Political leaders failed to halt a global stock market rout that gathered steam yesterday (8 August) as investors lost confidence that Europe and the United States can rein in their budgets quickly and fear spread of a double-dip recession.
The European Central Bank swept into the bond market to buy up Italian and Spanish debt and sling a safety net under the euro zone's third and fourth largest economies. But bickering persisted in Europe over a longer-term rescue plan.
In the United States, President Barack Obama called for urgent action on the US budget deficit but his proposal on taxes was promptly rebuffed by Republicans.
The G7 finance ministers' and central bankers' pledge on Sunday to help smooth markets if needed provided little solace.
A huge blow to investor confidence was the Standard and Poor's downgrade of the U.S. sovereign credit rating late Friday, which compounded spreading concerns that the worsening euro-zone debt crisis and a faltering US economy heighten the risks of a double-dip recession.
"People are asking, can the economy still grow in face of all this?" said John Carey, portfolio manager at Pioneer Investment Management in Boston, with $260 billion under management.
Realization on both sides of the Atlantic that the political obstacles to quick budgetary reform are so huge and the monetary options so limited, it has deepened the pessimism.
The worsening market turmoil puts significant pressure on the US Federal Reserve at its regular policy meeting on Tuesday to announce some fresh measures of support for a damaged US economy.
"If the Fed does nothing, it could prove to be a disappointment at this point," said JP Morgan analysts.
Recession fears grow
Stock losses have wiped more than $3.8 trillion from investor wealth globally in the last eight days and sent investors rushing for safety in the Swiss franc, the Japanese yen and gold. In the United States, estimates of recession risks are rising. Goldman Sachs had put them at one in three last week, before the latest sell-off.
"This massive move in the equity market does dim the economic outlook for the next six months," said Carl Riccadonna, senior US economist at Deutsche Bank in New York. "We would put the recession odds at about 40 percent and about two weeks ago they were at about a 10 percent chance."
The G7 financial policymakers from major industrialized nations said on Sunday they stand ready to provide extra cash if markets seize up, are consulting regularly and could cooperate to smooth volatile FX markets if needed.
Particularly worrisome was a more than 20 percent plunge in the shares of Bank of America, the largest US bank. AIG sued it for $10 billion for allegedly deceiving investors, on top of mounting concerns about the size of its potential losses from mortgages litigation and questions about management. The bank has shed nearly one third of its market value in three days.
ECB to the rescue
On the political front, Obama said he hoped that Standard and Poor's stripping the United States of its prized AAA credit rating would add urgency to US budget cutting plans.
Obama called for both tax hikes and cuts to welfare programs as part of the $1.5 trillion in deficit reduction that a special committee would deliver in late November. But Republican House Speaker John Boehner once again rejected the call, saying tax hikes were "simply the wrong approach."
Obama also spoke with Italian Prime Minister Silvio Berlusconi and Spanish PresidentJosé Luis Rodríguez Zapatero, welcoming measures by their governments to address the economic turmoil in Europe.
Traders estimated the ECB bought about 2 billion euros in Italian and Spanish debt after it agreed on Sunday to broaden its bond-buying program for the first time to halt an attack on the Mediterranean countries. Italian and Spanish yields declined sharply.
"The intervention by the European Central Bank this morning seems to have been working," Irish Finance Minister Michael Noonan told RTE public radio.
"Last week the risk was that as bond rates in Italy went toward 7.0 percent, they'd be driven into some kind of bailout program. They have fallen by almost one percent this morning so they are well out of the bailout territory now."
But French sovereign credit default swaps hit a record high of 160 basis points as the US rating downgrade raised questions about how long other AAA countries, such as France, could hold onto their top-notch ratings.
The ECB move was seen as only a temporary solution however, due to the sheer size of Italy's bond market — $1.6 trillion. European stocks sank to their lowest in nearly two years, with the German DAX closing down 5 percent as doubt about governments' ability to deal with the euro zone debt crisis and its impact on economic growth emerged.
A bailout of Italy would overwhelm Europe's emergency fund. Germany has so far opposed expanding it, a view unchanged on Monday, but French Finance Minister Francois Baroin said: "The allotment is 440 billion (euros) and we've already said if we need to go further we will go further."
EURACTIV with Reuters
European Central Bank President Jean-Claude Trichet defended the central bank's decision to buy sovereign bonds in a German television interview on Monday.
"We observed that our decisions in the euro zone did not have the intended effect," Trichet said, according to a German translation of his comments broadcast on Germany's ZDF network.
"That is why we decided to deviate from our monetary policy rules," Trichet added. There were no further comments from Trichet included in the ZDF broadcast.
Any big increase in the European Financial Stability Fund (EFSF), the European Union's emergency fund, could hit the credit ratings for guarantor countries, the Dutch finance minister Jan Kees de Jager warned on 8 August.
De Jager's comments were published in a written statement to parliament, in response to questions from various political parties about the euro zone crisis.
"An increase in the EFSF cannot be regarded as a panacea and cannot be an alternative to structural reforms," De Jager said.
"Any significant increase in the outstanding guarantees for the EFSF may also affect the creditworthiness of the guarantor countries," he added.
Under pressure to take more steps to cut a deficit that has put Spain at the heart of Europe's debt crisis, Spanish Economy Minister Elena Salgado on said on 7 August the government would use an August 19 cabinet meeting to outline further savings.
Salgado did not give details except to say that 2.5 billion euros of savings could be made through changes to the methodology for large companies' tax payments.
That change -- together with a plan to save an estimated 2.4 billion euros in drugs costs for regional governments through a new bill on generic medicines -- add up to a deficit reduction of half a percent of GDP.
Spain’s Popular Party -- the center-right opposition party -- called the tax announcement an accounting trick. It said the 2.5 billion euros would come from forcing large companies to pay taxes due in 2012 before the end of 2011.
Stephen King, chief global economist at HSBC in London, said that in order to shift the balance of global demand from the United States and Europe towards the emerging world, the United States would make an advance commitment to serious budget deficit reduction, while China would agree to revalue the yuan, permitting an export-led U.S. recovery.
"If you have reasonable international policy coordination, you can get out of this mess," he said.
In the absence of rebalancing, King fears the United States will be stuck with slow growth of about 2 percent a year that leads, as in Japan, to a high, suffocating debt-GDP ratio.
"The problem is not so much another recession, but the absence of a recovery," King said. "We could be stuck in the perma frost for years to come."
Since the euro zone's debt crisis erupted last year, the region's rich governments have aimed to limit it to Greece, Ireland and Portugal, which have so far signed up to bailouts totalling €273 billion - a sum that is small compared to the financial resources of the zone as a whole.
Spain, traditionally seen as the next potential domino in the crisis, has managed to retain its access to market funding through fiscal reforms. But due to the large size of the Spanish and Italian economies, pressure on the euro zone would increase dramatically if those countries were eventually to need financial assistance.
Private analysts have estimated a three-year bailout of Spain, based on its projected gross issuance of medium- and long-term debt in 2011, might cost some €300 billion - excluding any additional money for cleaning up Spain's banks. A three-year rescue of Italy could cost twice that.
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