European officials remained on high alert Wednesday, searching for ways to contain the region's government debt crisis amid on expectations that a rebound in government bond markets would prove only temporary.
EU regulators loosened rules on bank bailouts for at least another year, while traders looked to the European Central Bank in hopes that its meeting on Thursday would end with signs the bank will boost financial markets with cash.
A better-than-expected result on a Portugues bond sale Thursday gave markets a respite. The euro recovered slightly and the yields on bonds from vulnerable countries like Portugal, Ireland, and Greece. Just as significantly, pressure came off the debt of Spain and Italy, two countries that have stronger finances but who only Tuesday appeared to be facing increased skepticism from lenders as well.
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 for Portugal's sale of 500 million euros ($650 million) in treasury bills, it 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 euros in state aid, according to figures released Wednesday. While the overwhelming majority of that aid, 3.94 trillion euros, 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 euros ($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."
There are expectations that the ECB, which meets Thursday for a monetary policy decision, will extend its special liquidity measures to banks and may announce additional support over the longer term. A press conference by ECB President Jean-Claude Trichet will be the focus of the day.
Markets are looking to see whether Trichet takes the ECB's support a step further and increases 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.
"I'm very confident that the Portuguese and the Spanish governments are taking the necessary steps to redress their public finances, and they are doing so with determination, with courage, and they are also taking very hard steps in relation to structural reforming," said French Finance Minister Christine Lagarde said, citing Portugal efforts on its labor market and Spain on its pension system.
Lagarde also said she welcomed the "active" role played by the ECB to help resolve the crisis, but declined to say whether she thought the Frankfurt-based bank should do more. "I reserve my reflections to my European partners," Lagarde told journalists.
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 Jan. 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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