An attempt by Europe’s central bank to contain the rapidly deteriorating sovereign debt crisis backfired spectacularly Thursday, helping trigger a plunge on global stock markets and compounding threats to the world economy.
With banks in the eurozone ever more reluctant to lend to one another, ECB President Jean-Claude Trichet announced an injection of liquidity with a resumption of its program to purchase sovereign bonds. But the apparent exclusion of Italian and Spanish debt from that intervention stunned stock and bond markets in Europe.
“This is quite a dangerous phase,” said Jamie Dannhauser, senior economist at Lombard Street Research in London. “Market disruption yesterday and today looks as severe in Italian and Spanish bond markets as anything since Lehman Brothers.”
With the eurozone inching closer to an all-out currency crisis, and with bond yields in its third- and fourth-biggest economies at 14-year highs, investors are clearly concerned that European officials will be unable to backstop Italy and Spain from being claimed by the debt crisis.
“It’s not as deep a crisis yet as would be required to move the ECB in that direction. It would have to be convinced that the euro was about to come apart at the seams,” said Stephen Lewis, chief economist at London’s Monument Securities, a turn for the worse he predicts is as little as a week away.
That reality is dawning on markets, Mr. Lewis said. Stocks in London, Paris and Frankfurt lost more than 3% Thursday, while Madrid fell 4%, and Milan by more than 5%.
Eurozone leadership has failed to grasp the urgency warranted by the escalating tensions, Mr. Lewis said. “They’re all at the beach. They had their summit and all took off for their holidays.”
At that July 21 summit in Brussels, in addition to a second bailout package for Greece, eurozone leaders enhanced the €440-billion rescue fund, or the EFSF, with the ability to buy bonds on the secondary market and extend short-term lines of credit to troubled sovereigns.
But those new powers will not come into effect for a number of months, leaving the central bank as the lender of last resort for the time being.
At a crossroads of the debt saga, that “leaves the EU’s safety net woefully inadequate against the growing market contagion,” Lena Komileva, global head of G10 strategy at Brown Brothers Harriman, said in a research note. She called for an extraordinary international intervention to stem the risk of a “self-fulfilling investor panic” of the kind witnessed after Lehman Brothers collapsed in 2008. “The global market stresses are now at levels that warrant such action,” she said.
The focus of those stresses shifted abruptly in recent weeks from Greece to Spain and Italy, which also wrestle with massive sovereign debt burdens.
Yields on 10-year bonds recently rose well past the critical 6% threshold in both countries, while capital flows between banks began to dry up as financial institutions park more and more money in low-interest deposits with the ECB.
“This is a further breakdown of the interbank system in the eurozone, whereby strong banks simply hoard the liquidity they’re receiving,” Mr. Dannhauser said.
Banks in Italy and Spain are now finding it difficult to borrow, feeding worries the sector could fall into a cycle of credit contraction.
But to have the capacity to buy up large chunks of Spanish and Italian debt if required, the EFSF would need to increase by four or five times, Mr. Dannhauser said.
That kind of decisive action, however, seems unlikely, given the deep divisions among the eurozone’s member states, including German opposition to any additional bond-purchasing, he explained.
“The problem is that because at each stage of this crisis, they have done the minimum amount possible,” he said. “One hopes this week is going to drive them further towards a sustainable solution.”
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