European debt woes rear head again

Bond rating agency Fitch Ratings downgraded Portugal's long-term debt Thursday and placed the country on rating watch.

Fitch said it cut the country's sovereign credit rating to A- from A+ because of the government's resignation a day earlier following Parliament's rejection of new debt-reduction measures.

And markets took the resignation as proof the debt-heavy country will lose its year-long battle to avoid a bailout and deliver another setback to Europe's efforts to boost confidence in the euro.

Portugal's woes were just one the aspect in the renewed European soverign debt crisis, as leaders met in Brussels, a rating agency downgraded 30 Spanish banks and new data showed Ireland's economy contracted. 

The interest rate on 10-year Portuguese government bonds were pushed to a modern record of 7.71 per cent — an unsustainable level that shows investors are doubtful of the country's ability to finance itself.

It seems all but certain that Portugal will soon have to accept a bailout from the EU, similar those handed to Greece and Ireland in 2010.

It's unlikely an interim government will have the constitutional authority to negotiate assistance on the country's behalf. Elections would not be possible before the end of May, leaving months of unwelcome — and costly — uncertainty ahead.

Still, the euro rose against the U.S. dollar as the European Union opened a two-day summit to come up with a final plan on how to contain the debt crisis. At midday, it was up 0.7 per cent to $1.4184 US. 

Traders speculated that the European Central Bank will raise borrowing costs, and were prepared to focus less on the fiscal turmoil.

"For now, investors have taken comfort in the view that the beefed-up EU rescue fund is more than large enough to withstand a Portuguese bailout and prevent systemic risk to Europe's banking system," said Sal Guatieri, an analyst at BMO Capital Markets.

"Of course, this hinges on a belief that Spain — the fourth largest eurozone economy — is strongly committed to its austerity plan," Guatieri added.

A bailout for Portugal would likely be in the range of 70 billion euros, or a little under $100 billion Cdn. That would be much larger than the one Ireland accepted in late 2010.

Irish economy contracts

At the same time, new data released Thursday showed the Irish economy contracted by 1.6 per cent in the last quarter of 2010.

Irish lawmakers confirmed the country may be forced to make bondholders absorb losses at state-owned banks, a form of default, within the next few years.

"We have a problem with recapitalization of our banks," said Gay Mitchell, a European lawmaker for the governing Fine Gael party. "We're not threatening anybody. We're saying, 'please help us out on this — Ireland is not capable on its own of doing this.'"

Similar to what's happening in Portugal, the yield on 10-year Irish bonds went above 10 per cent on Thursday for the first time in history.

Portugal's jobless rate currently sits at a record 11.2 per cent. In neighbouring Spain, which has also been rattled by investor fears about its heavy debts, unemployment is above 20 per cent.

Spanish woes

Ratings agency Moody's downgraded the debt of 30 Spanish banks on Thursday. The company also kept its outlook for the sector at "negative."

"It seems increasingly plausible that hard choices will need to be made at some point over the rating horizon, balancing the sovereign's incentive to support the banks with the need to protect its own balance sheet," Moody's said in a statement. "It is, in Moody's view, increasingly likely that the sovereign will not be prepared to write all banks a blank cheque."

The Spanish government is working to ensure creditors bear the burden of the debt at many smaller banks, so taxpayers don't have to. But larger banks seen as key to maintaining the smooth running of the country's economy will be backstopped, Moody's predicted.

"That certain lenders have problems is well-known and can't be denied," Pablo Garcia of Oddo Sociedad de Valores in Madrid was quoted by Bloomberg as saying. "But in our opinion, at least 70 per cent of the Spanish financial system is highly solvent."