EU rescue plan may unravel as economic growth declines

LONDON - The rescue plan put together by the European Union may fail to contain the sovereign debt crisis as slowing economic growth impairs the ability of countries to reduce their debt levels.

After two crisis summits in four days, EU leaders agreed on Oct 27 to increase the bailout fund to 1 trillion euros ($1.4 trillion), recapitalize banks and write down Greek debt by 50 percent. Investors and analysts say the plan doesn't go far enough, and bond yields of heavily indebted nations such as Italy and Spain will keep rising relative to German bunds.

"The EU plan is a massive confidence trick," said Stuart Thomson, who helps oversee the equivalent of $121 billion as a fixed-income fund manager at Ignis Asset Management Ltd in Glasgow. "It's trying to disguise risk and the fact they don't have any money. That's what leverage is."

The EU agreement reached in Brussels also included a potentially bigger role for the International Monetary Fund, a commitment from Italy to do more to reduce its debt and a signal from leaders that the European Central Bank (ECB) will keep buying bonds in the secondary market to cap borrowing costs.

The economy of the 17 member eurozone grew 1.8 percent last year. The expansion will slow to 1.6 percent in 2011, and 0.7 percent the following year, according to Bloomberg News surveys of analysts. Portugal's gross domestic product will shrink 1.9 percent in 2011 and 2.3 percent the following year, the surveys show. The Greek economy will contract 5.3 percent this year and 2.2 percent in 2012.

"We remain unconvinced that the intended measures will mark the turning point of the crisis," Rainer Guntermann and Marcel Bross, analysts at Commerzbank AG in Frankfurt, wrote in an Oct 27 report. "We stick with our view of significantly lower bund yields and wider spreads into year-end."

German government bonds have returned 6.2 percent this year through Oct 28, according to indexes compiled by the European Federation of Financial Analysts Societies and Bloomberg. Italian debt lost 4.5 percent, Greek debt fell 39 percent and Spanish securities gained 4.6 percent, the indexes show.

French President Nicolas Sarkozy said last Thursday that the nation plans up to 8 billion euros in additional budget cuts to protect its AAA credit rating, after he said growth next year will slow to about 1 percent.

To compensate for lower tax revenue, Sarkozy said he will announce budget reductions of between 6 to 8 billion euros within 10 days. He's also considering increasing some taxes.

"Europe is heading for recession in 2012," Ignis' Thomson said. "We think growth will contract by about 0.5 percent. That means recession in the periphery, plus France."

The ECB started buying Italian and Spanish government bonds on Aug 8 after yields surged to euro-era records, according to people familiar with the transactions.

"The European market is heavily distorted by the action of the ECB, which is still buying," said Christoph Kind, head of asset allocation at Frankfurt Trust. "We don't have a real picture of yields and investor sentiment, so it remains to be seen what the market is doing when we again turn to a risk-off mode. The economic picture is a little grim for the fourth quarter and the first quarter of next year."

Italy's borrowing costs rose at the nation's first bond sale since the EU deal was announced amid concern the efforts to contain the debt crisis won't be enough to safeguard the region's third-largest economy.

The Rome-based Treasury auctioned 2.98 billion euros of bonds due in March 2022 on Oct 28 at an average yield of 6.06 percent, up from 5.86 percent at the previous sale of the securities on Sept 29.

"I don't see bund yields rising in one direction, so I think this is a temporary reaction," Frankfurt Trust's Kind said. "I don't think peripheral spreads are going to narrow from here. They will be wider again."

Bloomberg News