try to auction as much as €1.25-billion in bonds. Shortly thereafter, it must redeem €3.4-billion in bonds.

Spanish Economy Minister Elena Salgardo stood behind the Portuguese, saying in a radio interview that “Portugal doesn’t have to seek any type of rescue plan because it is meeting its commitments.” On Sunday, Portuguese officials had a similar message.

Investors, traders and economists were unconvinced. The euro remained near its four-month low against the U.S. dollar as the debt crisis returned to the fore.

If market sentiment continues to deteriorate in the next couple of weeks, Portugal will likely be forced to seek a bailout from the European Union and the International Monetary Fund, as Ireland did in November and Greece last May. In an interview, Jose Manuel Amor, partner and economist at AFI, a Madrid financial consultancy, said “I think they will get [a bailout], and soon.”

Working against Portugal this month is the start of an aggressive austerity program, which will cut government wages by an average of 5 per cent, reduce government employment and trim social spending such as unemployment benefits and family allowances. In its autumn forecast, the European Commission said the spending cutbacks, though needed, would harm Portugal’s tentative recovery. The EC now expects a 1-per-cent GDP fall in 2011, after an increase of 1.25 per cent last year.

Jens Nordvig, currency strategist in New York with Nomura Securities, said Portugal’s rising financing costs look like killers given the country’s ailing economy. “The debt dynamics looked borderline sustainable at the financing rates available in early 2010,” he wrote. “But with funding cost of 7 per cent (the 10-year rate after the latest spike in yields), the debt arithmetic is shifting toward unsustainable equilibrium.”

In a note published Friday, Deutsche Bank economists Gilles Moec and Marco Stringa said that the Portuguese government’s deteriorating cash position and funding stress point to “external help sooner rather than later … Our view is that there is a concrete risk that Portugal will have to fall in the arms of the EU and the IMF.”

They estimated that Portugal’s financing requirements between the first half of this year and 2012, including the cost of recapitalizing the country’s banks, would be €59-billion, suggesting an EU-IMF bailout would have to be a least that size. (Greece’s bailout was valued at €110-billion while Ireland’s was €85-billion.)

Portugal’s debt woes pushed down the prices of the bonds of other euro zone countries on Monday amid reports that France and Germany were putting pressure on Lisbon to accept a bailout. The cost of insuring a basket of European sovereign debt reached a record high.

Belgian and Spanish bonds were among the worst hit. The gap, or “spread,” between Spanish bonds and benchmark German bonds hit 267 basis points (a basis point is 1/100th of a percentage point) on Monday, which is not far short of the record 298 basis points on Nov. 30, just as Ireland was forced into a bailout. Historically, Spanish bond spreads have been a mere 15 basis points over German bonds. Spain is due to sell a new series of bonds on Thursday.

In spite of rising Spanish debt costs, some economists think Spain might just avoid a bailout. The Spanish economy, unlike Portugal’s, is expected to expand slightly this year and its debt-to-GDP ratio, at 63 per cent, is much lower than both Portugal’s, and the euro zone’s average of 79 per cent. Spain has some breathing room. The majority of its funding requirements come in the second half of the year, while those of Portugal come in the next few months.