The euro-zone crisis, again

Ireland’s plan for a brutal fiscal adjustment has done nothing to appease panicky bond markets. Portugal is also in their sights

Nov 11th 2010 | dublin

IN 2008 a strike by French and Spanish lorry drivers cut off the supply of components from Germany to Volkswagen’s Auto Europa plant, south of Lisbon, forcing the factory to close for a day. Two years on there is a more serious threat to the supply lines of countries on the fringes of the euro zone. The yield on Ireland’s ten-year government bond vaulted towards 9% on November 10th, 6.2 percentage points above the yield on safe German Bunds (see chart); Portugal’s topped 7%.

Such signs of distress may foreshadow a buyers’ strike that would eventually force both countries to turn to the European Financial Stability Facility, the euro zone’s rescue fund. At the very least, the panic should force the European Central Bank (ECB) to make bigger purchases of Irish bonds to stop a self-fulfilling run.
There are still some willing buyers for peripheral debt at the right price. On November 10th Portugal raised €1.25 billion ($1.7 billion) in a sale of six- and ten-year bonds, completing its fund-raising for this year. Portugal is aiming for a budget deficit of 4.6% of GDP next year, less than half Ireland’s target, though it has more debts to roll over. Ireland has no need to tap the markets soon: its debt-management agency has hoarded €20 billion of cash, according to Morgan Stanley (Portugal has squirrelled away €10 billion). That is enough to cover Ireland’s borrowing needs and bond redemptions well into next year.
Even if each government has a little breathing space, anxiety about public finances has eroded their banks’ ability to secure long-term debt finance, with knock-on effects for other types of corporate borrowing. Reliance on short-term loans from the ECB is worryingly high. Ireland’s banks fund 10.2% of their assets with ECB cash, according to Barclays Capital; the figure for Portugal is 7.2%. For now banks have access to ECB funds at its main interest rate, currently 1%, for up to three months. Some on the ECB’s council might have hoped soon to make the terms more restrictive, but that now seems unlikely. Portugal in particular has huge foreign debt, much of it channelled through its banks: some think this is the country’s main frailty. Fitch, a ratings agency, downgraded four of Portugal’s banks on November 8th, on concerns about funding.
Both Ireland and Portugal had hoped that bold efforts to cut budget deficits would appease bond markets and clear their funding channels. On November 4th Ireland’s government said that it planned budget cuts worth €6 billion (or 3.8% of GDP) in 2011. It will follow that with €9 billion of further measures in 2012-14. Details will be set out later this month in a four-year economic plan.

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Portugal’s budget for 2011 was finally approved on November 3rd: the main opposition party agreed not to block it after securing a smaller rise in taxes and bigger spending cuts than first planned. The measures include an increase in the standard VAT rate and a 5% average cut in public-sector wages. The overall fiscal tightening in 2011, including actions announced earlier, will be an eye-watering 4.3% of GDP, estimates Julian Callow, at Barclays Capital.
It is hard for economies to prosper under this sort of fiscal squeeze. In Ireland the hope has been that clarity about the fiscal outlook might persuade consumers to save less and spend more. But taxpayers have barely had time to absorb the news that the cost of bailing out the banks will push Ireland’s budget deficit to 32% of GDP this year, even after raiding a fund set aside to pay for future welfare costs. They have now been told that a further €15 billion-worth of fiscal pain is still to come—twice the figure suggested in last year’s budget—because of higher interest costs and more realistic growth forecasts. The natural reaction for householders is to fear the worst. As European leaders discuss ways to make creditors bear losses when countries default, that goes for bond markets too.