Financial markets swooned Thursday amid rising fears of a government debt default in Europe, highlighting the seriousness of the challenges facing the euro currency as fiscally challenged countries like Greece, Portugal and Spain dig themselves out of debt.
After a brief respite early this week, the cost of insuring against default the debt of euro-zone members with large budget deficits jumped late Wednesday and rattled investors more broadly on Thursday.
While Greece and Portugal have felt investors' fire in recent days, now even larger economies like Spain are starting to come under pressure from worries about their weakened public finances.
Blue-chip stock indexes in Spain and Portugal slumped nearly 6% and 5%, respectively, while an index of Europe's 600 biggest companies dropped 2.7%. The euro sank more than 1% against the U.S. dollar to an eight-month low of $1.3727 and lost 3% of its value against the Japanese yen.
The global economic downturn, and extensive government spending to fight it, have led to major fiscal problems in Europe, especially for less-dynamic economies like Greece, Portugal, Ireland and Spain. Such countries took advantage of their membership in the 16-nation euro bloc during the boom by borrowing at unusually low interest rates. But now, investors are worried about how they will reduce yawning budget deficits that exceed 12% of their economic output in the case of Greece and Ireland.
The debt troubles of Europe's weaker economies are also now raising questions about the nature of the euro zone, where countries share a currency but not financial policies. Some have speculated that a weaker country, like Greece, might end up falling out of the union or, worse, require a bailout by European policy makers or the International Monetary Fund. Such concerns are prompting investors to take a more careful look at the health of individual euro economies.
"A year ago, everyone assumed that these countries were the same," said Brian Yelvington, a strategist at fixed-income brokerage Knight Libertas. "Now people are trying to figure out how far Greek [bonds] should trade from Portugal."
European policy makers are trying to pressure wayward countries like Greece into taking stronger action to fix their finances. Greek markets eased a little earlier this week as investors awaited a move by the European Commission, the European Union's executive arm, to endorse Greece's budget plans.
However, the prospect of debt fears spreading to other countries like Spain creates new, and bigger, problems. Greece contributes only about 2.5% of the euro area's economic output; a larger economy like Spain or Italy, by contrast, would be harder to bail out.
Such concerns have weighed on Europe's single currency for many weeks, pushing its value down from a recent high of about $1.51 in December. To some extent, that is a boon for Europe's economy, since it makes it easier for German and other European exporters to sell their wares to consumers in the U.S. However, a sharp slide in the euro would erode its credibility.
Investors' worries were particularly sharp on Thursday. Prices of government bonds issued by Spain and Portugal sank along with their stock markets, while the cost to insure these bonds against default using insurance-like contracts known as credit-default swaps soared.
While Greece's bonds persevered Thursday, the cost to insure against a Greek sovereign default using credit-default swaps hit $429,000 annually to insure $10 million of debt, a new record, according to data provider CMA DataVision. Similar costs for Portugal and Spain also leaped. In a worrisome sign, concerns about the fiscal woes of European governments are starting to infect corners of the credit markets that European banks and companies rely on to raise money.
Prices of credit-default swaps tied to European companies with stronger credit ratings, including banks, also rose on Thursday, with the cost of insuring the debt of Spanish and Portuguese banks jumping in particular. Even banks like the U.K.'s Barclays PLC and Germany's Deutsche Bank AG saw their debt-default insurance costs rise.
Investors may be betting that banks and other European companies are likely to suffer if European governments like Greece are forced to institute austerity measures like higher taxes that end up snuffing out economic recoveries. Banks also are large buyers of European government bonds, and may be selling bonds or buying insurance using credit-default swaps to protect themselves from feared credit-ratings downgrades of countries. Furthermore, banks may be buying insurance to offset insurance they actually sold to other players, observers say.
Any fresh round of fear surrounding banks, meanwhile, would also imperil the companies that borrow from them.
In a recent report, analysts at Morgan Stanley said sovereign debt fears could, in a worse-than-expected scenario, end up hurting companies by leading governments to take actions that hurt their economic growth.