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An unhooked phone dangles at a station on the floor of the New York Stock Exchange at the end of trading Tuesday. Stocks dipped as investors absorbed poor earnings reports among lingering doubts about economic strength. (Chris Hondros/Getty Images)
An unhooked phone dangles at a station on the floor of the New York Stock Exchange at the end of trading Tuesday. Stocks dipped as investors absorbed poor earnings reports among lingering doubts about economic strength. (Chris Hondros/Getty Images)

Debt alarm over stimulus spending Add to ...

The enormous public cost of fighting the global crisis is haunting governments and unnerving investors.

Even as President Barack Obama declared Tuesday that the United States must continue to "spend our way out of this recession," international ratings agencies sent shivers through markets with warnings that spiralling budget deficits and soaring debt levels are putting sovereign ratings at risk.

Analysts do not expect a return to fiscal stability soon, and some countries continue to rely on stimulus spending to support fragile economies. But the credit watchdogs are looking for sensible strategies to rein in deficits and bring debt back down to manageable levels within four to five years.

Concerns encompass the U.S., Britain, France, Ireland, Portugal, Dubai and, most notably, deeply troubled Greece, whose credit rating was cut by one debt monitor and put on watch for a downgrade by another.

International ratings agencies are warning that other governments face similar actions if they don't come up with plans to get their fiscal houses in order.

"The whole high-grade universe has become much more indebted than it was," said Paul Rawkins, a senior director with Fitch Ratings' sovereign team in London. "The issue for all of them [the Europeans and the U.S.]is that at some point one needs to see credible medium-term consolidation programs that will bring the debt back down again."

Moody's Investors Service said in a report Tuesday that the weakening public finances in the U.S. and Britain may "test the Aaa [triple-A]boundaries" for their ratings.

No one expects either government to suddenly lose its coveted triple-A rating. Both have access to deep capital markets and retain considerable capacity to raise taxes.

But further worries about the euro zone risks and possible defaults in Dubai and by other heavy borrowers are sparking a new flight by jittery investors toward the perceived haven of the U.S. dollar and the deep U.S. Treasury market. The greenback rose Tuesday.

"Markets are quite sensitive at the moment, especially with what happened to Dubai during the last couple of weeks," said IHS Global Insight economist Diego Iscaro in London. "Sovereign [debt]has been in the spotlight."

While major developed countries have plenty of taxing power and access to deep capital markets, the less stable fringe players are already feeling the heat.

In Europe, Ireland, Portugal and even France are under pressure to rein in shortfalls. Greece has become the first of the 16 euro zone countries to fall below a single-A rating.

Fitch Ratings cut Greece by a notch to triple-B plus. That's barely above junk status and typically means the government will have to pay investors more to buy its bonds.

Standard & Poor's put the country on its watch list Monday for a possible downgrade.

Spreads on Greek bonds were already ballooning as a result of a worsening crisis and lack of credibility after steep revisions of economic performance and deficit projections.

Fears about unfunded social commitments also hang over the market.

The Fitch cut came after Athens announced Tuesday that the fiscal deficit for this year is likely to hit 12.5 per cent of GDP, far above its official projection last January of 3.7 per cent.

The rating agency now expects government debt to total 115 per cent of GDP by year-end and probably 120 per cent by the end of next year.

"It's an issue of credibility and a lack of track record," Mr. Rawkins said. "The numbers for 2009 are so much worse than had initially been suggested."

The rating agency also considered the new government's capacity to dish out the bitter medicine needed in the years beyond 2010 to get its fiscal house in order. These would include deep public service cuts and means confrontations with militant public sector unions.

Market reaction was quick, as the euro fell and investors fled Greek bonds and equities.

Although the fear that a hard-pressed government will delay repayments or even default on its obligations hangs over the market, analysts said such an outcome is unlikely in the case of Greece or other European governments facing spiralling debt costs.

Indeed, demand for Greek bonds at recent auctions was strong, thanks to higher yields relative to other euro bond issuers, and the view that its euro zone colleagues would ride to the rescue, if only to protect their shared currency.

"In the short term, the risk [of default]is not significant," Mr. Iscaro said. "They have raised most of their funding requirements for next year."

Fitch followed its downgrade of Greece's debt by cutting the ratings of five Greek banks. This is normal procedure, as corporate borrowers typically fall below their national governments on the ratings scale. Also, Greek banks own large amounts of their government's bonds.

Meanwhile, any risks to the bigger industrial countries appear minimal. "The risks of a credit downgrade for the U.S. and U.K. are pretty low," said Geoffrey Somes, senior economist with State Street Global Advisors.

"Yes, the current fiscal situations are pretty poor, with budget deficits over 10 per cent of GDP and debt levels over 50 per cent of GDP and rising fast. But these imbalances developed during what was for both countries one of the worst economic downturns" in the postwar period.

Even a "moderate pace of recovery" would brighten their fiscal prospects considerably, Mr. Somes said.

Canada, which went through wrenching cuts to impose fiscal discipline in the late 1990s, is still basking in the afterglow of that, despite its own widening deficit.

Indeed, this country is viewed as a model of what can be accomplished once corralling government deficits becomes a top public priority.

Coming out of the 1991-92 recession, Canada aroused similar concerns among debt watchers. But it took another five years for the then Liberal government to implement harsh but effective policies to get spending under control, recalls Mark Chandler, head of Canadian fixed-income and currency strategy with RBC Dominion Securities Inc.

"There's definitely a three- to five-year window where they can show what needs to be done," Mr. Chandler said of G7 governments. "The recognition appears to be there at the highest levels. But that's different than showing the political will to do something."

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