INVESTORS DOUBT THAT EUROPE IS IN CONTROL / THE NEW YORK TIMES NEWS ANALYSIS ( VERY HIGHLY RECOMMENDED READING )

January 7, 2011

Investors Doubt That Europe Is in Control

By LANDON THOMAS Jr.

LONDON — Europe’s sovereign debt crisis is back — if it ever went away.


Less than a month after bailing out Ireland, and following a holiday lull in the markets that may have looked mistakenly like calming, the European Union is again struggling to persuade investors that it has the cash and will to address the root cause of the euro zone’s travails: a growing debt overhang that is strangling governments and their banks.


On Friday, the yield on Portuguese 10-year sovereign bonds hit a recent high of 7.1 percent, the cost of insuring the debt of banks in Italy and Spain rose sharply, and the euro hit a three-month low against the dollar.


Driving the recent sell-off was a report by the European Commission that proposed that holders of senior bank debt be required to take a loss when a bank fails.


While the European authorities took pains to say that the rules would not apply to the more than €1 trillion, or $1.3 trillion, in current bank and sovereign debt in the 17-member euro zone, investors were not biting. They chose instead to interpret the report as a signal that they would be forced to take losses on their bank and government obligations.


It was hard to blame them.


“It is clear that the debt which will take a haircut is the current debt, not the future debt,” said Willem Buiter, chief economist at Citigroup, who on Friday published an 80-page report explaining why debt restructuring in Greece, Ireland and Spain was inevitable. “All bank and sovereign debt is now at risk — that is the reality.”


Mr. Buiter refers to the latest sell-off as the crisis overhang of the accumulation of government debt in Greece and bank debt in Ireland that in both cases led the European Union and the International Monetary Fund to come up with close to €200 billion to keep these countries from going under.


But with Greece and Ireland now paying out 80 percent of their export revenues toward external debt, governments will find it much harder to justify why hard-pressed citizens should be further squeezed to pay foreign creditors.


In Ireland, pressure is building for holders of senior bank debt to take losses, and the Greek government has had to deny rumors that it has approached its creditors about restructuring its own debt.


As a result, jaded investors have become increasingly reluctant to lend to so-called peripheral euro-zone countries like Portugal and Spain.


With an economy growing at just 1 percent and hampered by uncompetitive exports and steep budget and current account deficits, Portugal is entirely dependent on outside investors for financing. But no one expects it to keep borrowing money at 7 percent — a level that led Ireland and Greece to exit the bond market and seek assistance from the European Union and the I.M.F.


Spain is the Ireland to Portugal’s Greece. It entered the crisis with a low level of government debt, but sustained a tremendous bank-financed real estate boom and has been stubbornly slow in recognizing bank losses.


While top Spanish banks have been aggressive in finding sources of outside financing, they, like those in Portugal, have had to pay a higher price for the capital that they need to survive. B.B.V.A. and Santander, the two most profitable Spanish banks, issued debt this week at higher-than-usual spreads, or risk premiums.


And while these two banks benefit from having large parts of their business outside of Spain, the rest of the Spanish banking sector is not so lucky: The large proportion of the banks’ loan books is tied up in sinking Spanish real estate.


Spanish real estate prices are still on a downward spiral, yet the country still has one of the most overvalued housing markets in the world. And while the government has set up a bailout fund, it has devoted only 1 percent of gross domestic product to bailing out the banks — compared with a government commitment of more than 30 percent in Ireland.


“The Spanish government will need to put more money on the table for its banks,” said Marcello Zanardo, an analyst at Sanford C. Bernstein in London. In a report Friday, Mr. Zanardo said he expected real estate prices in Spain to fall 8 percent in 2011, and he pointed out that nonperforming loans at Spanish banks now represented 5.67 percent of total lending, an all-time high. “There is more pain to come,” he added.


Mr. Buiter, a former member of the Bank of England’s monetary policy committee, has long warned that Europe’s debt levels are not sustainable, so his latest offering of gloom is not a surprise.


Yet one of his main criticisms — that Europe has been perpetually slow to grasp the seriousness of the problem — has become increasingly difficult to refute. That skepticism is set to grow if Portugal and then Spain have to tap the €440 billion European rescue facility established last spring in the wake of the Greek crisis.


“The problem is that the facility is not big enough,” Mr. Buiter said. “So you will be forced to find ammunition elsewhere.”