The European Central Bank pumped €1-trillion ($1.3-trillion) into the financial system in the winter to buy governments some time – and the clock is now ticking.
Spain struggled to round up investors for a debt auction Wednesday, creating new jitters about the European economy that once again rippled through European and North American stock markets. The Standard & Poor's 500 index suffered its second-biggest decline of the year and the S&P/TSX index fell 1.2 per cent to 12,178.66.
The lack of enthusiasm for Spain's latest debt sale broke the relative peace achieved by the ECB's extraordinary lending. The country's borrowing costs jumped higher, serving as a reminder that the continent's governments have much work left to do in convincing investors the debt of countries such as Italy, France and Belgium is a safe bet.
Spanish Prime Minister Mariano Rajoy is attempting to narrow a budget deficit that is 8.5 per cent of gross domestic product with a budget plan that would slash spending and raise taxes by an amount equal to €27-billion. The plan, which was tabled in Parliament on Tuesday, is running into opposition, prompting the Prime Minister to raise the spectre of default.
"Spain is facing an economic situation of extreme difficulty, I repeat, extreme difficulty, and anyone who doesn't understand that is fooling themselves," Mr. Rajoy told a meeting of his People's Party Wednesday in the southern coastal city of Malaga, according to an account by Bloomberg News.
Talk of default rattled investors. Spain raised €2.59-billion at an auction of securities that mature in October, 2016, just more than the minimum level of funding the government set out to achieve. The average yield on the bonds was 4.319 per cent, compared with 3.376 per cent last month, signalling a significant drop in confidence.
Higher borrowing costs in Spain, Europe's fourth-biggest economy, exacerbate the strains on a region that has slipped into recession. Spain's budget, for example, sets aside €29-billion for interest payments, which is about the same amount the government would spend on the unemployed. The country's jobless rate is 24 per cent, the highest in the European Union.
Despite signs of heightened pressure, the ECB held its nerve, opting against new measures at its latest policy meeting Wednesday in Frankfurt. President Mario Draghi reiterated that the central bank sees "signs of stability," although he said it would be "premature" to begin unwinding stimulus measures.
Mr. Draghi has lowered the benchmark lending rate for the 17 countries that use the euro by half a percentage point since taking over in November. More importantly, he opened the vaults to stabilize the European financial system, lending hundreds of banks a total of €1-trillion in December and February that won't have to be repaid for three years.
The unprecedented lending operation had the double effect of easing concerns about the bankruptcy of a big European bank and lowering the borrowing costs of euro-zone countries. The latter was achieved by banks using their ECB loans to buy the debt of European countries.
But the positive effect of the ECB's emergency lending on sovereign debt yields appears to be waning. Italian interest rates are also rising. That is increasing pressure on the region's debt-ridden governments to get their spending under control, and make difficult structural adjustments that could stoke faster economic growth.
"We are seeing the sugar high from the ECB gradually dissipating," said Jacob Kirkegaard, a research fellow at the Peterson Institute of International Economics in Washington. The jump in Spanish bond yields represents a "fundamental evaluation about whether Spain is the next bailout candidate," Mr. Kirkegaard said.
The drop in equity prices wasn't entirely about Spain's bond sale. Investors continued to unwind bets that the U.S. Federal Reserve will deploy a third asset-purchase program, after the minutes of the Fed's latest policy meeting showed Tuesday that most at the central bank oppose new measures. The S&P 500 dropped 1 per cent, to 1,398.96. The Dow Jones Industrial Average also slumped 1 per cent, to 13,074.75.