After tumult, debt worries ease in Europe

Graham Bowley

Just two months ago, Europe's sovereign debt problems seemed grave enough to imperil the global economic recovery.

Now, at least some investors are treating it as the crisis that wasn't.

Spain held an auction of 15-year bonds last week that went off without a hitch, raising 3 billion euros, or about $3.8 billion, at a relatively favourable interest rate of 5.116 percent.

That was up from 4.434 percent on a debt sale in late April, though the latest one was far more heavily subscribed.

Also last week, Moody's Investors Service downgraded Portugal's credit by two notches, citing the nation's debt burden and poor growth prospects, a sign that the country's underlying problems are not over.

Yet investors, rather than punish assets linked to Portugal's economy, seemed to take the news in stride.

Nations like Spain, Portugal and Greece had been cautious about holding big debt auctions as recently as last spring.

Then, weak demand would almost certainly rattle global markets on fears that European nations would have trouble raising new money to cover their groaning debts. Investors were quick to sell on the mere hint of a credit downgrade.

How quickly investor psychology has changed.

'Europe has had a pretty good crisis,' said Jacob Funk Kirkegaard, a fellow at the Peterson Institute for International Economics in Washington.

"In the short term, it made a number of very constructive decisions that had the effect of calming down the markets or shifting market attention elsewhere." Indeed, there has been a string of calming news of late: well-subscribed bond auctions in Portugal and Italy, a deal to freeze wages in Greece as it tries to rein in its public spending, and signs that German industry, so important for the rest of Europe, is growing more strongly than expected, according to data for May.

Europe has also had help from an unexpected quarter: signs of renewed weakness in the American economy.

Two months ago, Europe's plight contrasted with the faster-growing United States, which seemed to be pulling quickly toward economic expansion after a period of recession.

Since then, however, economic data has pointed to an unexpected slowdown in growth, and unemployment remains stubbornly high.

As the effects of the public sector stimulus wear off and few new jobs are created in the private sector, some officials within the Federal Reserve have begun voicing concerns about deflation, and last week the Fed revised down its growth forecast for this year to a range of 3 to 3.5 percent, from its 3.2 percent to 3.7 percent forecast in April.

Suddenly, Europe seems more stable to many investors than the United States, where there has been talk of a double-dip recession.

"In Europe, output and production has continued to expand, and there is scant sign of anything crashing to a halt," senior market strategist at the Interactive Brokers Group Andrew Wilkinson said. "But then there has been the slowdown in the U.S. economy. I didn't see it coming, but here it is."

Economists warn that the optimism over Europe's prospects could prove temporary, a pause before another step down. On Friday, European regulators are to publish the results of stress tests of 91 European banks, a belated attempt at transparency along the lines of the tests the United States carried out last year.

The regulators hope the results will draw a line under fears about the bad debts European banks hold, though some economists fear it could reveal a more worrying picture of the problems.

Nevertheless, the euro, which fell 15 percent in the first six months of this year, is now back at its highest level in more than two months.

Other market measures have also improved: The Markit iTraxx SovX index, which tracks the cost of insuring European sovereign debt and measures investor sentiment on the likelihood of a government default, stands at 135 basis points, down from around 170 at the end of June, although still above 70, roughly the level in the mid-January.

And amid worries that Europe's banking sector could freeze up, Libor, the rate at which banks borrow money from one another in the London wholesale money market, rose sharply in the spring.

It is still at relatively high levels, but it has not gotten any worse, analysts say.

At these rates, some economists say, European debt is a good buy - one reason the bond auctions are going so smoothly.

"If you think it is very long odds that a major European country is going to default, then you are getting terrific yields in an era of very low interest rates," said Zach Pandl, a New York economist for the Japanese bank Nomura.

Behind the new optimism are the changes Europe put in place in the middle of the tumult earlier this year. These include a step by the European Central Bank to begin buying securities from banks, the creation of a 440 billion euro stabilization fund to bail out troubled nations, and an agreement to let the International Monetary Fund intervene in European affairs to impose the bailout packages.

The European nations at the center of the crisis have gone on the offensive, setting austerity measures to cut back bloated public sectors.

Spain is making spending cuts and structural reforms in an attempt to cut its 20 percent unemployment rate.

At the time, these interventions, agreed upon reluctantly and amid much bickering, seemed only to reflect the hopeless foot-dragging and paralysis in European decision-making. But over time, they have proved pivotal to improving investor confidence, at least for now.

Mohamed El-Erian, of the giant bond investor Pimco, said: "Through the E.C.B., E.U. and I.M.F., the official sector has stepped in with its balance sheet to assume liabilities previously held by the private sector, thereby allowing private investors to exit in an orderly fashion."

He cautioned, however, that "measures of market risk in the euro zone remain elevated." European policy makers are taking whatever opportunity they can to signal their belief that skeptical outsiders overdid their prognostications of doom, despite lingering questions about whether the severe austerity measures might crimp growth across Europe.

In an interview with the French newspaper Liberation last week, the president of the European Central Bank, Jean-Claude Trichet, took to finger-wagging, saying, "There is a tendency among some investors and market participants to underestimate Europe's ability to take bold decisions."

He added: "It would be a mistake to underestimate Europe, in general, and the euro area, in particular."

Courtesy: The New York Times