EU debt crisis spreads to richer nations

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The debt crisis that rocked the euro zone's weakest countries has hit Italy and deepened in Spain, triggering a sharp selloff that roiled markets around the world.

Monday's market turmoil came after Spain's Socialist Party suffered an election rout, confidence in Italy's economic reform efforts fell and fresh data showed that euro zone growth is slowing after a remarkable spurt early this year.

The triple dose of bad news sent the euro to a record low against the Swiss franc and a two-month low against the U.S. dollar. In London, the FTSE 100 index lost 1.9 per cent and dragged down the American markets and commodities. Oil lost about $3 (U.S.) a barrel.

Bond yields of the weakest euro zone countries went to record highs as Greece, attempting to forestall a debt restructuring that most economists think is inevitable, prepared a fifth austerity package since it accepted a €110-billion ($150-billion) bailout last spring.

Standard & Poor's announcement Saturday that it may cut Italy's credit rating made the market selloff all but inevitable. Anemic Italian growth - gross domestic product rose only 0.1 per cent in the first quarter - and political turmoil were behind S&P's reasons to put Italy's rating on a negative outlook, implying a one in three chance of an actual downgrade in the next two years.

"Italy's current growth prospects are weak, and the political commitment for productivity-enhancing reforms appears to be faltering," the agency said. "Potential political gridlock could contribute to fiscal slippage ... we believe Italy's prospects for reducing its general government debt have diminished."

Late on Monday, Fitch Ratings added to the debt anxiety by cutting Belgium's outlook from stable to negative because of the protracted political stalemate between the Dutch-speaking north and the French-speaking south. Fitch doubts that Belgium can fix its finances in the absence of a resolution to its constitutional crisis, which may result in the breakup of the country.

Sunday's mauling of the ruling Socialist Party in Spain's municipal and regional elections added to the sense that the euro zone's debt crisis is far from over. Prime Minister Jose Luis Rodriguez Zapatero said the victories by the opposition Popular Party (PP) "were very clearly related to the economic crisis," which has sent the country's unemployment rate to 21 per cent, the highest on the continent, and brought tens of thousands of demonstrators into the streets of Madrid and other cities.

Analysts and economists said the minority government's setback could undermine Mr. Zapatero's aggressive efforts to cut back the budget deficit and push through economic reforms. In a note published just before the vote, Citigroup economists said "political defeat for the Socialist Party would reinforce our doubts" that Spain's deficit-cutting targets would be achieved.

In 2010, Spain's budget deficit as a percentage of GDP was 9.2 per cent, twice Italy's level and not far short of Greece's. Deutsche Bank expects Spain's deficit to fall to 6.5 per cent this year, but notes that "the fiscal behaviour of the autonomous regions will have a major impact on the overall success of the budgetary consolidation currently implemented in Spain."

On Monday, Spanish 10-year bond yields climbed to 5.56 per cent, their highest level since September, 2000.

Undeclared debt is one potential live grenade. Last November, when Catalan nationalists unseated the Socialist government, the new government determined that the regional deficit was twice as big as reported. Fudged debt figures led to the Greek debt crisis a year and a half ago.

Governments counting on an economic rebound to flatter their deficit reduction efforts could be disappointed by May data that reveal slowing growth after a strong showing earlier this year. The preliminary euro zone purchasing managers' index slumped to a seven-month low, suggesting the recovery will be muted, though economists do not expect a dramatic falloff from the euro zone's 0.8 per cent GDP expansion in the first quarter.

Greece on Monday ramped up its austerity efforts as its bond yields rose to yet another record high. Yields on 10-year bonds exceeded 17 per cent, almost two percentage points higher than the start of last week, reflecting investors' unwillingness to extend fresh loans to a country that may be close to a debt restructuring.

The International Monetary Fund, co-sponsor of Greece's bailout, has warned that additional funding is contingent on accelerated reform and privatization efforts. Greece is considering ways to sell €50-billion of state assets, equivalent to almost a quarter of GDP. Although Athens fears that speedy sales will result in fire-sale prices, it announced Monday night that it would proceed with the sale of state investments in ports, water companies and OTE, the country's largest telecommunications provider.

"Greece risks a sovereign default and finance ministers have expressed strong doubts about the sluggish progress," Christine Lagarde, Frances's Finance Minister and lead candidate to replace Dominique Strauss-Kahn as IMF boss, said in a May 20 interview with Austria's Der Standard newspaper.

The new cuts are expected to close tax loopholes, boost taxes on the wealthy and may include public service pay reductions and firings. Previous public spending reduction efforts were greeted with mass protests, a few of which turned violent.

A team of Deutsche Bank economists said Athens will have to find another €6-billion in savings if it is to hit the deficit target of 7.5 per cent of GDP in 2011. Its deficit last year was 10.5 per cent of GDP and many economists doubt the country will be able to bridge the gap.