Europe's medicine is injected and now the pain begins

Share

As euphoria over Europe's $1-trillion (U.S.) bailout fund fades, the focus turns to the hard work ahead for euro zone countries facing a wrenching spending overhaul that is bound to drag down growth.

The euro resumed its slide Tuesday and European stocks gave back some of the gains made when the bailout package sponsored by the European Union and the International Monetary Fund triggered a spectacular global markets rally Monday. Gold prices hit new highs as nervous investors sought safety.

"The euphoria of 24 hours ago has passed," Derek Halpenny, European head of global currency research at Bank of Tokyo Mitsubishi UFJ, said in a report. "We are in little doubt that steps taken will offer the euro little support and the aid package does not change the fact that Spain and Portugal in particular will still have to undergo further painful austerity measures."

The market reversal came as investors concluded that the loans and loan guarantees offered by the EU and the International Monetary Fund, collectively worth as much as €750-billion ($948-billion), did not change the outlook for the weakest euro zone countries. They are in recession, are uncompetitive and must implement severe spending cuts to reduce their budget deficits.

At least three of the 16 euro zone countries - Spain, Greece and Ireland - are expected to remain in recession this year after a brutal downturn in 2009, according to Deutsche Bank forecasts. A fourth, Portugal, could easily fall back into recession if any austerity measures demanded by the EU and the IMF prove painful. Growth in the other euro zone countries is forecast to be modest - at best half of the 3.5 per cent GDP growth expected in the United States.

And Europe's bailout fund sends a problematic message to struggling countries. Investors and economists fear that Spain and Portugal, and perhaps Italy, won't take the painful steps needed to reduce their debt and deficit, and make their economies more flexible, now that hundreds of billions of euros of relatively inexpensive funding is suddenly available.

Cat:e528746c-3414-401a-b14b-50247e3bdf01Forum:2d13dc33-9921-4d4a-815f-e809277631e4

"Taken at face value, this initiative would be an incentive for a hypothetical 'non-virtuous' country to keep being non-virtuous, as it would benefit from cheap funding," a UBS report said.

The European Commission (the EU's executive arm) would only advance funds to the countries in trouble if they promise to tackle their deficits. But UBS notes that the EC has no legal tool to monitor any fiscal progress. The euro zone's own Stability and Growth Pact, which had set a 3-per-cent limit on deficits, has proven entirely ineffective. No euro zone country of any size is expected to have a deficit of less than 3 per cent this year.

Italy's bond auction on Tuesday - the first test of euro zone debt after the EU-IMF bailout package - hinted that the worst was not over for countries laden with high debt, high business costs and bloated bureaucracies. While Italy, where debt is 115 per cent of GDP, got its €5.5-billon, 12-month bonds out the door, it had to pay the highest yield in a year to do so. The premium was 0.15 percentage points above comparable debt traded on the market.

Italian debt will be tested again on Thursday, when the government is to sell as much as €3-billion of 5-year bonds and between €1-billion and €2-billion of 15-year notes.

Spain and Portugal, however, represent a far bigger threat than Italy to the credibility of the euro. While their overall public debt loads are smaller, their budget deficits, at an expected 11.4 per cent and 9.2 per cent respectively this year, are about double Italy's and their bond yields have soared to the point that they have had difficulty raising debt.

On Monday, Moody's Investors Service said it might downgrade the ratings on Portugal and Greece, whose debt could fall to junk status. Standard & Poor's cut Greece's sovereign rating to junk last month.

One struggling EU country - Latvia - put a deep-cut austerity program in place in exchange for support, worth $10-billion (U.S.), from the EU and the IMF. Its Prime Minister, Valdis Dombrovskis, recently said "reform starts where the money ends."

But Latvia's version has come at horrendous cost to the economy and its workers. More than 20 per cent of public sector jobs have gone. The wages of the survivors have been cut by 25 per cent or more. The savage cuts led to an 18-per-cent economic contraction last year, far worse than any of the euro zone countries (Latvia is not part of the euro zone, but fixes its exchange rate to the euro). A less severe drop is expected this year.

Greece, Portugal and Spain may have to embrace similar austerity programs to put their fiscal houses in order. The question is whether their governments will have the political courage to do so when their citizens are already resisting less drastic cutbacks than Latvia's. In recent months, Greece has been hit by protests and rioting, resulting in three fatalities in Athens last week, even though a massive jobs cull is not expected.

Europe's financial instability should be a wake-up call for the United States and United Kingdom, which need to lay out clear plans to tackle their debt levels, says an international watchdog co-led by former Bank of Canada governor David Dodge.

"Countries such as the U.K. and the U.S. should move swiftly to articulate clear and convincing medium-term plans for fiscal adjustment, with careful co-ordination to avoid undermining global economic growth," the Institute of International Finance's market monitoring group said in a statement Tuesday.

With files from reporter Tara Perkins in Toronto

The outlook for PIIGS

How would the economies of Portugal, Italy, Ireland, Greece and Spain perform if their deficit-to-GDP ratios returned to the 3 per cent ceiling they're supposed to stick to under the little-enforced euro zone rules?

According to research by Gluskin Sheff chief economist & strategist David Rosenberg, Europe's GDP in general would be reduced by about 1 per cent annually over the next three years, while the hit to the PIIGS would be "very painful." For Ireland, four percentage points would be taken off annual GDP over the next three years. Greece would see a reduction of 3.5 percentage points, Spain 2.8 points, Portugal 2.2 points and Italy 0.8 points.

Mr. Rosenberg forecast that other countries would suffer GDP declines as follows:

France: 1.5%

Belgium: 1.0%

Netherlands: 0.8%

Austria: 0.2%

Germany: 0.1%