Traders brace for eurozone crisis fallout

The German chancellor warned that Standard & Poor's decision to downgrade nine eurozone countries on Friday evening demonstrated that politicians needed to step up their efforts to resolve the crisis, warning that it was a "longer process" that would take more than a few months.

"The decision confirms my conviction that we have a long way ahead of us before investor confidence returns," she said in a radio address. Germany was not among the countries downgraded.

The downgrades, after markets closed on Friday, marked a further escalation of the debt crisis, which has seen investors lose faith in euro governments' ability to service their debts.

Stalled talks over "haircuts", or writedowns, of Greek government debt will further worry investors, as they pose the threat of Athens making a disorderly default.

Nicolas Sarkozy, the French President, yesterday called for cool heads after his country was scalped of its prized triple-A rating, pushing up its borrowing costs.

"The crisis can be overcome provided that we have the collective will and the courage to reform our country," he said. "We must resist, we must fight, we must show courage, we must remain calm."

The rating agency had explained its move by warning that recent European policies "may be insufficient to fully address systemic stresses in the eurozone". While downgrades were widely rumoured, its decision to cut the ratings of some but not all eurozone nations has complicated the political situation.

In the UK, William Hague, the Foreign Secretary, warned that the clutch of downgrades "is serious. It underlines the fact that the eurozone is not through its problems."

Spanish Prime Minister Mariano Rajoy, responding to his country's own downgrade, pledged spending cuts and a reform of Spain's banking system.

While European leaders appeared to be signing from the same hymn sheet of reform yesterday, eurozone officials suggested there remained considerable doubts over how the region's bail-out fund would be funded, and by who.

"There is a debate. The question is still open and there is no consensus so far," one official reportedly told news agency AFP. Germany is thought to be still unwilling to increase its contribution to the European Financial Stability Facility (EFSF). The S&P downgrades could hit the EFSF's triple-A rating, economists have warned, sending borrowing costs higher.

In an example of the affect the crisis is having outside the region, Japan's prime minister warned that his country, hobbled with the world's largest debt load, could fall into the same problems. Yoshihiko Noda said Europe's situation "isn't a house burning on the other side of the river," telling voters: "We must have a great sense of crisis."

Attempts to stabilise the euro situation were further undermined on Friday after talks between the Greek government, international lenders and private sector holders of Greek debt collapsed.

Officials from the "troika" of Greece's international lenders – the International Monetary Fund, European Commission and European Central Bank – are due in Athens tomorrow to assess the country's efforts in cutting its borrowing and enacting reforms.

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The two halves of the eurozone are locked in a broken marriage

Europe’s inspectors will henceforth establish an occupation office in Athens to ensure the "full implementation" of austerity policies, for as long as it takes. Greece has been stripped even of the pretence of sovereignty.

This country that freed itself from Ottoman control in the 1820s (with French help), is reduced to a Sanjak of the new imperial order.

The Greeks will find out soon whether these officials answering to one Horst Reichenbach - unfortunately named for this delicate assignment (couldn't they find a Spaniard, or a Slovene?) - intend to foreclose on sovereign assets and transfer the proceeds to North European creditors. I do not think it would be wise for them to try.

Yes, Greece has gained debt relief: roughly €100bn, if you think life insurers, pension funds, and others will "volunteer" to join banks in accepting their 50pc haircut.

This will leave Greece with a public debt of 120pc of GDP in 2020 after nine years of depression, if all goes perfectly, the same level that set off the crisis.

Fresh EU-IMF loans will once again finance Greece’s trade deficit and ratchet up its foreign debt. Europe is papering over the elemental fact that Greece has an over-valued currency, cannot compete within EMU, and should leave. But that is to disturb the sanctity of the Project.

In Spain, unemployment is within a whisker of five million, reaching a crisis-high of 21.5pc in September. There are 1.4m households where no member of the family has a job. Some 560,000 people have no support at all.

The latest job losses have been in health care and education, a foretaste of what will happen once the EU-imposed guillotine drops in earnest after this month's elections.

It is an unhappy starting point for an economy tipping back into a double-dip recession. The business federation (CEOE) said a credit crunch is already "strangling Spain's industry".

"We can't go on like this. It is impossible to get out this crisis with austerity alone," said Socialist leader Alfredo Rubalcaba, calling on Europe's Left to force a change in EU policy. Buena suerte, Señor, or rather Viel Glück.

Meanwhile, Germany's jobless rate has fallen dramatically over the last five years to just 6pc, and there lies the rub. The promised EMU convergence never happened. What exists instead is a 30pc or 40pc intra-EMU currency misalignment between North and South. This is Europe's cancer.

The two halves are locked together in a broken marriage. To pretend otherwise is no longer responsible. The structural gap cannot be closed by debt-deflation in the South – the current default setting of EU policy. It could arguably be closed if Germany were to let the European Central Bank reflate the whole eurozone system.

Instead, the ECB has done the opposite, opting to blight the chances that Spain might just be able to claw its way back to viability within the constraints of EMU.

Spain is tightening fiscal policy with heroic stoicism. The ECB did not have to have make matters worse by tightening monetary policy as well. It choose to do so, knowing that 98pc of Spanish mortgages are linked to floating Euribor rates.

It did so when money supply growth was minimal across the eurozone, and core inflation was tame, and knowing that Europe's banks are about to shrink their balance sheets drastically to meet capital rules. "In trying to keep its monetary virginity in tact, the bank threatens to destroy the eurozone," said Paul de Grauwe from Leuven University.

So, the ancient nation of Spain – whether you date it from Sancho III (Rex Hispaniarum) in 1035 or Los Reyes Catolicos in 1496 – was ordered by the EU summit to "strictly implement" fiscal retrenchment.

Spain will be subject to "rigorous surveillance" and "discipline", like all the other EMU victims of mispriced German, Dutch, Belgian, and French capital flows, and the ECB's (earlier) negative real interest rates.

Who will subject the excess savers and capital flooders to "surveillance" and hold them to account for destabilizing Southern Europe? Who will "discipline" Germany? Who will tell Berlin to cut VAT and reduce covert export subsidies in order to mitigate North-South imbalances? Yes, this is cheeky. I make the point only because the inexorable logic of EMU has reduced us to such discussions. If Germany and her satellites had their own Thaler, their currency would rise to reflect underlying economic strength. The underlying crisis would solve itself.

As for the ancient nation of Portugal – dating to Vimara Peres in 868 – it is already under EU-IMF administration, or a "state of occupation" in the words of labour leader Carvalho da Silva. The unions have called a general strike for November 24.

This honourable nation, which pays its debts, has been put in a position by the warped effects of EMU where its external capital accounts have swung from surplus to a deficit of 104pc of GDP. The current account deficit is still 8pc of GDP.

What Portugal needs is a 40pc devaluation against Germany. Instead, premier Pedro Passos Coelho is trying to regain competitiveness through an "internal devalution", with swingeing cuts to pay, pensions, welfare, and health. These reforms are necessary, but you cannot deflate an economy back to viability where (EMU-induced) total debt is around 350pc of GDP. It is mathematical suicide.

In Italy, the coalition of premier Silvio Berlusconi was given an ultimatum to submit concrete plans within 48 hours on how to reorganize Italy’s complex society, touching on the neuralgic issues of labour rights (Article 18 of the labour code) and how to treat the elderly.

Nobody tells us what to do,retorted a furious Mr Berlusconi, who then gave his first hint of revenge by calling the euro a strange hybrid creation that hasnt convinced anybody.

The country has been told to reach a balanced budget by 2013, even though it already has a primary surplus, and one of the lower debt levels (public and private) in the OECD club. This policy risks pushing Italy into a slump that could set off the destructive debt dynamic so feared, as has just occured in Greece.

It misdiagnoses the problem in any case. Italy is in crisis because it cannot compete, not because of debt. (The stess has revealed itself in the debt markets, but that is a different matter). Italy is simply in the wrong currency. It will languish in perma-slump until wage rates once again reflect global market reality.

The EU refuses to confront the core issue, instead seeking to buy time for Europe's South by conjuring a €1.2 trillion bail-out fund (EFSF) that seeks uber-leverage through "first loss" insurance of bonds.

This concentrates risk for creditors. It further endangers France's AAA rating, the foundation of the fund. It almost guarantees faster contagion to euroland’s core.

Europe has resorted to this twisted device because Germany has vetoed all moves to fiscal union, Eurobonds, debt-pooling, or ECB activism. It is a Hail Mary pass, a last gamble when all else fails.

Chancellor Angela Merkel warned last week that euro failure threatens a thousand plagues. "No one should think that another half-century of peace and prosperity is assured"

She has the matter backwards. The euro itself is has become an engine of destruction and bitter cross-border rancour.

Europe will not be whole and happy again until the currency is broken into workable parts, and this misguided experiment is shut down for ever.

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IMF warns markets "not persuaded" eurozone leaders can resolve the debt crisis and prevent damage to the global economy

The IMF said that despite not "support of the euro Member States and the ECB, market participants remain convinced that a lasting solution is at hand".

"It would be very expensive for the euro area but also for the economy to delay to tackle the crisis of the sovereign,"said Luc Everaert, head of the political area of the IMF European common Euro."

The IMF said that despite not "support of the euro Member States and the ECB, market participants remain convinced that a lasting solution is at hand".

He said in a staff report that the results of any political decision would be "unpredictable" and that the euro-zone needed money more private in support of the "most vulnerable" of his "still-frail banks."

The Fund has recommended that the European financial stability facility (EFSF) have increased in size and allowed to buy debt on the secondary market, as a means to mitigate the threat of contagion of the peripheral States of the euro area.

He also said the indispensable to the adoption of the much stronger economic governance of the euro area. "We need more not less Europe," said Mr. Everaert.

Markets she said Tuesday, and the fears of mounting that politicians cannot resolve the sliding equities sent eurozone debt crisis Monday. The FTSE 100 gained 0. 65pc, the Germany DAX 1. 1pc, France CAC 1. 2pc, the Spain Ibex 1pc and Italy MIB 1. 9pc.

However, traders said the rebound was lowest in the belief that the liquidation were exaggerated and the fear is that jitters on a dangerous rift in Europe, top of the criticism of the euro Thursday the advance on the Greece can trigger falls further.

The Summit should attempt to complete a second round of aid for the Greece, a value of €110bn, but nations are divided on how to structure it and comments of Angela Merkel, German Chancellor Tuesday that the Summit will not be the last step in the resolution of the debt of the Greece crisis did not help sentiment.

The the euro fell against the dollar, after she said in a joint press conference with the President of Russian Dmitry Medvedev: "additional steps will be necessary and not simply a spectacular event that fixes everything." Which takes political responsibility seriously knows that such a dramatic step will not happen. »

To solve the problems of the Greece once and for all, the euro area need to consider options to reduce its debt and increase its competitiveness, said.

"Europe is unthinkable without the euro, and therefore it is worth of effort responsible for really solve the problems in the same root", she said.

Russian President says financial woes of the euro area is not a fault of the euro, but a result he used by countries to the uneven economy.

"The main euro today is a problem that a strong and respectable currency serves the countries with very different levels of the economy, said Medvedev." "It never happened in the history of humanity."

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Eurozone members left to push only markets

IMF Chief Dominique Strauss-Kahn and the ECB President Jean-Claude Trichet speaking before the meeting of the Council of the Eurogroup Photo: AFP/Getty Images

Ministers says each country shall take necessary measures with the Ireland describing a 6bn austerity package € (emissions from £) for 2011 and Portugal should follow the same path despite the recent general strike on the planned reforms.

Instead of this, the EU Finance Ministers confirmed that a second, more stringent round on the sides stress tests would be carried out in February and the details of a troubled EU permanent crisis resolution mechanism could be described next week.

Weaker nations had been pushing for the plan to rescue €440bn euro area increase to calm quaking on bond markets. Face resistance Germany, the greatest nation in the block of the single currency, the plans were dropped. President of the European Herman Van Rompuy said: "so far it is necessary to increase the means available for installation." If necessary, we will consider, but there is no doubt today. »

In the meantime, the European Central Bank continues to support the Greece, the Ireland and Portugal buying their sovereign debt of the banks to provide liquidity. Last week, he bought almost €transmitters - its concerted within five months.

Said Merchants Bank is resistant to buy a Spanish sovereign debt to draw a line between peripheral troubled nations and their many Qallunaat Mediterranean neighbour, a lot of fear people can be infected by default fears sweeping across Europe. Legal & general Investment Management writer drew fresh pressure on the country Tuesday, although by warning it not buy Spanish debt that the ECB has taken the lead. Spain has a huge exercise refinancing next year.

European Ministers hope to actions of the ECB, clarity on the mechanism for resolution, the new transparency on the shores and austerity programmes each country will be sufficient to restore confidence in the euro area. However, Chief Dominique Strauss - Kahn of the Monetary Fund international warned that fixes "to the blow by blow" would not work and a "global" solution is necessary.

Attention now is switching to Portugal, which is considered the next weakest link of the chain after €110bn bailout the Greece and rescue of € the Ireland 85bn. Speaking after a two-day EU Finance Ministers meeting, Mr Olli Rehn, European Commissioner for Economic Affairs, said: "at the present time the Government is preparing its next steps and in our opinion, it is important that the Portuguese Government will soon be justify measures of consolidation for the next year."

He has developed plans to reduce its budget deficit to 4 6pc of GDP in 2011 in 7 3pc this year through €emission increases in taxes and spending cuts.

The euro has recovered a little and 10 years for device States sovereign bond yields the region have climbed down from their record level, but remain high breaking. Yields edged Tuesday, more but spread against the German bund narrowed - suggesting markets begin to believe the nations of the euro will be agglutinate.

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Eurozone debt crisis spreads to Belgium on rising political risk

The country has been limping along with caretaker ministers since Flemish separatists emerged as the biggest party in June. Talks have broken down over the scale of subsidies to the poorer French-speaking areas, making Belgium a microcosm of EMU's North-South divide.

It is unclear whether the political system can muster the discipline of the early 1990s when Belgium came back from the brink of a debt compound spiral with an impressive fiscal squeeze.

"We believe Belgium's prolonged domestic political uncertainty poses risks," said S&P. "Belgium's current caretaker government may be ill-equipped to respond to shocks to public finances. If Belgium fails to form a government soon, a downgrade could occur, potentially within six months."

Spain also faced fresh debt woes at an auction on Tuesday. The yield on €2bn (£1.7bn) of one-year bills jumped to 3.4pc, up 100 basis points in a month. "It was pretty dire," said David Owen from Jefferies Fixed Income.

Mr Owen said the surge in yields on US Treasuries is causing the cost of capital to jump across the global system, including Spain. "This is raising the bar for everybody," he said.

While Spain can still borrow at a manageable cost, it is storing up rollover risk by issuing debt at short maturities. The IMF said Spain must refinance €220bn this year. Moody's this week raised its estimate of Spanish bank losses to €176bn, up from €108bn a year ago.

Jean-Claude Trichet, head of the European Central Bank (ECB), said a "quasi-fiscal union" may now be required to stabilise the eurozone's debt markets, adding the EU's €440bn rescue fund should be deployed with "maximum flexibility", and beefed up in "quantity and quality".

Mr Trichet hopes to prod political leaders into authorising use of the fund for pre-emptive purchases of bonds, perhaps from Spain, relieving the ECB of its lonely burden. The ECB has been stuck with the task of propping up the banks and debt markets of peripheral Europe, conducting a fiscal rescue without a legal mandate and on slender resources.

Officials are mulling plans to raise the ECB's capital to cope growing liabilities, which means asking member states to provide fresh money. Its capital base is just €5.8bn, compared with the US Federal Reserve's $57bn (£36bn).

Toby Nangle, from Baring Asset Management, said the ECB may already be insolvent under strict accounting rules. "Could the international financial system cope with a bankrupt ECB? The fact that it is not easy to dismiss this out of hand is cause for great concern," he said.

The agenda for this week's EU summit shows that the EU plans to slipping through the creation of its new permanent rescue fund from 2013 without the need for a fresh treaty, using the "simplified revision procedure" of Article 48.

"We always feared the EU would stretch this clause to ratchet up their powers," said Mats Persson from Open Europe. "Article 48 can be used only if it does not expand the powers of the EU, but the crisis mechanism clearly does because it allows the Commission to make key decisions about the future of countries in trouble."

The IMF said Belgium does not have the luxury of cutting its budget deficit slowly, tightening to 4pc of GDP this year instead of 4.7pc to send a "strong signal" to markets.

Belgium has an oversized banking system with assets equal to 340pc of GDP and big state guarantees. Belgian banks, led by Dexia and KBC, have $54bn of exposure to Ireland alone, according to the Bank for International Settlements.

Belgium has a current account surplus and large private savings. However, the IMF said suffered a big erosion of labour competitiveness against Germany since 2000, and now faces a major aging shock.

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Trichet bond purchase hint calms eurozone markets

Fingers: a warning by Mr Jean-Claude Trichet, the President of the ECB, not underestimate Europe? s determination to solve the growing softer temporarily euro area financial markets crisis.

A warning to the markets of Jean-Claude Trichet, President of the ECB, not underestimate Europe's determination to solve the growing crisis of the zone euro was taken as a signal that the Central Bank will step.

Fears that Portugal can follow the Ireland and the Greece receive a solid international financial bailout has sent the euro sinking for a period of two months low less $1.30 Tuesday.

Single currency recovered somewhat Wednesday, standing at $1.3098 just before noon on the London market, compared to $1.2983 at the end on Tuesday in New York.

"The euro has stabilised during the night after the comments of the President of the ECB Trichet, noting that the ECB could consider expanding its sovereign debt purchasing program" said Lee Hardman, analyst at the Bank of Tokyo-Mitsubishi UFJ in London.

Government bond rates day after 10 years borrowing Spanish and Italian government costs to record wide gap above benchmark eurozone rate Germany must pay pink eased.

Price Portuguese obligations to 10 years to join the CBI news active buyer was continued. Rate loan of 10 years for the Spain eased 5 285pc have reached 5 5pc Tuesday, such as those on the Italian, Belgian, Hungarian, Italian and Irish bonds. Only Greek 10-year bond yields has continued to increase.

Despite improved sense European debt crisis has always dominated with Portugal on credit watch by standard & Poor, ratings agency who saw "risks to the solvency of the Government.

Traders have been cautious. Harry Sebag, head of sales trading at Saxo Bank, said: "we're having a rebound of the technique." A number of indicators shows as "oversold" indexes and some investors started in search of bargains. But we will keep a close eye on performance bond spreads to see if this stock rebound has legs.

Commerzbank analyst, Ulrich Leuchtmann said: "markets are still concerned about the debt crisis is spreading to other countries.

FTSE 100 in London was increased by 1. 6pc Frankfurt advances 1. 8pc and 1pc in Paris and trade in the morning. Madrid shot up to 3 3pc and share price also acquired Italy and the Portugal.

"For the misfortunes of the moment, the equity markets continue to be reasonably strong," said Simon Denham, head of exchange differences in capital of the group.

Analysts noted that ECB plans aboard to normal monetary policy of the Board of Directors meets Thursday could have blown off course by the Irish debt crisis.

When the Greek crisis ready markets markets freeze in April, the ECB started to provide unlimited banks loans short term low levels.

As lending markets in most eurozone countries return to normal, the ECB started to look for an "exit strategy" at the end, its exceptional measures, but the Irish crisis awakened concerns.

"The ECB will need to continue to provide outstanding support, despite earlier indications" ABN-Amro analysts said in a research note.

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The eurozone is in bad need of an undertaker

Even if Chancellor Merkel wished to take this course – and even if the Bundestag approved it – the scheme would still be torn to pieces by the German constitutional court unless legitimised by radical EU treaty changes, which would in turn take years, require referenda, and face populist revolt in half Europe.

What the German people are being asked to do is to surrender fiscal sovereignty and pay open-ended transfers to Southern Europe, taking on a burden up to six times reunification with East Germany.

“If we pool the debts of the countries in the south-west periphery of Europe, we are blighting our children’s future: the debt levels are astronomic,” said Hans-Werner Sinn, head of Germany IFO institute.

Any attempt to prop up the status quo will cement the current account imbalances of EMU’s North and South, to the detriment of both sides.

“I doubt that the current leaders of Europe fully understand the economic implications of their decisions. They are repeating the mistakes that Germany made over reunification,” he told the Handelsblatt.

Transfers to the East are still running at €60bn a year two decades after the fall of the Berlin Wall. There has been no meaningful East-West convergence for the last 15 years.

To those who blithely argue that EMU is a good racket for German exporters because it locks in Germany’s competitive advantage, he retorts that a trade surplus is the flip side of a capital deficit. Germany has seen €1 trillion – or two thirds of its entire savings since 2002 – leak out to fund the EMU party, gutting investment at home. This is toxic for Germany too.

It is no surprise to eurosceptics that Europe should have reached this fateful point where leaders must choose between the twin traumas of EMU break-up or giving up their countries. Nor is it a surprise to an inner-core of schemers within the EU system, who have always calculated that they could exploit such a crisis to catalyse political union.

However, it is a big surprise to Europe’s leaders, and they do not know what to do about it.

Chancellor Merkel and President Sarkozy seem unwilling even to boost the firepower of the European Financial Stability Facility, though in this they may be right.

The drama has moved beyond the point where headline "shock and awe" pledges can achieve anything. Markets are already looking beyond the debt-stricken periphery to the creditor core, fearing that bail-out costs will themselves create a chain of contamination. Credit default swaps on France have risen above 100 basis points, where they linger stubbornly.

A Fitch report on the European Stability Mechanism (ESM) said the new rescue fund “could result in lower ratings” on the risky sovereigns because the EU would have instant debt seniority, leaving private bondholders exposed to the risk of bigger haircuts. To make matters worse, debt restructuring would depend on the whim of politicians. The incoherence of the rescue machinery itself is feeding the debt crisis.

So as EU leaders flounder, the task of saving monetary union falls to the ECB. Yet it too has declined the burden, refusing to go nuclear with bond purchases. “Each country needs to be held responsible for its own debt," said Germany’s monetary avenger at the ECB, Jurgen Stark.

He was joined last week by Mario Draghi, Italy’s governor and candidate for ECB chief, who said it was not the job of a central bank to carry out fiscal rescues. “We could easily cross the line and lose everything we have, lose independence, and basically violate the Treaty," he said.

Indeed. Maastricht forbids the ECB from buying the debt of eurozone states except for specific purposes of liquidity management. But this saga no longer has anything to do with liquidity. Southern Europe faces a solvency crisis.

The ECB has postponed its threat to pull away the lending props beneath the banking systems of the PIGS. Beyond that it has limited itself to tactical strikes in the small illiquid debt markets of Ireland and Portugal, buying enough bonds to ram down yields and burn a few hedge funds.

The effect has faded within days. It had little impact on Spanish and Italian bonds in any case. Spanish 10-year yields reached 5.45pc last week, far above 5pc level where compound arithmetic comes into play.

At the end of the day, debtor governments still have to persuade Japanese life insurers, Mideast wealth funds, or French and German banks, to put up real money to buy their bonds at a bearable interest rate.

Credit Agricole said last week that it would hold back at next week’s auction of Spanish debt because it is not yet clear whether the ECB will back-stop the country. “The risk is simply too large for our appetite,” it said.

So we drift on with rising yields into 2011, when Portugal must raise €38bn, Belgium €85bn, Spain €210bn, and Italy €374bn – according to Goldman Sachs.

Europe’s leaders still seem to hope that brisk global growth will lift everybody off the reefs. That too is wishful thinking. Recovery brings its own set of problems, and will make intra-EMU tensions even worse.

Germany will hit the inflation buffers and force the ECB to raise interest rates before the trickle down benefits of trade have begun to make any difference in the closed economies of the South. Floating Euribor rates that determine 98pc of mortgages in Spain have been shooting up already, even as wages fall. The vice is still tightening on Spain.

The reflex of the EU elites is to blame this structural mess on lack of statesmanship.

“There is something surreal about the unfolding financial crisis,” said Stefano Micossi from the College of Europe, the sanctum sanctorum of the European Project.

“Leaders grudgingly do what is needed to prevent disaster at the last minute before it is too late, and the next minute they go back to the behaviour that brought them against the wall in the first place. The eurozone is in bad need of a psychiatrist,” he wrote at VoxEU

“If the eurozone follows this path, either all of the sovereign debts become German public debt, or the euro will collapse,” he said.This is admirably candid in one sense, but is today’s crisis really just a failure of leadership? Was EMU not dysfunctional from the first day? Did it not inflict negative real interest rates on Club Med and Ireland in the boom years, driving them into distastrously pro-cyclical policies?

Did it not lock in chronic imbalances between North and South? Has it not left victim states trapped in debt deflation or slumps which have gone too far to respond an austerity cure, and from which there seems to be no escape on terms acceptable to Germany?

Should we blame the current hapless leaders, or the guilty men of Maastricht who created this doomsday machine? If the project itself is rotten, surely what the eurozone needs most is an undertaker.

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Political upheaval rocks eurozone debt markets

Finance minister Fernando Texeira dos Santos said failure to agree on budget cuts will 'plunge the country into a very deep financial crisis' Photo: AP

Hopes of a budget deal in Portugal collapsed after marathon talks between the minority government of socialist premier Jose Socrates and conservative leaders ended in acrimony.

Finance minister Fernando Texeira dos Santos said failure to agree on budget cuts will "plunge the country into a very deep financial crisis".

Meanwhile, Ireland has announced fiscal retrenchement of €15bn over the next four years, twice the original plan. It is already cutting public wages by 13pc.

John Fitzgerald from Ireland’s Economic and Social Research Institute said there is a risk that austerity tips the economy into a downward spiral, comparing it to an overdose of "chemotherapy" that does more harm than good.

Finance minister Brian Lenihan said the country had no choice. "The cost of borrowing is high and rising, and if we do not act soon to live within our means, people may stop lending to us. We will not fool the markets for an instant if we seek to defer any longer what evidently needs to be done now. The Irish people will have to accept cuts in public expenditures and higher taxes," he said.

In Greece, yields on 10-year bonds surged 67 points to 10.26pc, the biggest jump since the turmoil in June. The sell-off came after permier George Papandreou warned that the country was still in danger, and threatened to call early elections.

Finance minister George Papaconstaninou refused to rule out a request for an extension of the repayment period for the EU rescue package and confirmed that tax revenues are falling short. "We are deluding ourselves as a country in thinking we have a tax system. We don’t," he said.

He confirmed leaks that the budget deficit for 2009 would be "above 15pc" of GDP, higher than the last estimate of 13.8pc and five time the original claim of 3pc by the previous government.

Gavan Nolan from Markit said fears of "political instability in sovereign credits" had moved onto the radar screen, with investors now paying closer attention to whether or not governments can actually deliver on austerity plans.

It unclear whether Portugal can salvage anything over coming days in what amounts to a game of brinkmanship, with the socialists demanding VAT tax rises and the conservatives demanding spending cuts.

The opposition denied that there was "any possibility" of continuing talks, but hinted that it would abstain on the budget vote. Mr Socrates in turn has said he will resign if there is no accord.

Julian Callow from Barclays Capital said politics is intruding in the eurozone fiscal crisis. "It is one thing to promise cuts but it is very different to agree on details and decide where the axe will fall. There are some encouraging signs but Portugal has an awesome undertaking ahead in squeezing fiscal policy by 4pc of GDP over the next year, and the the task may be too great."

Yields on 10-bonds jumped 25 basis points on Wednesday to 5.77pc, far above the likely rate available from the EU’s bail-out fund and the International Monatery Fund. A string of top economists in Portugual have said the country should call in the IMF to gain breathing time.

As members of the eurozone, Portugal, Ireland, Greece cannot devalue or resort to monetary stimulus offset fiscal tightening. They must each pursue a policy of "internal devaluation", meaning deflation within the currency bloc to regain lost competitiveness.

This is risky for economies with total debt levels above 300pc of GDP, as is the case in Ireland and Portugal. Ireland’s nominal GDP has already contracted by over 20pc of GDP, yet the debt burden has not diminished.

The test will be whether these countries can generate enough exports to trade their way out of crisis over coming years, or remain trapped in slump with rising political tensions.

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