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Europe Hit By Downgrades As Deficits Balloon

  • Kathleen Moore

PRAGUE -- With recession here or looming, governments across Europe have reacted in much the same way -- by throwing money at it. They've rolled out massive spending plans, including stimulus packages intended to cushion their economies, and bailouts for the banks.

All this at a time of lower budget revenues thanks to the downturn.

Kornelius Purps of Unicredit in Munich has a name for it: "The public balances have to deal now with a triple whammy."

That "triple whammy" is exacerbating what were already high deficits and debt levels in some countries.

And now international credit rating agencies are taking note of the ballooning deficits and worries governments won't be able to pay their debts.

Standard & Poor's this week downgraded Spain's sovereign credit ratings (to 'AA+' from 'AAA'). The previous week, the same agency downgraded Greece (to 'A-' from 'A).

Those actions followed downgrades by various rating agencies late last year of Romania, Russia, and Latvia.

"The outcome is that the rating agencies come up with downgrades and that the market is punishing those countries with wider spreads," Purps says, referring to the difference between the interest rates certain countries pay to borrow and the rate paid by Germany, whose government bonds are seen as the safest in the eurozone. "We have spreads in the area of 100, 200, even 270 basis points above German government [bonds] currently, which is quite punishing. In the case of Greece this means 10-year yields are in the area of 5.5 to 6 percent."

Spain, Greece, and others were already paying more for their borrowing, with the spread widening in recent months to the biggest level since the euro came into being.

It is a result of investors demanding a higher return for what they perceive as a higher level of risk.

Now these credit downgrades mean the cost of borrowing is likely to rise further. Analysts say other countries that use the euro are also in line for a possible downgrade, particularly Portugal and Ireland.

Neil Mackinnon, chief economist at ECU Group in London, adds another likely candidate, this time outside the eurozone: Britain, thanks in part to another huge bank bailout announced this week.

"The bailout costs of helping the banking sector is likely to put significant upward pressure on Britain's debt-to-GDP level, which is currently 54 percent. I've seen some estimates that suggest Britain's debt-GDP ratio could double, which would take it to levels that we see in countries like Greece, Italy and Belgium," Mackinnon says. "All of these countries don't have a triple-A credit rating. It's something investors are focusing on and explains why Sterling has been under pressure."

To be sure, Spain and Greece were only downgraded one notch.

Joaquin Almunia, the Economic and Monetary Affairs Commissioner, this week said the risk of default was tiny for any country in the eurozone.

But the actions have raised the question: What if a eurozone country did default on its debts?

"Other countries' spreads would rise to levels several hundred basis points above [German government bonds] and we would see a domino effect where the spreads widening on other countries' government bonds would trigger probably other defaults," Purps explains. "It's a kind of EMU (European Economic Monetary Union) Armageddon scenario."

That's why, he says, Spain's downgrade has kicked off a discussion "about the survival" of monetary union.

Mackinnon says there are worries a country such as Greece might decide to pull out. "Such a scenario would have been regarded as quite extraordinary 12 months ago, but as the events in the financial markets and the global economy during 2008 made clear, anything is possible," Mackinnon says. "We can't rule out the possibility that a country could exit."

However, leaving the eurozone would be extremely costly.

Wolfgang Munchau of the "Financial Times" wrote in a recent column (http://www.ft.com/cms/s/0/fce0eb80-e5c8-11dd-afe4-0000779fd2ac.html?nclick_check=1) that a government about to default "would be mad to leave the eurozone," as it would add a currency and banking crisis to the woes of a debt crisis.

He says a member-country default won't lead the eurozone to fall apart. Much more likely, he says, is that other EU governments would step in with a bailout for the defaulter.

But however Europe coped with a potential default, Purps says, one thing is sure -- it won't be good for the euro, which has recently fallen to under $1.30.

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