With Italy and Spain, Further Tests for Europe

BRUSSELS — Is the euro crisis back with a vengeance, or do investors have a needless case of anxiety?

Until very recently, the gloom over the Continent had seemed to be lifting, with the conclusion of Greece’s second bailout and the calming effect on the financial sector of cheap loans from the European Central Bank. But last week’s jump in borrowing costs for Spain and Italy provided a clear signal that the euro’s problems are far from solved.

“Financial strains in Europe have eased somewhat since December,” Christine Lagarde, director of the International Monetary Fund, said in a speech in Washington on Thursday. “However, events of the past week remind us that markets remain volatile and that turning the corner is never easy.”

The turn looks tightest in Spain, which is still under intense pressure from the European Union to narrow a gaping budget deficit and clean up its banking system after a housing bubble burst, even as the country slides back into recession, with roughly one in four workers unemployed.

Yields on Spanish 10-year bonds hit a worrisome level of 6 percent Wednesday for the first time in four months and closed the week nearly that high. At the same time, investors seeking safety drove the 10-year German bond, or bund, to a near-record low of 1.6 percent.

Interest rates on Spanish bonds could climb again this week if two debt auctions, scheduled for Tuesday and Thursday, go poorly.

Italy, which has an even heavier debt load and is further behind on its refinancing needs for this year, is under similar stress.

Neither Spain nor Italy seems a good candidate for meeting the deficit-reduction targets they have agreed to with the European Union, especially if the downturn deepens. Neither do many of the other member states, however, including the Netherlands, traditionally a deficit hawk but now scrambling to find additional savings as its economy falters.

Their deficit-trimming will be detailed in the medium-term budget plans that each European Union member must submit to Brussels by the end of the month for vetting under stricter procedures approved last fall. The procedures are intended to catch the kind of slippage that got the euro zone into its current mess.

The verdicts will be based in large part on official indicators of the region’s fiscal and economic health to be released over the next few weeks. Those include final debt and deficit figures for 2011 as verified by Eurostat, the union’s statistics agency, to be released next Monday, and the European Commission’s spring economic forecast, which covers not only growth and inflation expectations, but also deficit and debt figures, to be released on May 11.

Countries whose budgets are judged to be off-track will face demands for corrective action, which are now supposed to be harder to avoid. That prospect, however, seems certain to renew debate over whether a regional economy teetering on the brink of recession can withstand a new round of austerity.

“On this the market is entirely schizophrenic,” said Gilles Moëc, an economist at Deutsche Bank in London. “They complain about growth, and they complain about fiscal policy. Well, you can’t have both.”

Carsten Brzeski, senior economist at ING Belgium, agrees that European policy makers are in something of a no-win situation right now. But to bend the rules so soon after tightening them, he added, “would have an enormous negative impact on credibility.”

While the austerity debate simmers, a more pressing concern is efforts by Italy and Spain to raise financing for government debt they will need to roll over this year. Italy has so far raised only a little more than one-third of the estimated 215 billion euros ($281 billion) it will need this year, according to Reuters calculations. Spain is about half of the way to its goal, the economy minister, Luis de Guindos, said last Tuesday. According to the 2012 budget, the Spanish treasury plans gross issuance of 186 billion euros ($243 billion) of debt this year.

The European Central Bank relieved a great deal of pressure with two rounds of cheap, three-year loans to banks in December and February that pumped 1 trillion euros ($1.3 trillion) into the region’s banking system. Many banks, especially in the southern countries like Spain and Italy, turned around and used that money to buy their government’s debt.

That debt-buying is now tapering off, said Guntram Wolff, deputy director at Bruegel, a research organization in Brussels. That raises the question of who might step in to finance these governments. “Investors are starting to express big doubts,” Mr. Wolff said.

Few analysts expect the central bank to open the taps again, especially because the earlier moves have already started having unintended consequences. While the loan program was meant chiefly to address an acute financing problem for the banks, it also ended up tying their fate more closely to that of their governments, said Jacques Cailloux, chief European economist at the Royal Bank of Scotland in London.

Now that sovereign yields are rising again, he said, the banks are faced with the prospect of large paper losses on their freshly purchased bond holdings, as well as sinking stock prices.

Many economists say Spain still needs to fully address the impact of a housing bubble that burst in 2008 in the wake of the global financial crisis. Many homeowners struggle to make payments. And real estate prices still have further to fall, which will force the banks to take more write-offs.

The Spanish central bank governor, Miguel Ángel Fernández Ordóñez, conceded last week that Spanish banks could need more capital if the economy deteriorated.

The banks’ “ever-increasing” losses “hang like a sword of Damocles over the public sector,” according to a paper published on Sunday by Cinzia Alcidi and Daniel Gros at the Center for European Policy Studies in Brussels.

“They cannot and should not go on just writing off the absolute minimum,” Mr. Gros said in an interview. “Much better to follow the Irish example and have it over with.”

Deutsche Bank estimates that Spanish banks could need about 50 billion euros in additional capital — more than the banks could probably raise on their own under current market conditions, and more than the Spanish government could afford.

That leaves the European Union’s newly bolstered bailout fund. Mr. Gros suggested it could lend money directly to the Spanish banks to avoid increasing government debt and avert a full-blown bailout.

Still, admitting you need outside help is “toxic politically” for any government, said Mr. Moëc, the Deutsche Bank economist. “I don’t think they feel cornered yet,” he added.

Italy does not have a housing crash to cope with, or Spain’s high level of private debt. But it has a much higher public debt than Spain, similarly anemic growth and a calcified labor market that Prime Minister Mario Monti, a technocrat appointed in November, has struggled to change against an increasingly hostile political environment.

In the latest display of Italian public anger, thousands of union members turned out on the streets of Rome on Friday to protest plans to raise the minimum age for a state pension.

In such a charged climate, it is little wonder that barbs have started to fly across borders.

Mr. Monti has in recent days sought to blame the problems in Spain for the run-up in Italian bond yields, while French President Nicolas Sarkozy, who is running for re-election, has raised hackles in Madrid by suggesting that France could end up like Spain if people voted for his Socialist Party opponent.

On Wednesday, Mariano Rajoy, the Spanish prime minister, fired back, calling on European leaders to be “more cautious in their statements.”

“We don’t talk about other countries,” he told members of his Popular Party in Madrid. “We wish other E.U. and euro zone countries the best.”