A debt crisis is rippling through the weak economies of Europe, eliminating any hope that Greece's financial woes can be boxed in and raising the likelihood that European growth forecasts will be trimmed.
In spite of spending cutbacks announced by the Greek government, bond yields in Portugal and Spain shot up as investors, fearing default, unloaded their holdings Thursday.
As the day wore on, the fears spread beyond Europe, feeding a slump in major stock exchanges like New York and Toronto and in commodities. The MSCI World Index of 23 developed markets fell 2.9 per cent. Oil lost 5 per cent and gold dropped 4.3 per cent, in large part because the euro weakened against the greenback. The Dow Jones industrial average lost 2.6 per cent and the S&P/TSX composite 2.3 per cent.
Europe's mounting debt woes put Jean Claude-Trichet, the president of the European Central Bank (ECB), on the defensive as he sought to reassure investors that the problems of a few small countries did not mean the euro zone as a whole was in trouble. The broad selloff in euro zone bonds and stock markets, and the plunging euro, suggested investors did not share his confidence and expect the debt crisis to deepen.
"This is sweeping from one country to another, and Spain and Portugal are next," said Russell Jones, managing director of strategy at Royal Bank of Canada's investment arm in London.
In Europe, Portugal took the worst hit. On Thursday, the cost to insure Portuguese bonds against default rose to a record high of more than 200 basis points (100 points equals one percentage point), or the equivalent of $200,000 (U.S.) for each $10-million in bonds.
The yield spread between Portuguese bonds and benchmark German bonds widened by 10 basis points to 157 points, more than four times greater than their five-year average. Spanish bond yields and default insurance costs also climbed.
The Portuguese and Spanish bond selloffs triggered stock market slumps in European countries with large budget deficits. The Portuguese, Spanish, Greek and Hungarian bourses lost between 2.5 and 6 per cent, with Spain taking the worst drubbing. Spanish and Portuguese bank shares also got trounced, and the euro fell to a fresh, seven-month low against the dollar.
The ECB on Thursday left its benchmark interest rate at a record low of 1 per cent as the debt problems of the so-called PIIGS - Portugal, Italy, Ireland, Greece and Spain - pick up momentum and threaten to stall wider European economic recovery.
As the debt crisis spreads, economists realize that forecasts for an economic rebound in the euro zone - the 16 EU countries that share the euro currency - might have to be scaled back. "I think a downgrading of the euro zone's growth outlook looks inevitable," said UniCredit chief economist Marco Annunziata.
Mr. Jones, of RBC, had a similar view. "This can only make the recovery more difficult, not just for one or two more years, but longer."
He said the unravelling of the small Greek and Portuguese economies alone wouldn't kill euro zone growth. But if Spain, where the jobless rate is about 20 per cent, goes from recession to depression, the problem will deepen because the country accounts for a hefty 12 per cent of euro zone GDP.
"The labour market situation in Spain is absolutely catastrophic. Officially, there are four million unemployed Spaniards. The real figure might be closer to five million."
According to the ECB's last forecast, in December, the euro zone economy will grow 0.8 per cent this year and 1.2 per cent in 2011. It probably contracted 4 per cent last year.
Fiscal tightening in Greece, Spain and Portugal might spread to Italy, France and Germany, Mr. Annunziata said, in an effort to prevent a general rise in long-term yields that would make debt financing costlier. This tightening could slow growth, though the weakening euro would take up some of the slack by boosting European exports.
The runup of debt in the euro zone has been phenomenal, partly because the enforcement mechanisms of the euro zone's Stability And Growth Pact (SGP), which ostensibly puts tight limits on deficit spending, have not been effective. The International Monetary fund predicts a steadily rising debt-to-GDP ratio for the euro zone to as a whole. In 2007, it was 66 per cent. This year the figure will be about 86 per cent, rising to 96 per cent in 2014, the IMF says.
"As the enforcement mechanisms of the SGP are toothless, countries have no incentive to be fiscally responsible," Mr. Annunziata said. "If you run a loose fiscal polity, the benefits are all yours - higher economic growth and happy voters - whereas the costs are spread over the whole euro zone, and eventually someone will help you out."
While a bailout of Greece sponsored by the IMF or the euro zone countries is possible, Mr. Trichet of the ECB said he was "confident that the Greek government will take all the decisions that will permit [it]to reach that goal" of cutting is deficit to 3 per cent of GDP, the European Union's limit, in 2012. Greece's budget deficit is currently 12.7 per cent, the EU's biggest.
Greece's austerity plan is only partly in place. So far it includes a tax on fuels and the extension of a wage freeze to the whole public sector. The government also announced it intends to raise the retirement age, but has given no details. The European Commission, the EU's executive arm, has endorsed the plan, but insisted that Greece "can and must do better."
The Greek government's spending reductions are politically unpopular, especially since the wage freeze reverses a post-election pledge made in October by Prime Minister George Papandreou. To protest the cutbacks, Greece's biggest union, the GSEE, approved the second mass strike this month and tax collectors began a 48-hour walkout.
The GSEE represents about two million workers in the private sector and voted to walk out on Feb. 24. The biggest public employee union plans a Feb. 10 strike.
With files from reporter Boyd Erman
Eric Reguly