Fresh euro turmoil on eve of summit

TURMOIL RETURNED to financial markets on the eve of a crucial euro zone summit as Spain’s credit rating was cut and Portugal came under pressure to take new austerity measures to avert a bailout.

As euro zone leaders seek a “contingent agreement” tonight on a German-inspired competitiveness pact, senior European diplomats said they remained deeply divided over the extent to which any measures to enlarge the scope and lending capacity of the single currency bailout fund.

Officials played down any expectation of a major breakthrough at the dinner summit, which is expected to continue late into night. Senior diplomats say the Netherlands, Finland and Austria continue to support Germany in its opposition to any appreciable widening of the bailout fund’s mandate.

With Italy under pressure this week and Belgium vulnerable, officials fear any failure to agree a comprehensive reform package by the self-imposed deadline of March 25th would be heavily punished by markets.

Only days after a sweeping downgrade of Greek debt, Moody’s cut Spain’s rating by a notch to Aa2 with a negative out.

The agency said the costs of supporting the Spanish banking system – estimated yesterday at €15.2 billion by the Bank of Spain – would greatly exceed Madrid’s forecasts.

“There is a meaningful risk that the eventual cost of the recapitalisation effort could considerably exceed the government’s current projections,” Moody’s said.

The overall cost was likely to be nearer €40-€50 billion and could rise as high as €120 billion in a more stressed scenario, said Moody’s.

Rival agency Fitch underlined the strain on Spanish banks, saying the system could have a capital shortfall of €38 billion in a “base-case stress scenario” and possibly as much as €96.7 billion in an extreme case.

Such figures were in stark contrast to the latest central bank assessment of the capital requirements for 12 Spanish banks, eight of them in the weakened savings bank sector.

The Moody’s downgrade bore down on the euro, adding to pressure on political leaders to overcome their differences on bailout fund reforms. The single currency dropped 0.8 per cent to $1.3803 in early New York trade and dipped at one point to $1.3792, the lowest since March 2nd. The dollar strengthened 0.4 per cent to ¥83.07 from ¥82.74.

The risk premium on Spanish bonds widened and the cost of insuring Spanish, Greek and Portuguese debt against default rose as a fresh wave of euro zone jitters hit financial markets.

Long seen as a major weak point in the euro zone, Spain has been trying for almost a year to convince markets that it can overcome on its own the combined forces of recession, a 20 per cent unemployment rate and mounting bank losses.

With Portuguese borrowing costs at levels deemed unsustainable even by its government, both the European Commission and the European Central Bank are said to be unhappy with Lisbon’s promises of additional measures to tame the deficit.

Prime minister José Sócrates may encounter fresh pressure from his counterparts this evening to intensify economic reforms.