“Investors are increasingly thinking about the risk of the unthinkable in Europe,” said Stu Schweitzer, a global market strategist at J.P. Morgan Private Bank in New York. “The concern is contagion.”
That reality will force EU policy makers to confront the prospect that the crisis could spread to larger economies, in particular Spain. Greece and Portugal are small countries that account for only a fraction of the euro zone’s economy and most economists believe that the EU, if necessary, could bail them both out. That isn’t true for Spain, however, a country of 46 million and the euro zone’s fourth-largest economy.
Spain, which is trying to emerge from a steep recession following a housing bubble, is running a 11.2% budget deficit. That compares to Portugal’s 9.4% deficit and Greece’s 13.6% deficit.
Like past debt crises, this one has fed on itself. Europe’s failure to act decisively has led investors to sell off Greek debt, making it far more expensive for the country to borrow money, prompting further downgrades.
News of Tuesday’s rating cuts came as investors were already unnerved by signs that a €45 billion ($60 billion) aid package for Greece from the EU and the International Monetary Fund could be delayed by political infighting in Germany.
European Central Bank President Jean Claude Trichet and IMF Managing Director Dominique Strauss-Kahn are expected to meet with German lawmakers in Berlin on Wednesday and urge them to act quickly on the EU’s aid package.
The shuttle diplomacy amid the worsening market turmoil suggests officials’ previous claims of an EU-wide consensus on a rescue were premature.
Political debate in Germany over the Greek bailout has become particularly heated in recent days because the issue has blown up in the midst of a campaign for a crucial regional election set for May 9 that could influence the balance of power in Germany’s national parliament.
That has led a number of German politicians to berate the government over its handling of the Greek crisis, playing to domestic opinion even in the face of criticism from other EU governments that accuse Germany of unsettling financial markets.
Germany is ultimately expected to contribute to the Greek rescue as EU leaders have agreed, despite the domestic political posturing in Berlin, analysts say.
“What it’s down to is whether Germany is going to step up to the plate and vote in support of the euro,” says Mark Dowding, head of institutional fixed income in Europe for DB Advisors.
“You have a number of countries in Europe who have sovereign debt situations where the debt burden is barely sustainable, particularly if yields move higher,” Mr. Dowding said. “The thinking is that if a package is not agreed to on a timely basis, effectively what you could be looking at unfolding is the European sovereign version of the Lehman crisis.”
As Greek bonds yield jumped to new record highs, the selling spilled into Portugese, Italian and Spanish bonds. Even Ireland’s government bond market took a hit though the country’s efforts to get its own fiscal house in order are these days being held up as an example for Greece to follow.