Trichet’s Vision Unravels as Investors Shun Italy, Spain Debt

By Emma Ross-Thomas

Jan. 16 (Bloomberg) -- European Central Bank President Jean-Claude Trichet’s vision of economies converging behind the shield of a shared currency may be unraveling.

The gap between the interest rates Spain, Italy, Greece and Portugal must pay investors to borrow for 10 years and the rate charged to Germany has ballooned to the widest since before they joined the euro. The difference may grow further as Europe’s worst recession since World War II hurts budgets and credit ratings across the region.

Diverging bond yields hurt Trichet’s argument that the ECB’s inflation-fighting mandate ushered in an era of stability for nations that once suffered rampant price growth. They also make it tougher for the ECB, which cut its key rate to a record yesterday, to set one benchmark for all 16 euro nations. That may delay recovery as governments try to fund stimulus plans.

“It will act as an additional braking mechanism on these economies,” said Julian Callow, chief European economist at Barclays Capital in London. “For the ECB it makes it harder to determine the future evolution of the economy.”

Trichet has asserted that the ECB, which was modeled on the Bundesbank, and the prospect of euro membership helped some nations import the credibility built up by Germany in the decades after World War II. In May, Trichet said the euro prompted a “convergence of market interest rates” to the level set by “the most credible national currencies” before monetary union.

The yield on Spain’s 10-year bond averaged 8.5 percent in the six years before it joined the euro and the gap with the equivalent German bond was 246 basis points. In the next eight years, the average yield fell to 4.5 percent and the spread to 13 basis points.

Greek Downgrade

That convergence is now being thrown into reverse. In the past week, Standard & Poor’s has downgraded Greece’s credit rating, and those of Portugal and Spain are also under threat.

The difference between the Spanish and German 10-year bonds rose to 114 basis points yesterday, the highest since 1997. The spread on Italy’s bond was also the most in 12 years and the Greek spread was the most since 1999.

Investors are becoming more discerning about who they lend to as shrinking economies force governments to increase budget deficits. Greece’s shortfall may widen to 3 percent of gross domestic product next year, Ireland’s to 7.2 percent and Portugal’s to 3.3 percent, the European Commission said in November. Standard & Poor’s said Jan. 12 that Spain’s deficit could top 6 percent this year.

Toll on Currency

The worsening economic outlook is pushing the euro lower. The currency has lost 7 percent against the Swiss franc, 5 percent versus the yen and 4 percent compared with the dollar in the past month. It has declined 8 percent versus the pound since Dec. 30, when it reached an all-time high of 98 pence.

As well as spoiling Trichet’s dream of a more-united European economy, the differing borrowing costs mean rate cuts will have a more uneven impact across the region and restrain recoveries in some countries.

Trichet said yesterday officials were “observing the market spreads,” which were related in part to the broader financial market turmoil. The widening spreads underlined the importance of governments keeping within European budget rules, he said.

The ECB cut its main rate by a half point to 2 percent yesterday, which matches the record low set between 2003 and 2005.

“There is a question mark about a much more patchy upswing,” said Ken Wattret, senior economist at BNP Paribas SA in London. “The divergence of economies will continue to raise questions about whether monetary union is functioning.”

Fiscal Challenge

That last debate has received a fresh airing among those who question whether the single currency is ultimately sustainable without a common fiscal policy. Harvard University economist Martin Feldstein, who was skeptical of the euro from the start, said in November that diverging bond yields suggest investors “regard a breakup as a real possibility.”

While part of the recent trading may amount to a bet the bloc will splinter, the probability remains “very, very small, given the political will and the perceived complications of someone leaving,” said Jonathan Loynes, chief European economist at Capital Economics Ltd. in London.

Spanish Finance Minister Pedro Solbes said Jan. 13 the idea of a country leaving the euro zone was “inconceivable.” Italian Finance Minister Giulio Tremonti said yesterday the euro project was “totally sustainable.”

Inside Advantages

“When push comes to shove it would be more expensive to be out of the system right now than inside,” said Marc Chandler, head of currency strategy at Brown Brothers Harriman & Co. in New York. While the yield on Greece’s 10-year bond stood at 5.4 percent yesterday, Hungary, which may set a new euro entry target date by March, must pay 9 percent.

The problem for Trichet is that bond spreads will probably continue to widen, said David Owen, chief economist at Dresdner Kleinwort. With governments borrowing to stimulate their economies, bonds sold by the more-troubled economies may become even less attractive, he said.

“You don’t, within the euro-system, have to buy Spanish paper at all,” Owen said.

Thomas Mayer, chief European economist at Deutsche Bank AG, said the diverging yields are a “warning shot” to governments to improve competitiveness through restraining costs or have investors impose discipline on them by choking off capital just when they need it most.

“You get this if you enter a really bad recession,” he said. “It’s obviously a very harsh medicine but you could say the market is dishing out this medicine.”

To contact the reporter on this story: Emma Ross-Thomas in Madrid at erossthomas@bloomberg.net