Spain grits teeth yet again as austerity deepens

The conservative leader pledged to fight Spain's unemployment curse by shaking up the labour markets. The jobless rate has hit 22.8pc with 5.4m people out of work. The tally is certain to rise further as the economy falls back into recession.

Spain's 10-year bond yields dropped to 5.09pc, far below the 6.5pc stress peak seen last month, even though Mr Rajoy said the government will miss its budget deficit target of 6pc of GDP this year.

Global funds are gobbling up Spanish and Italian debt on bets that lenders will exploit the European Central Bank's offer of three-year credit at 1pc to buy sovereign debt, playing the "carry trade" on the yield spread.

Mr Rajoy evoked the triumph of the mid-1990s when Spain clawed its way back to viability and astonished EU officials by meeting EMU entry terms. But the path was smoothed by a peseta devaluation of 45pc over the preceeding three years.

It may prove harder this time within the euro straight-jacket. "The global economy was much stronger then and they benefitted from devaluation," said Dario Perkins from Lombard Street Research.

"Europe is repeating the same disastrous policy tried in Greece. They have not learned the lesson and it is hard to see how the outcome can be much better in Spain. The banking debts have been hidden and we don't yet know how much this will cost the government."

Mr Rajoy warned of further bank rescues as lenders struggle with €176bn in "troubled" assets. "A second wave of restructuring is inevitable," he said.

The fiscal cuts for 2012 will amount to 1.6pc of GDP, though details are scant. It follows earlier cuts of 1pc in May. Early retirement has been ended. Even saints days have been culled, shifting the holiday to Mondays to end the "bridge" of long weekends.

The package came as Standard & Poor's downgraded the region of Valencia to BBB- after it covered just 59pc of a bond issue. The agency said Valencia has "no clear access" to the capital markets. There is little risk of default on €1.6bn of maturing debt on Thursday, but S&P said the Junta is being kept afloat by money from Madrid.

Days earlier Fitch Ratings issued a downgrade warning for Spain and a clutch of EMU states and warned that a comprehensive solution to Europe's debt crisis may be "technically and politically beyond reach".

The agency said: "Of particular concern is the absence of a credible financial backstop. This requires more active and explicit commitment from the European Central Bank to mitigate the risk of self-fulfilling liquidity crises for potentially illiquid but solvent euro area member states."

The Bank of Spain said bad loans had reached a 17-year high of 7.4pc in October as the damge continues to filter through from the housing crash. The Madrid property consultants RR de Acuna predicts that prices will have to fall another 20pc before the market clears an overhang of one million homes.

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Spain in race against time to avert bail-out

Yields on three-month Spanish notes jumped to 5.11pc at a sale on Tuesday, higher than rates paid by Greece last week.

Mr Rajoy's team is scrambling to find ways to shorten the paralysing hiatus until mid-December when the new government is finally able to take charge under Spanish law.

"We have to go beyond strictly legal requirements because the markets are not going to wait," said Miguel Arias Canete head of the Partido Popular's top body.

Close advisers to Mr Rajoy said the party will have to flesh out exactly how it plans to pull the country out of its downward spiral, and perhaps reach an accord with the outgoing socialist to start implementing emergency measures. The country may need €30bn (£26bn) in fresh cuts to reach its 4.4pc deficit target next year.

HSBC said the country is in a race against time to avoid becoming the fourth EMU country to need a bail-out. "The question now is whether the new government is able to reassure markets that it can deliver quickly enough to beat back the market bears and avoid turning to the (EU-IMF) troika," said the bank's strategist Madhur Jha.

HSBC called for "more clarity" on bank policy, labour reforms and budget austerity. "Markets are clearly worried about the Spanish banking sector – bank restructuring and the provisioning of real estate loans on banks balance sheets," he said.

The bank said the double whammy of surging borrowing costs and a slide back into recession together risk inflicting serious damage to Spain's debt-dynamics, pushing public debt above 86pc of GDP over the next three years.

"Spain cannot face this crisis by itself. The sovereign crisis is a eurozone problem and needs a eurozone-wide solution. The last few weeks have shown that the window of opportunity is rapidly closing for Spain and other peripheral countries unless some very concrete decisions are taken at the eurozone level to negate all talk of a euro break-up. With governments dragging their feet, the bulk of support over the next few months will have to come from the ECB."

"What Spain needs is a policy mix similar to that seen in the UK, with the government having a strong medium-term austerity plan in place while the central bank provides the backstop, stimulating the economy through its ultra-easy monetary policy," said the bank.

There is no sign yet that Germany is willing to drop its vehement opposition to any such action by the ECB.

Bundesbank chief Jens Weidmann repeated on Tuesday that the ECB has no legal mandate to act as a lender of last resort, and compared money printing to the deadly temptation of drinking sea water.

"Whoever believes that the current crisis can be overcome by giving up crucial principles of stability orientation, pushing current legislation aside, is wrong," he said.

A growing chorus of critics in Paris, Brussels, Rome and Madrid say Germany is cherry-picking EU law to justify its hardline stance, ignoring the ECB's duty to safeguard "economic cohesion" and the survival of monetary union under Article 3 of the Lisbon Treaty.

Comments this week by Austria's central bank governor Ewald Nowotny point to a varied spectrum of opinion within the ECB. When asked if the bank might resort to printing money to shore up bond markets, he replied "in this simple form, of course not."

Citigroup's Jürgen Michels said the careful wording is the latest sign that "the debate is shifting within the ECB's Governing Council towards a more pro-active stance given the systemic nature of the crisis."

The ECB majority can overrule the German-led bloc of hawks – and has already done so in buying around €120bn of Spanish and Italian bonds - but mass purchases or quantitative easing would risk a high-stakes political showdown with the eurozone's hegemonic power.

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Spain - the fifth victim to fall in Europe's arc of depression

Philip Whyte and Simon Tilford argue in a paper for the Centre for European Reform (CER) that this is a “damagingly partial and self-serving” version of events.

“It wrongly assigns all the blame for peripheral indebtedness to government profligacy; it makes no mention of the far from innocent role played by creditor countries in the run-up to the crisis. The result was an explosion of current-account imbalances inside the eurozone. As a share of GDP, these imbalances were far bigger than those between the US and China,” they said.

More than any other country, Spain exposes the lie behind this German narrative. It did not cheat, like Greece. It did not breach the Maastricht Treaty’s 60pc debt ceiling like Italy (or Germany itself). Its public debt was 36pc of GDP before the Great Recession. It ran a budget surplus of almost 2pc of GDP in 2007 and 2008.

We can all agree that Spain has been far too slow to dismantle its Franco-era apparatus of labour privileges, or to end the inflation-linked wage rises eating away at intra-EMU competitiveness. But that is just one aspect of the story.

“The eurozone crisis is as much a tale of excess bank leverage and poor risk management in the core as of excess consumption and wasteful investment in the periphery,” said the CER paper.

Indeed, Spain has been the biggest victim of cheap capital from German, Dutch, and French banks. It was further destabilized by the loose policies of the European Central Bank.

Lest it be forgotten, the ECB allowed the eurozone’s M3 money supply to rise at double-digit rates in the middle of the last decade (against a target of 4.5pc) in order to lift Germany out of slump. It tilted policy to German needs, blighting the South.

ECB monetary policy led to real interest rates of minus 2pc for Spain, fuelling a destructive credit bubble despite the heroic efforts of the Bank of Spain to contain the damage. Yes, Spain would have had a crisis anyway. A fast-growing catch-up economy needs a higher interest rate structure, but all Europe seemed to have forgotten that elemental truth on E-day.

This credit excess is the reason why there is now an overhang of 1.5m homes on the market or still being built, according to data from consultants RR de Acuña. Property prices have already dropped 28pc. The firm predicts further falls of 20pc.

It is why Spain’s international investment balance has swung wildly negative to over €1 trillion, or 90pc of GDP.

Given that the structure of EMU itself caused the North-South imbalances that lie behind the crisis, the EU authorities and the creditor states surely have a duty of care to the countries now trapped in slump. Instead, we heard last week from Brussels that the Spain must “help itself”, and from Germany the usual mantra of reform.

“Some of the governments imposing measures ought to apply the same medicine to themselves,” said the PP’s finance chief Cristóbal Montoso.

The Rajoy team hopes this will be a replay of 1996 when the party took over a prostrate economy from the socialists, and unemployment was almost as high. It tightened then with Prussian discipline, stunning Europe by meeting the entry terms for EMU.

“Spain is going to take the lead in economic stability once again, as we did in the 1990s: the situation is not so different now,” said Mr Montoso.

One admires the grit, but this is nothing like the mid-1990s, when the world was growing briskly, and the devalued peseta was super-competitive against the D-Mark. Today the whole of Europe is tipping back into recession and Spain is 30pc less competitive against Germany.

My own view is that Spain is still fundamentally “saveable” within EMU. Spanish exports rebounded from the 2008-2009 crash almost as fast German exports, outperforming Italy and France.

But this cannot be achieved as long as fiscal and monetary policy are set on slow grinding slump; nor if the burden of adjustment falls entirely on the weaker states as in the 1930s, forcing these countries to slash themselves into a Grecian vortex of self-feeding recession.

German finance minister Wolfgang Schauble – the most dangerous man in the world – is imposing a reactionary policy of synchronized tightening on the whole eurozone through the EU institutions, invoking a doctrine of “expansionary fiscal contractions” that has no record of success without offsetting monetary and exchange stimulus. What is abject is that EU bodies should acquiesce in this primitive dogma.

“Too much virtue has become a collective vice. The collective outcome of all member-states tightening fiscal policy has proved brutally contractionary for the region as a whole,” said the CER paper.

“Household and business confidence is crumbling rapidly across the currency union. On current policy trends, a wave of sovereign defaults and bank failures are unavoidable. Much of the currency union faces depression and deflation.”

It Germany genuinely wishes to save Spain and Italy, it must allow EMU-wide reflation and mobilize the ECB as a lender of last resort to halt the bond crisis, since the EFSF rescue fund does not exist.

To create a currency without such a backstop is criminally irresponsible. If this role is illegal under EU treaty law – and that is arguable – then EU treaties must be changed immediately.

If Germany cannot accept this for understandable reasons of sovereignty or ideology, it should accept the implications and prepare an orderly break-up of monetary union. That is the only honourable course.

In the meantime, one can only watch with grim foreboding as the fifth successive government collapses in Europe’s arc of depression, to be replaced by saviours who can save nothing.

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German 'Nein' leaves Italy and Spain in turmoil

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European Central Bank tightens screw on Ireland, Portugal and Spain

 European Central Bank President Jean Claude Trichet warned Ireland not to depend on long-term support from Europe Photo: Reuters

“The central bank must guard against the danger that the necessary measures in a crisis period evolve into a dependency as conditions normalise,” said Jean-Claude Trichet, the ECB’s president.

Luxembourg’s ECB governor, Yves Mersch, echoed the warnings, saying the bank could not continue “cleaning up” in crises. “If rates are low for too long, this leads to a higher risk appetite. We will pay the price if we fail to confront these inevitable dangers,” he said.

More than 98pc of Spanish mortgages are priced off the floating Euribor rate. Any ECB rate rise would be devastating given that there is already a glut of 1.5m homes coming on to the market, according to consultants RR de Acuna.

The ECB warnings came as a troika of officials from the ECB, the Commission, and the International Monetary Fund began a fact-finding mission in Dublin, examining books to determine whether Ireland is strong enough prop up its banking system.

Finance minister Brian Lenihan admitted that Dublin was considering “substantial contingency capital” to boost banks, but denied that this would burden the Irish state.

Dublin insists that there is no threat to Ireland’s 12.5pc corporation tax rate but Mary Lou McDonald from Sinn Féin said the country was essentially under foreign occupation. “Officials from the EU and IMF and any other vultures circling around this country should be told to get lost.”

Central bank governor Patrick Honohan said a rescue would amount to “tens of billions”. The Irish state is funded until June but this is proving no defence against a run on the banking system.

The euro recovered against the dollar and Europe’s bourses rallied on hopes that the Irish crisis has been contained, but Fitch Ratings said there was still “considerable uncertainty” about the fate of Irish bank debt and bondholder losses.

Credit default swaps on Irish, Greek, Portuguese and Spanish debt continued to hover at high levels yesterday amid confusion over the contagion risk.

Any bail-out depletes the EU’s €440bn (£374bn) rescue fund, reducing the safety buffer for other countries.

Each rescue reduces the number of donor states able to support the EU safety net, and tests political patience in Germany. “There is a danger that once Ireland has been dealt with markets will concentrate even more on countries such as Portugal and Spain,” said Ulrich Leuchtmann of Commerzbank.

Rescue loans for Ireland – as for Greece – add to the debt load without tackling the core problem of solvency. A view is taking hold in the markets that this policy merely delays the inevitable day of EMU debt restructuring.

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Flat-Earth European Central Bank misreads oil spike again, and kicks Spain in the teeth

Dr Weber could hardly have done more to fuel the raging flames of euroscepticism in Germany, where 189 professors have warned of "fatal consequences" if the EU crosses the Rubicon to a `transfer union’ of shared debt liabilities. The three Bundestag blocs in Angela Merkel's coalition have issued a paper virtually ordering her to resist demands for yet more bail-out concessions at this month’s EU summit.

So yes, the ECB has a credibility problem in Germany. Yet to raise rates into an oil shock – as it did July 2008 when the global system was already buckling – is the central banking cousin of Flat Earth belief.

This is not a repeat of 2008, of course, yet something is still deeply wrong. The M3 money supply contracted in January and December. It has been negative since August (from €9.52 trillion to €9.48 trillion), and so has narrow M1. Private credit is growing at just 2pc.

This is the same bank that sat on its hands through the torrid autumn of 2005, keeping real rates negative as M3 growth rose at 8pc (double the ECB’s reference rate of 4.5pc), and as the Irish/Club Med property bubbles spiralled out of control.

Germany needed rates below the Euroland equilibrium at that moment. This is dirty secret that almost everybody in the German policy debate now chooses to forget, or never acknowledged. The ECB discriminated against Club Med. I should have thought Spain could sue the bank for misconduct at the European Court over that breach of its mandate.

Spain is now being whacked again. One-year Euribor rates jumped 14 basis points to 1.92pc within hours after ECB chief Jean-Claude Trichet uttered the code words “strong vigilance”. As the ECB knows, this is the rate used to price most Spanish mortgages.

Homeowners due for rescheduling in March will take the hit immediately. Fresh waves will follow each month, with knock-on effects for banks and Cajas already grappling with record defaults. Fitch Ratings said on Friday that the financial system will need €38bn in fresh capital to right the ship.

The Spanish might justly feel aggrieved, and judging by the comment threads of the Madrid press – "Put Trichet on trial", "Leave the EU immediately", "Create a currency for the South" – a vocal minority of Spaniards are going through their moment of EMU Epiphany.

Spain is doing what is required: slashing its twin deficits; biting the bullet on the Cajas (unlike Germany with the Landesbanken); and boosting exports faster than France or Italy. But Spain's chances of pulling through without a blow-up are contingent on EU authorities not committing another of their serial stupidities.

It was Mrs Merkel's call for creditor haircuts in October that pulled the rug from under the Irish, and set off EMU's Autumn contagion. Now the ECB is tossing its own hand-grenade into the peripheral debt markets, and doing so before there is any grand deal by EU leaders on a viable EU rescue machinery.

A month ago Mr Trichet sought to dampen prospects of a rate rise, insisting that inflation was "contained". Since then there has been a Mid-East revolution, the loss of 1m barrels of day (bpd) of Libyan oil, and a $15 premium on Brent crude to reflect the risk of Saudi revolt? This is dramatic, but not in itself inflationary.

Oil supply shocks depress the rest of the economy. They drain demand, acting as a tax siphoned off to Mid-East rentiers or the Kremlin. Headline inflation rises, but it signals the opposite of what is happening below the water line.

The ECB seems caught in a 1970s time-warp, wedded to the fallacy that the Yom Kippur oil shock caused the Great Inflation. The actual cause was rampant growth of the broad money supply, US spending on the Vietnam War and the Great Society, and a near ubiquitous picture of over-stimulus and over-heating across the West. It was a demand story, not a supply shock. Chalk and cheese.

The West is not over-heating today, except perhaps Germany, and that may not last as China slows. The eurozone grew just 0.3pc in the fourth quarter of 2010. The UK contracted. The US labour participation rate has continued falling over the last year to 64.2pc, the lowest since 1984.

Yes, China, India, and Brazil are overheating, pushing up global crude, metal, and grain prices. China alone is adding 850,000 bpd of oil demand each year, eating deep into global spare capacity. This is indeed a commodity demand story for the BRICs, but it has the characteristics of a supply shock for the West. There is nothing the ECB can usefully do about this, and it is suicidal to try. It is the task of the People's Bank to curb China’s credit bubble.

Trichet invoked the ECB's shibboleth of "second round” inflation effects. This is a sick joke as Spain and Portugal cut public wages by 5pc, Italy imposes a pay-freeze, and Ireland cuts the minimum wage by 11pc.

What he really meant is that settlements in Germany are creeping up. The car workers union IG Metall has secured a pay deal of 3pc to 3.5pc. Higher pay in Germany is exactly what is needed to help narrow the North-South gap in competitiveness without forcing wage deflation on Club Med, and it is exactly what the EMU-lords refuse to countenance. So the whole Euroland system must have a 1930s deflation bias.

It is twelve years since the launch of EMU. There has been no meaningful convergence of the disparate economies since then. The one-size-fits-all monetary policy continues to cause havoc. All that changes with the evolving economic cycle is a rotation in the locus of stress, and a change in its features.

Meanwhile, everything is tilted to meet the German imperative, but not enough to satisfy Germany. Nobody is satisfied.

Membership of monetary union as currently constructed is like walking with a sharp stone in your shoe, forever. You can put up with it, or take the stone out.

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Germany faces its awful choice as Spain wobbles

“All debts of Greece, Cyprus, Italy, Spain, Portugal, and Ireland will be fused immediately with German debt; a single treasury will control spending, and issue euro-bonds for all Euroland,” or some such formula.

This is the sort of game-changer that may now be required to save EMU and the Monnet dream. Germany must contemplate doing for Euroland what it has done for its own Volk in the East over the last 20 years – pay big transfers – or watch its strategic investment in the post-War order of Europe collapse with a bang, and in hideous acrimony. Tough call.

It is clear to those working in the bond markets that the debt crisis in the EMU periphery is nearing danger point, and risks spiralling out of control as quickly as the Lehman-AIG-Fannie-Freddie crisis in 2008.

Prof Willem Buiter, chief economist at Citigroup, said last week that Portugal is likely to need a rescue before the end of the year and that Spain will follow “soon after”.

Klaus Baader from Societe Generale issued a report the same day entitled “Eurozone sovereign debt crisis: next stop Spain”. He suggests that the EU bail-out fund raises money to buy Spanish bonds pre-emptively. Nice idea, but what would the German constitutional court have to say about that?

At Deutsche Bank, Thomas Mayer said Spain might soon need a flexible credit from the IMF. Informed opinion has turned.

Markets are already pricing a 23pc chance of default in Spain (34pc for Portugal, and 39pc for Ireland). If the country needs a rescue, it instantly exhausts the credible financial and political firepower of the EMU system.

The EU’s €440bn (£372bn) rescue fund “looks small, very small, too small”, says Dr Buiter. Alleged plans for a double-up are circulating “en coulisses” in the Berlaymont, but Berlin squashed the idea as “completely over the top”.

In any case, we are beyond the point where escalating bluffs can achieve anything. Markets doubt that it makes sense to heap further debt on states that cannot service existing debt.

The EU strategy of hair-shirt austerity and 1930s debt-deflation for crippled economies has been tested in Ireland, and has led to the same doleful outcome as the 1930s. Tax revenues have collapsed. The deficit has hardly shrunk at all. The policy is based on mechanical theories of the “fiscal multiplier”, and is patently self-defeating. Sinn Fein’s landslide victory in Donegal is a condign response to this academic hocus pocus.

Should the EU really impose a 6.7pc interest charge on Ireland’s bail-out loans, it should not be surprised if the new Irish government in January walks away from the whole stinking arrangement, and pulls the plug on Europe’s banking system. Many might cheer.

However, it is Spain that determines EMU’s fate. Spanish premier Jose Luis Zapatero said there is “absolutely” no chance that his country would need a rescue. “Those investors shorting Spain are making a big mistake.”

As Keynes once said, blaming economic crises on speculators is “not far removed, intellectually, from ascription of cattle disease to the “evil eye”.

Has Mr Zapatero read the IMF’s devastating Article IV report on his own country? It states that the government’s “gross financing needs” for 2011 will be €226bn, or 21pc of GDP. “Spain’s financing requirements are large and, retaining market confidence will be critical. Spain has exhausted its fiscal space. Targets should be made more credible.”

Madrid must attract €226bn of good money from Spanish savers, German pension funds, French banks, Japanese life insurers, and China’s central bank, so that an incompetent government (this one happens to be socialist, but the Greek conservatives were worse) can continue to run budget deficits of 7pc to 8pc of GDP in 2011. Why should they lend a single pfennig, having already been told by EU leaders that they will face scalping if Spain ever needs a rescue?

“The economy is highly indebted and has one of the most negative international investment positions (IIP) among advanced countries,” said the IMF. Its external accounts are under water by 80pc of GDP.

Furthermore, Spanish banks will need to roll over €220bn in 2011 and 2012, according to Enrique Goñi, head of Banca Cívica. “We’re in the antechamber of a new liquidity crisis. We’re living through a financial pre-collapse,” he said.

Now, before yet more Iberian brickbats fly my way, let me say that Spain’s public debt will be a modest 63pc of GDP this year (though total debt is over 270pc, which is what matters). The savings rate is high.

The Banco de Espana has been heroic, but then it needed to be given that Spain no longer has control over its policy levers. The country had to contend with real interest rates of minus 2pc during the long boom, and cannot offset the horrendous bust with monetary stimulus or a properly valued peseta.

Spanish readers like to point out that British failings are comparable or worse. Whether or not that is true, it is irrelevant. Britain is not a prisoner of EMU. You might as well compare chalk and cheese.

We can argue whether the overhang of unsold properties in Spain will reach 1.5m, or six years’ supply, as claimed by Madrid consultants RR de Acuna, but there is little doubt that the "Cajas" and smaller banks have played a game of “extend and pretend” to disguise the true scale of losses on their property loans.

This then is the headache facing Angela Merkel. By the time she inherited the EMU debacle, imbalances were already chronic, and she certainly does not have popular mandate for Churchillian gestures right now.

Even so, it is remarkable that Berlin is not even allowing the European Central Bank to pursue the first and obvious line of defence, which is to calm eurozone bond markets by using its financial stability powers to buy Irish, Portuguese, and Spanish debt on a nuclear scale.

As the storm rages, the ECB is tightening monetary policy by draining liquidity (the Eonia rate is up from 0.4pc to 0.8pc since mid-year) and by signalling that they may soon shut the lending window that keeps Greek, Irish and Iberian banks alive.

Frankfurt is doing this even though the eurozone’s M3 money supply contracted on a month-to-month basis in both September and October, as did private credit. Is this just incompetence, or is somebody pushing PIGS into the slaughterhouse?

As for Britain’s offer in 1940, it is hard to see how such a union could ever have worked over time. It was rejected by the French cabinet, though premier Paul Reynaud pleaded in favour. One Gallic patriot said that utter destruction was better than becoming a “dominion of the British Empire”.

By the same token, today’s eurozone patriots might ask whether it is really worth giving up ancient sovereignty to keep a currency.

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Spain orders drastic caja clean-up to win confidence and fight off EMU debt contagion

 The Spanish media reports that the cajas have yet to come clean on 80bn euros of exposure to property loans Photo: AFP

The weaker banks, or "cajas", must raise Tier 1 core capital to 10pc by September if they depend on wholesale capital markets for more than a fifth of their funding or if less than a fifth of their shares are in private hands. If they fail to do so, the government will seize control through the state bailout fund (FROB).

The demands are even tougher than the broad-brush plans unveiled last month and shows the determination of the authorites to cut out any cancers rather than allowing the sort of drift that bedevilled Japan in the 1990s.

The move comes after yields on Portuguese 10-year bonds punched to a post-EMU high of 7.66pc, renewing fears of a spill-over into Spain. The European Central Bank intervened on Thursday to restore calm but it is clear that Euroland euphoria over Chinese purchases of Portuguese debt has not lasted long.

Jose Manuel Campa, Spain’s economy secretary and the architect of the financial overhaul, acknowledged that the most vulnerable cajas are unlikely to find private investors. "It will be a challenge. They have not taken part in the equity markets for some time," he told The Telegraph.

Only five of the 17 cajas meet the 10pc rule. Caixa Nova is 6.0, Unnim is 6.22, Caixa Galicia 6.43 and Catalyunia Caixa 6.6. Even the giant Caja Madrid with €328bn (£277bn) of assets has core capital of just 7.1, though it is already preparing a stock listing.

Mr Campa is hopeful that cajas will be able to raise "a big chunk" from investors given the strides made in cleaning up their books. He said fresh capital of €20bn will be enough to restore the caja industry to health, disputing claims by City analysts that €40bn to €80bn will be needed. "These high numbers are based on very stretched scenarios, with a fall in house prices by 50pc and land prices by 70pc," he said.

Madrid is basing its estimates on bank stress tests last July that included a severe double-dip recession, with a 3pc fall in GDP over the two years of 2010 and 2011. Since the economy in fact contracted by just 0.1pc last year, it would take a dire relapse at this point to exhaust the safety buffer.

However, there is a risk that Spain may have missed a chance once again to "get ahead" of the crisis. A report this week by the world’s Financial Stability Board (FSB) said the sheer scale of Spain’s property bubble had overwhlemed the country's seemingly tough rules on loss provisions.

While the FSB praised Spain’s latest efforts to strengthen its banking system, there was a sting in the tail. "Such determined actions became necessary partly because of the delay in addressing earlier the structural weaknesses of savings banks," it said.

The Spanish media reports that the cajas have yet to come clean on €80bn of exposure to property loans, and are under fresh scrutiny by central bank inspectors.

Mr Campa blamed the renewed eruption of the bond crisis last Autumn on Franco-German talk of haircuts for holders of EMU sovereign debt, coupled with the failure of the Irish authorities to carry out rigorous stress tests of their banks. "That really hurt us. We had made huge efforts to be transparent, but the Irish crisis devalued the quality of the tests for everybody."

The fate of the cajas is inseparable from the Spanish property market. Mr Campa said construction has fallen from 700,000 homes year during the bubble to around 200,000 until well into the next decade, helping to clear an overhang of properties estimated by consultants RR de Acuna to be as high as 1m.

The uber-bubbles were in the Madrid suburbs and parts of the tourist belt on the coast, but the market is much closer to balance in the rest of the country.

Mr Campa, a free market economist who taught at New York’s Stern School of Business with arch-bear Nouriel Roubini, was brought in to restore Spain’s credibility in world finance after the crisis was in full swing.

He advises astute investors that right now may prove to be the optimal moment to buy a house in Spain. "The Germans are coming back. We need the English, too," he said.

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Spain downgrade sparks storm over rating agencies

The central bank said on Thursday that 12 cajas (savings banks) and other banks must raise €15.2bn between them by September, led by Bankia (€5.8bn), Novacaixagalicia (€2.6bn), and Catalunyacaixa (€1.7bn).

Moody's praised Spain for its market reforms and said "debt sustainability is not under threat." But it also warned of fresh "episodes of funding stress". The government, regional juntas, and banks must together must raise or roll over €300bn of debt this year.

Fitch Ratings also issued a report concluding that the bail-out costs might spiral, putting the figure at €97bn in an Irish-style "stress scenario" where property losses reach 58pc. The Irish parallel has infuriated Madrid since delinquency rates on Spanish homes are low. Loan-to-value ratios on mortgages average just 62pc.

Spanish officials said it was astonishing that Moody's should drop its bombshell hours before the central bank was due to publish its own far more detailed analysis. "Moody's don't explain how they come up with these numbers," said one source.

European anger over the power of "Anglo-Saxon" rating agencies has been welling for months but has now reached fever pitch. Greece's finance minister George Papaconstantinou wrote on Thursday to the EU authorities calling for restraining action after Moody's cut Greek debt three notches three-notch. "Such unjustified and imbalanced decisions could become self-fulfilling prophecies. Rating agencies must be regulated effectively at a European and world level," he said.

Brussels is drawing up tougher rules, perhaps making Moody's, Fitch, and S&P liable for the damage of "incorrect ratings". An EU source said it was scandalous that one agency had rated Greece by sending a single person to the country twice a year for a half a day. "When the IMF goes in, they send a whole team for a week. We want to know how much serious time and effort goes into these ratings."

Spanish officials feel aggrieved that they are being punished after taking the lead in eurozone bank reform, going beyond Basel III rules with earlier compliance and requirements for core Tier I capital of 10pc for some banks with a reliance on wholesale funding. Indeed, the ECB even warned in its monthly bulletin that Spain is perhaps too "ambitious", creating the risk of a credit squeeze .

For all the fury over Moody's, Spain undoubtedly faces an ordeal by fire as the ECB prepares to raise rate rises as soon April. One-year Euribor rates used to set the cost of most Spanish mortgages and corporate loans have surged to 1.95pc since the ECB shift, part of an instant tightening effect rippling through Spain's economy. This is potentially threatening. Private debt is near 240pc of GDP.

Julian Callow from Barclays Capital said Spanish house prices are falling steeply after a lull late last year, with the Fotocasa index falling at 5.2pc rate. "Spain has suffered a series of negative shocks, with energy costs going up and no magic package yet in sight from the EU. The ECB should not be rushing into monetary tightening at this moment, The more property prices fall, the more strain this puts on banks," he said.

EU officials are playing down hopes of an EU deal on Friday. A draft "Pact for the Euro" – an enhanced Stability Pact – has been watered down to meet the furious objections of several states and may not be enough to satisfy German demands for Teutonic rigour.

However, it still includes plans for a "debt-break" along German lines that is constitutionally "binding" on all states, as well as intrusive rules on pensions, collective-bargaining, labour costs, and wage indexation.

It empowers the European Commission to vet rules "before" they have been approved by national parliaments. This treads on sensitive toes. The power to tax, borrow, and spend is the essence of national sovereignty. While the document states that the "prerogatives of national parliaments" should be respected, it is far from clear how these can be reconciled.

EU diplomats say the implicit quid pro quo is that Club Med must accept this straight-jacket to secure German backing for a more muscular bail-out fund (EFSF). Yet it is unclear whether Chancellor Angela Merkel can offer meaningful concessions, given a broad-based revolt by Germany's Bundestag, Lander, and academia.

Mrs Merkel is likely to block plans to let the bail-out fund buy eurozone bonds, since this would usher in fiscal union by the back door. Nor does she seem willing to cut the penal rate of interest on the Irish and Greek rescue by enough to make any difference. Capital flight from the eurozone is likely to gather pace if none of these changes are agreed this month. This risks raising the stakes for Spain, and perhaps Italy.

The yield on Italian 10-year bonds pushed above 5pc on Thursday, a level that could start to endanger debt sustainability given the catatonic state of the economy and the sheer size of Italy's public debt at 120pc of GDP. Italy's industrial output fell 1.5pc in January, and has barely recovered from the Great Recession.

Bundesbank chief Axel Weber said that Germany's rebound should not be exaggerated. The growth speed on the economy is just 1pc over time. "Europe will become more and more insignificant in the global economy," he said.

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Spain and Portugal under fire as bond spreads hit record

Saxo Bank said the EU's ?370bn bail-out fund would lose its AAA credit rating if Spain needed serious help Photo: PA

Yields on 10-year Portuguese bonds jumped to 6.9pc, replicating the pattern seen in Greece and Ireland just before they capitulated and turned to the EU and the International Monetary Fund.

Spreads on 10-year Spanish bonds rose to a post-EMU record of 233 basis points over Bunds, pushing the yield to 4.87pc. Spain's central bank governor, Miguel Angel Fenrandez Ordonez, said the contagion had spread rapidly to the eurozone periphery and "made itself felt" in the Spanish debt markets. He called on Madrid to accelerate fiscal reforms to persuade the markets the country really means to put its house in order.

"Spain is a bit too big to be bailed out," said Antonia Garcia Pascual, of Barclays Capital. "The size of rescue required would use up all the funds available and then you have Italy with contagion as well."

Saxo Bank said the EU's €440bn (£370bn) bail-out fund would lose its AAA credit rating if Spain needed serious help. Germany and France would have to put up fresh money, creating a political storm.

German Chancellor Angela Merkel admitted on Tuesday that the eurozone was "facing an exceptionally serious situation". She brushed aside criticism that German insistence on bondholder "haircuts" from 2013 was fuelling the crisis. "I will not let up on this because the primacy of politics over markets must be enforced," she said.

Dutch finance minister Jan Kees de Jager sent a further chill through markets, saying "holders of subordinated bonds in Irish banks will have to bleed" under the Irish rescue. The comment touched a neuralgic nerve, heightening fears that investors may be treated harshly under the bail-out terms for any other country needing a rescue.

Bank of Ireland shares crashed 23pc and Allied Irish Bank's fell 19pc on fears that shareholders will be wiped out. Ominously, there was a sharp sell-off of Spain's two top banks, with Santander down 4.7pc and BBVA down 3.9pc.

Markets, further unsettled by the tensions in Korea, fell around the world. The FTSE 100 closed down 1.75pc at 5581.28. In Spain the Ibex index fell 3pc, while in France the CAC lost 2.5pc.

"The Irish rescue has done absolutely nothing to calm the markets: it has done the opposite," said Elizabeth Afseth, a bond expert at Evolution. "It is dangerous to talk about creditor losses. Investors will be very wary of lending to Portugal. It looks as if Europe is going to push this to the edge of the cliff."

EU president Herman Van Rompuy denied that Lisbon needs a lifeline, insisting that Portugal's banks are well capitalised and do not face property losses. "Portugal does not need any help – it is in a very different situation to Ireland," he said.

However, Portuguese banks have been shut out of the capital markets. The country's total debt level is one of the world's highest, at 325pc of GDP, and it has a current account deficit of 10pc – which requires a flow of external funding.

The euro fell to a two-month low of $1.3380 against the dollar, in part fed by fears of paralysis in Ireland as the crumbling coalition unveils a four-year austerity drive and tries to push through budget cuts before an election next year. Opposition parties said premier Brian Cowen no longer had the authority to act for the nation, while rebels in his own Fianna Fail party demanded his resignation.

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Spain tempts fate with minimalist bank rescue

Elena Salgado, the Spanish Economy Minister, said the country's savings banks have seven months to boost capital through private investors or the state will partially take them over. 

Finance minister Elena Salgado said capital injections into the cajas would “in no way exceed €20bn [£17bn]”, with a large part coming from the private sector. Spanish banks will have to boost their core Tier 1 capital ratio to 8pc, even stricter than the Basel III rules.

“This is unlikely to be a game-changer, and could potentially unwind the relief rally we have seen in the markets,” said Silvio Peruzzo, RBS’s Europe economist.

“We view €50bn as the minimum recapitalisation for the Spanish banking system that would restore investors’ confidence,” said the bank.

RBS said Spain remains caught in a vice of tightening fiscal policy and a deepening property slump that may culminate in a 40pc fall in house prices, eroding the solvency of the cajas. The Madrid consultants RR de Acuna estimate the overhang of unsold homes at 1.2m.

Mr Peruzzo called on EU leaders to take much bolder action to overcome the crisis, demonstrating that they really mean to “save Spain” by beefing up the rescue machinery. EU ministers played for time at a key meeting last week, giving an impression of complacency.

A report by RBS said the real firepower of the EU’s €440bn bail-out fund must be greatly increased to cope with the risk of a full-blown Iberian crisis. The fund should be allowed to buy Spanish and other eurozone bonds pre-emptively, and recapitalise banks.

EU leaders are starting to recognise that the sort of loan packages provided to Greece and Ireland are no answer to a solvency crisis caused by excess debt, but have not yet agreed to a formula that allows these economies to claw their way back to health.

RBS said there is a risk that new proposals in the pipeline will not be “forceful enough” to mark a turning point in the eurozone drama. It said Spain “will remain exposed to contagion”, unless the EU takes pre-emptive action.

Goldman Sachs takes a rosier view, deeming Spain to be fundamentally “solvent”. It estimates further caja losses at €15bn. Even if Spain slips into a double-dip recession this year under a “pessimistic scenario”, public debt will peak below 90pc of GDP. Exports are recovering, with car shipments at record highs.

Analysts are split over the true state of the cajas. Arturo de Frias at Evolution Securities said parts of Spain’s banking system look “Irish”. The “problem ratio” on €439bn of property debt may reach 60pc. “We calculate a worst case of €142bn future impairments – €59bn for banks, and €83bn for the Cajas,” he said.

Brussels clearly fears that Spain is still at risk. Olli Rehn, the EU’s economics commissioner, called for urgent action to beef up the rescue fund (EFSF) before the next spasm of debt jitters. “We need to agree as quickly as possible. The recent lull in market tensions gives us breathing room, but we can’t sit back: we must act now with full determination,” he told Die Welt.

Mr Rehn said EU leaders must redesign the bail-out fund so that it can lend a full €440bn. “If you buy a Mercedes with 440 horsepower, you want all 440 horsepower,” he said.

The EFSF has a lending limit near €250bn owing to the need for extra collateral to anchor its AAA rating. EU experts are exploring ways to boost the total without needing fresh money from member states, which would entail a Bundestag vote at a bad moment before regional elections.

They have support from German finance minister Wolfgang Schauble, who said the EU cannot keep “stumbling from one crisis to the next”. But the Free Democrats (FDP) and Bavaria’s Social Christians are still dragging their feet within the ruling coalition.

Guido Westerwelle, the FDP leader, has sounded euro sceptic over recent weeks, accusing EU officials of trying to bounce Germany into signing a blank cheque for a “Transferunion”, arguably in breach of both German and EU treaty law. He admonished EU officials for their “ex-cathedra” demands, reminding them that the rescue fund remains the prerogative of the member states that pay for it.

“It bothers me that some in Europe seem to think nothing has happened in this financial crisis, and think they can solve the problem by taking on fresh debt,” he said, invoking the name of Ludwig Erhard, the free-market apostle who created the foundations of the post-war German miracle.

Jean-Claude Juncker, head of the Eurogroup, said the FDP’s new tone is alarming. “I am appalled by how some German liberals are compromising their European political heritage. It is deeply painful for me to see that some in the FDP are now flirting with a populist course regarding Europe,” he told Spiegel.

Mr Juncker said icily that Germany was not the only country in Europe with a AAA-rating and is not the only contributor to the EU bail-outs. “We could criticise the Greeks, Portuguese and others more credibly if Germany and France hadn’t violated the Stability Pact on purpose in 2003,” he said.

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Vibrant exports will save Spain, and perhaps the euro

The saga is by now well-known. Germany screwed down wages after the launch of EMU, while Spain succumbed to an inflationary credit bubble – La Burbuja – caused by real interest rates of minus 2pc (set by Frankfurt) that were far too low for its exuberant fast-growing economy.

The result was a 30pc rise in labour costs compared to Germany, though this oft-cited number is misleading: Spain joined EMU at a greatly undervalued rate – unlike Portugal, which locked in too high.

But the Devil is in the details. A study by Natacha Valla at Goldman Sachs found that Spain had the eurozone’s highest skew towards "price inelastic" exports with a score of 60, compared to 59 for Germany, 55 for France, 53 for Italy, 50 for Greece, and 48 for Portugal. This is a complex stuff – Balassa theory to anoraks – but it broadly means that Spain’s exports are high enough up the technology ladder to let quality trump price.

Economy Secretary Jose Manuel Campa said Spain had lost 15pc in competitiveness against euroland by the peak in 2008 but has since clawed back a third through wage restraint and a blast of labour reform. Much of that loss was in reality "convergence," he said. If so, the claim that Spain has priced itself out of monetary union falls apart.

ITP has clearly not been broken by the crisis. It has cut costs with a partial pay freeze but is now bullish enough to launch an investment blitz aimed at doubling sales by 2015. ITP is building a plant in Mexico to hedge costs in an industry where sales contracts are in dollars. Mr Alzola said a euro near $1.20 rather than $1.36 would make life a lot easier, but the firm is maintaining core engineering in its Basque homeland.

In Madrid, the computer logistics group Indra has just pulled off the impossible. The 30,000-strong company – which supplied the electronic voting system for the London Mayor’s election – has not only astounded Chancellor Angela Merkel by taking charge of Germany’s upper airspace, it has also won the contract to manage 80pc of China’s air traffic from the control centres at Chengdu and Xian.

China’s deputy premier Li Keqiang said last month that he has his eye on Indra’s flight simulator, already used by the US Navy for Harriers and F18s. It lets pilots fly in virtual 3D through eerily convincing terrain, adjusted for speed and time.

Indra’s foreign sales jumped a tenth last year to 40pc of the total while sales in Spain fell 3pc, keeping earnings nearly level through the crisis. It is a textbook case of rebalancing, yet achieved without the crutch of Peseta devaluation as in the early 1990s.

Strategic director Juan Jose González said the company is cutting costs by shifting plant to cheaper areas within Spain, rather than to Asia. "We have our own 'near offshore’ a few hundred kilometres from Madrid where unemployment is higher and wages are lower," he said.

Nearby at the ZED Group – which struck rich with the video game "Commandos" and is now the world leader in digital content for mobile phones – chairman Javier Pérez Dolset told me it was a myth that Spain had let wages soar into the stratosphere. "It still costs less than half to produce here than in the UK or Northern Europe, and the level of skill and artistic talent is greater," he said.

Anthropologically, you could say that Spain has refound its 14th Century creativity when it was the most dynamic society on earth, before Conquista gold corrupted the Iberian soul. Its chefs are sought everywhere, its sportsmen are triumphant. Even its boom-bust ordeal is the symptom of a thrusting nation in a great secular upswing, like Holland in the 1630s, or England in the 1720s. It is the declining plodders you need to worry about.

Spain’s current account deficit was second only to the US in absolute terms in 2007. It has since plummeted from 10pc to 4pc of GDP, in stark contrast to Portugal where the rot is structural. The trump card is Asiatic levels of savings, which makes it easier for the country to carry a public-private debt near 300pc of GDP.

Mr Campa said the investment rate reached 30pc of GDP during the boom. While a chunk was squandered on construction, most was spent on machinery and infrastructure. "This was real investment for the future, and that is the difference with Portugal and Greece," he said.

Spain is not out of the woods yet. It must raise €300bn of sovereign, regional, or bank debt this year in a hostile market. Unemployment is stuck at 20pc. There is an overhang of almost 1m unsold homes on the market.

A Chinese hard-landing and a US-EU relapse would vastly complicate matters, and there is always the risk of a temper tantrum in Berlin or a ruling by the German constitutional court that the EU bail-out machinery is illegal. Yet short of an external shock, Spain should pull through.

Perhaps too much Rioja has gone to my head, but I no longer think it matters whether Portugal follows Greece and Ireland in needing an EU-IMF rescue. The risk of instant contagion across the Rio Guadiano – undoubtedly real a few months ago – has diminished with each passing week, while the EU bail-fund is at last taking a half-way credible form.

This does not mean that EMU’s yawning North-South chasm has been bridged, or that monetary union has yet proved itself workable without fiscal transfers and a debt union, or that such political union could ever be democratically healthy and accountable if achieved.

But those who still thinks that Spain will trigger the break-up of the euro are barking up the wrong tree.

Germany is another matter, of course, and so is France.

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Vibrant exports will save Spain, and perhaps the euro

The saga is by now well-known. Germany screwed down wages after the launch of EMU, while Spain succumbed to an inflationary credit bubble – La Burbuja – caused by real interest rates of minus 2pc (set by Frankfurt) that were far too low for its exuberant fast-growing economy.

The result was a 30pc rise in labour costs compared to Germany, though this oft-cited number is misleading: Spain joined EMU at a greatly undervalued rate – unlike Portugal, which locked in too high.

But the Devil is in the details. A study by Natacha Valla at Goldman Sachs found that Spain had the eurozone’s highest skew towards "price inelastic" exports with a score of 60, compared to 59 for Germany, 55 for France, 53 for Italy, 50 for Greece, and 48 for Portugal. This is a complex stuff – Balassa theory to anoraks – but it broadly means that Spain’s exports are high enough up the technology ladder to let quality trump price.

Economy Secretary Jose Manuel Campa said Spain had lost 15pc in competitiveness against euroland by the peak in 2008 but has since clawed back a third through wage restraint and a blast of labour reform. Much of that loss was in reality "convergence," he said. If so, the claim that Spain has priced itself out of monetary union falls apart.

ITP has clearly not been broken by the crisis. It has cut costs with a partial pay freeze but is now bullish enough to launch an investment blitz aimed at doubling sales by 2015. ITP is building a plant in Mexico to hedge costs in an industry where sales contracts are in dollars. Mr Alzola said a euro near $1.20 rather than $1.36 would make life a lot easier, but the firm is maintaining core engineering in its Basque homeland.

In Madrid, the computer logistics group Indra has just pulled off the impossible. The 30,000-strong company – which supplied the electronic voting system for the London Mayor’s election – has not only astounded Chancellor Angela Merkel by taking charge of Germany’s upper airspace, it has also won the contract to manage 80pc of China’s air traffic from the control centres at Chengdu and Xian.

China’s deputy premier Li Keqiang said last month that he has his eye on Indra’s flight simulator, already used by the US Navy for Harriers and F18s. It lets pilots fly in virtual 3D through eerily convincing terrain, adjusted for speed and time.

Indra’s foreign sales jumped a tenth last year to 40pc of the total while sales in Spain fell 3pc, keeping earnings nearly level through the crisis. It is a textbook case of rebalancing, yet achieved without the crutch of Peseta devaluation as in the early 1990s.

Strategic director Juan Jose González said the company is cutting costs by shifting plant to cheaper areas within Spain, rather than to Asia. "We have our own 'near offshore’ a few hundred kilometres from Madrid where unemployment is higher and wages are lower," he said.

Nearby at the ZED Group – which struck rich with the video game "Commandos" and is now the world leader in digital content for mobile phones – chairman Javier Pérez Dolset told me it was a myth that Spain had let wages soar into the stratosphere. "It still costs less than half to produce here than in the UK or Northern Europe, and the level of skill and artistic talent is greater," he said.

Anthropologically, you could say that Spain has refound its 14th Century creativity when it was the most dynamic society on earth, before Conquista gold corrupted the Iberian soul. Its chefs are sought everywhere, its sportsmen are triumphant. Even its boom-bust ordeal is the symptom of a thrusting nation in a great secular upswing, like Holland in the 1630s, or England in the 1720s. It is the declining plodders you need to worry about.

Spain’s current account deficit was second only to the US in absolute terms in 2007. It has since plummeted from 10pc to 4pc of GDP, in stark contrast to Portugal where the rot is structural. The trump card is Asiatic levels of savings, which makes it easier for the country to carry a public-private debt near 300pc of GDP.

Mr Campa said the investment rate reached 30pc of GDP during the boom. While a chunk was squandered on construction, most was spent on machinery and infrastructure. "This was real investment for the future, and that is the difference with Portugal and Greece," he said.

Spain is not out of the woods yet. It must raise €300bn of sovereign, regional, or bank debt this year in a hostile market. Unemployment is stuck at 20pc. There is an overhang of almost 1m unsold homes on the market.

A Chinese hard-landing and a US-EU relapse would vastly complicate matters, and there is always the risk of a temper tantrum in Berlin or a ruling by the German constitutional court that the EU bail-out machinery is illegal. Yet short of an external shock, Spain should pull through.

Perhaps too much Rioja has gone to my head, but I no longer think it matters whether Portugal follows Greece and Ireland in needing an EU-IMF rescue. The risk of instant contagion across the Rio Guadiano – undoubtedly real a few months ago – has diminished with each passing week, while the EU bail-fund is at last taking a half-way credible form.

This does not mean that EMU’s yawning North-South chasm has been bridged, or that monetary union has yet proved itself workable without fiscal transfers and a debt union, or that such political union could ever be democratically healthy and accountable if achieved.

But those who still thinks that Spain will trigger the break-up of the euro are barking up the wrong tree.

Germany is another matter, of course, and so is France.

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Angela Merkel consigns Ireland, Portugal and Spain to their fate

“We must keep in mind the feelings of our people, who have a justified desire to see that private investors are also on the hook, and not just taxpayers,” said German Chancellor Angela Merkel.

Or in the words of Bundesbank chief Axel Weber: “Next time there is a problem, (bondholders) should be part of the solution rather than part of the problem. So far the only ones who have paid for the solution are the taxpayers.”

These were the terms imposed by Germany at Friday’s EU summit as the Quid Pro Quo for the creation of a permanent rescue fund in 2013. A treaty change will be rammed through under Article 48 of the Lisbon Treaty, a trick that circumvents the need for full ratification. Eurosceptics can feel vindicated in warning that this “escalator” clause would soon be exploited for unchecked treaty-creep.

Mrs Merkel needs a treaty change to prevent the German constitutional court from blocking the bail-out fund as a breach of EU law, and a treaty change is what she will get. “This will strengthen my position with the Karlsruhe court,” she admitted openly.

One might argue that bondholders should have been punished for their errors long ago. The stench of moral hazard has been sickening, on both sides of the Atlantic. An orderly bankruptcy along lines routinely engineered by the International Monetary Fund is exactly what Greece needs. It makes no sense to push Greece further into a debt compound spiral by raising public debt from 115pc of GDP at the outset of the “rescue” to 150pc at the end of the ordeal.

If you strip out the humbug, the Greek package allows banks and funds to shift roughly €150bn of liabilities onto EU governments, or the European Central Bank, or the IMF. Greek citizens are being subjected to the full pain of austerity under false pretences, without being offered the cure of debt relief.

It is in reality a bail-out for investors. There is a touch of cruelty in this. Needless to say, the Greek Left has noticed. A socialist dissident from the “anti-Memorandum” bloc (ie anti EU-IMF) is likely to win the Athens region in coming elections.

Note too that the ruling socialists have fallen to 25pc in the Portuguese polls, while the Communists and hard-left Bloco are together up to 18pc. Ain’t seen nothing, you might say.

Yet opening the door to bondholder haircuts at this delicate juncture – with spreads reaching fresh records in Ireland last week, and Portugal struggling to pass a budget – is to toss a hand-grenade into the eurozone periphery.

We now know that that ECB’s Jean-Claude Trichet warned EU leaders on Thursday night that it was dangerous to stir up this hornets’ nest, and moreover that the politicians did not understand what they were unleashing. He was slammed down acrimoniously by French President Nicolas Sarkozy, who later denied that he lost his temper.

“Mr Trichet expressed a number of reserves. There was a debate, there is always a debate, but the European Council took its decision,” he said.

“It is wrong to say I was irritated. You can reproach heads of state for all kinds of things in a democracy, but I don’t think you can reproach them for not being aware of the seriousness of the situation,” he snorted.

Mr Sarkozy was not going to let his Brussels `triomphe’ slip away after stitching up EU affairs once again in a pre-emptive deal with Germany and imposing his will. The notion that the Franco-German axis still runs Europe is potent politics in France, even if the decisions actually reached are often of little value or – as in this case – ill-advised. Such is the chemistry of EU summits, where mad things happen.

Spain’s premier Jose-Luis Zapatero knew he had been mugged. “We need to listen carefully to what the head of the ECB says about the rescue mechanism. Great care is called for because this message is risky,” he said.

Eurozone sovereign states must issue €915bn in new bonds next year, according the UBS, either to roll over debt or to cover very big deficits – though it is hard to outdo Ireland’s deficit of 32pc of GDP in 2009. Yet investors have just been told in blunt terms to charge a hefty risk premium on any peripheral debt that expires after 2013, with great confusion over what happens even before that date. Can any investor be sure what the terms will be if Ireland or Portugal needs to access the EU’s bail-out fund next week, or next month, or next year? Are haircuts already de rigueur?

A study by Giada Giani at Citigroup entitled Bondholders Moving Back Home said data from the second quarter reveals a sharp drop in foreign ownership of debt from Greece (-14pc), Portugal (-12pc), Spain (-8pc), and Ireland (-5pc).

Local banks have stepped into the breach, borrowing cheaply from the ECB to buy their own state debt at higher yields in a `carry trade’ that concentrates risk. These four countries account for the lion’s share of the €448bn in ECB funding for banks (Spain €98bn, Greece €94bn). Frankfurt is propping up this unstable edifice. Mr Trichet may well fret.

A strong case can be made that Spain has decoupled from other PIGS in pain, though the deficit will still be 6pc next year, and the economy is at serious risk of a double-dip recession as wage cuts and higher taxes bite in earnest. But none are safe yet.

An ominous pattern has emerged across much of the eurozone periphery: tax revenue keeps falling short of what was hoped. Austerity measures are eating deeper into the economy than expected, forcing further fiscal cuts. It goes too far to call this a self-feeding spiral, but such policies test political patience to snapping point.

There is little that these nations can do in the short-run as EMU members. They cannot offset fiscal tightening with full monetary stimulus or a weaker exchange rate – as Britain can. All they do can is soldier on, sell family silver to the Chinese and Gulf Arabs, beg the ECB to join the currency war to bring down the euro, and pray that the fragile global recovery does not sputter out.

Chancellor Merkel is ultimately correct. A mechanism for sovereign defaults is entirely healthy. Had it been in place long ago, EMU would have been stronger. The proper timing for this was at the Maastricht Treaty, or Amsterdam, or at the latest Nice, but in those days the EU elites were still arrogantly dismissive about the implications of a currency union. To wait until now borders on careless.

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