The wrath of bond investors is forcing European leaders to confront sweeping changes to the nature of the euro zone monetary union.
Governments have toppled, billions of euros in aid have been pledged and harsh reforms have been foisted upon angry citizens. Yet the euro debt crisis not only refuses to ease, it continues to spread, as skeptical bond investors tighten the screws by the day, intensifying pressure on leaders to use more radical tools if they hope to save the 17-member organization.
Deep divisions between the countries have prevented the euro zone from taking steps that have the potential to reshape the currency union. One of those would be granting more power to its central bank, including turning it into a lender of last resort. The prescription for saving the euro also includes a plan for some permanent form of fiscal federalism and a pan-European bond.
But Germany stands opposed to more forceful intervention by the European Central Bank or the issue of eurobonds guaranteed by all 17 member countries. And other governments refuse to yield to what they fear will be a loss of sovereignty to the Germans and unelected officials in Brussels.
These rifts are roiling bond markets, which have pushed borrowing costs to unbearable levels for countries such as Italy and Spain, and are threatening to blow the euro zone apart. Italian bond spreads edged back above 7 per cent on Wednesday, despite more buying by the ECB and the appointment of a new government of technocrats in Rome, designed specifically to push through tough austerity measures and clean up critical fiscal problems.
The rise in rates came after Maria Cannata, the Italian treasury official responsible for public debt, estimated that Rome will need to raise €430-billion ($592-billion) in the debt markets next year to meet its financing needs.
"It sounds prohibitive but it's not, even if things have gotten more complicated because investors are frightened by the volatility in markets," Ms. Cannata told a conference in Milan.
Debt watchdogs issued more warnings and bank rating cuts Wednesday, spooking stock markets. U.S. equities fell sharply over fears of worsening contagion, after Fitch Ratings cautioned that "the broad outlook for U.S. banks will darken" if the Europeans do not resolve their debt crisis soon.
Then, Moody's Investors Service cut ratings on 10 state-owned banks, most of them wholesale institutions known as landesbanks. The ratings agency cited "a lower likelihood that these banks would receive external support, if required." Six of the banks saw their ratings fall three notches. Only one of those under review since July, Landesbank Berlin AG, escaped unscathed.
Moody's stressed that the downgrades are not linked to the sovereign debt woes, but added that it is closely monitoring "the credit implications of the ongoing euro-area crisis."
Meanwhile worried depositors continued what one European economist called a "bank walk," pulling billions of euros out of banks in Greece, Italy and other debt hot spots. Germany's Der Spiegel reports that Greeks have withdrawn about €50-billion from their accounts, 20 per cent of total deposits, since the beginning of the crisis. Italian central bank data show that more than €80-billion was transferred out of the country in August and September.
These developments highlight the growing fragility of the euro zone's banks and the threat that poses to the rest of the highly interconnected world financial system.
A eurobond backed by all 17 countries has considerable appeal as a solution, mainly because it would eradicate the widening bond spreads that have made it prohibitively expensive for weaker members to finance their rising deficits and roll over massive debts. Financially sound Germany can tap the capital markets at record low rates, but cash-strapped Italy and Spain face billions of euros in added financing costs.
But eurobonds have one significant opponent – namely Germany. the single euro-zone country powerful enough to ensure a strong reception for such issues. German Chancellor Angela Merkel repeated her long-held objection to eurobonds on Wednesday, arguing that it would remove an important incentive for governments to follow sound fiscal policies.
But Germany's real worry is twofold, analysts say. Eurobonds will raise Germany's own cost of capital, because a bond encompassing the entire union will not be as strong as Germany's own bunds. And they will leave the German treasury on the hook, as the main backstop for the new bonds.
"The single biggest roadblock is that it requires large political compromises, votes and treaty changes, and as such, isn't something that can just be slapped together quickly," said Richard Kelly, TD Securities' head of European rates and foreign exchange research in London. "Unfortunately, that is exactly what the market is pushing us towards."
Eurobonds are just a concrete form of the fiscal federalism the euro zone must adopt if it is to survive, analysts now agree.
The German Council of Economic Experts last week came up with an idea it calls the European Redemption Fund. Analysts say it is simply another version of the eurobond. The fund would assume excess public debt of countries that break Brussels' limit of 60 per cent of GDP. In return, the affected governments would have to live with strong EU oversight of economic and fiscal policies and impose measures to drastically reduce debt.
Smaller countries have already signalled their objections to such heavy interference in their affairs.