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Tuesday, May 4, 2010

Bailout Fails to Calm Europe

The Wall Street Journal

International stock and bond markets sank Tuesday, dashing hopes that a weekend deal to bail out Greece would calm investors and stop the government-debt crisis from spreading.

In Athens stocks tumbled 6.7%, and in Spain they dropped 5.4%. Especially hard hit were shares of European banks that have hefty exposure to Greece's debt and economy. The cost of protecting against default on sovereign debt soared, and the euro hit a 12-month low.

The selling spread across the Atlantic, sending the Dow Jones Industrial Average down 225.06 points, or 2%, its biggest drop in three months. Investors bid up prices of U.S. Treasurys as they sought their relative safety.

Social unrest in Greece, coupled with uncertainty over whether European nations will approve the bailout plan, fueled investor concern about Greece and about whether European officials will take seriously concerns about the deficit outlooks for countries such as Spain, Portugal and Italy.

"It's Kabuki theater," said John Brynjolfsson, chief investment officer at hedge-fund manager Armored Wolf. "They describe this bailout as a done deal, but it's not a done deal."

That was highlighted by officials in Germany and Slovakia, who continued to cast doubt on whether Greece would be able to live up to its commitment to implement austerity measures to rein in its deficit—steps that are required for the European Union to hand over the bailout money.

In Slovakia, a new entrant to the euro zone, Prime Minister Robert Fico said he doubted whether Greece would be able to go through with the austerity measures outlined.

"Personally, I don't believe that the Greek parliament will be able to approve the restrictions," Mr. Fico said.

In Germany, politicians have been busy defending the €110 billion ($143 billion) aid package for Greece against public skepticism in Europe's biggest economy. Finance Minister Wolfgang Schäuble told the Rheinische Post newspaper that Greece won't get the emergency funds if it doesn't stick to its austerity pledges. "Then Athens may be on the verge of insolvency again," Mr. Schäuble said.

As markets kept falling, investors began speculating that the European Central Bank would have to take more aggressive steps to shore up the continent's bond markets, such as buying European sovereign debt or lowering interest rates.

In a sign of rising fear in the markets, Spanish bonds fell on Tuesday as rumors swirled that Spain would soon seek a bailout, prompting Prime Minister José Luis Rodríguez Zapatero to issue a public denial.

At a press conference in Brussels, Mr. Zapatero condemned the talk as "complete madness." Worry about any other country besides Greece "is totally unfounded and irresponsible," he said.

The challenge facing policy makers is that until they can prove to investors that budget-deficit issues will be addressed, the markets can end up in a cycle that makes the situation that much harder to control.

Bond markets punish heavily indebted countries by forcing them to pay higher interest rates, making it harder for those countries to pay lenders.

In addition, those higher interest rates slow economic growth, which reduces tax revenues.

"The debt dynamics [for Greece] look like the Argentina dynamic did in 2000," a year before that country defaulted on its debt, said Michael Hasenstab, manager of the Templeton Global Bond Fund.

While the bailout package should help Greece pay its bills in 2010, "our primary concern is that the crisis will come back in 2011, 2012 and 2013," said Mr. Hasenstab, who is betting that the euro will decline in value.

There are parallels to the financial crisis of 2008, when many investors believed the collapse of the market for subprime mortgages would be contained. Losses on those loans turned out to infect markets around the world.

Subprime problems largely infected banks and institutions that bought the debt. A similar situation could arise in Europe.

Holders of sovereign debt, primarily banks in Germany, France and Spain, are seeing their stocks decline and their borrowing costs rise as investors factor in losses on those bond portfolios.

That in turn can make it harder for those banks to lend to businesses, which could damp economic growth.

It was the selling of bank shares that spooked the markets most on Tuesday, traders said. In Spain, Banco Santander SA slumped 7.3% and Banco de Valencia SA fell 7.7%.

Some investors reacted with displeasure to the European Central Bank's decision on Monday to ease the pressure on Greek banks by saying it would accept any Greek government bonds as collateral for loans, no matter their credit rating.

The ECB's past rule had been to accept only bonds above a certain minimum rating. ECB President Jean-Claude Trichet had said previously he would not take such a step.

For investors, the move highlights how the ECB is effectively absorbing some of the risks facing Greek banks, since those institutions will now be able to exchange even "junk"-rated bonds for cash.

Such lenience, some fear, could soon be applied to other profligate European countries, further entrenching Europe's debt problems.

"That's a blow to the ECB's credibility," said Claire Dissaux, head of global economics and strategy at Millennium Global Investments in London. She said she expects the euro to fall further.