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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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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