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Originally published Wednesday, November 10, 2010 at 4:04 AM

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Irish bonds sink as Europe's debt fears grow

Anxiety over heavy government debts in Europe flared up again Wednesday, as investors questioned whether countries like Ireland, Greece or Portugal can cut their budget deficits without choking off desperately needed economic growth.

Associated Press

DUBLIN —

Anxiety over heavy government debts in Europe flared up again Wednesday, as investors questioned whether countries like Ireland, Greece or Portugal can cut their budget deficits without choking off desperately needed economic growth.

Markets were increasingly betting that Ireland might be next in line for a massive financial bailout from its partners in the euro currency, after Greece's euro110 billion rescue from the brink of bankruptcy in May.

The interest rate, or yield, on Ireland's 10-year bonds jumped above 8 percent for the first time since the euro was introduced in 1999, reaching 8.64 percent in afternoon trading. Portugal managed to raise euro1.25 billion ($1.74 billion) in 6- and 10-year bonds, but at significantly higher interest costs than in September and August.

The fall in Irish bonds was accompanied by an announcement from London-based LCH.Clearnet Group, the world's second-largest bond clearing house, that it is significantly increasing the cash deposits it requires from traders dealing in those bonds.

The concerns over Irish debt rise comes as European Commissioner Olli Rehn visited Dublin in an effort to convince opposition lawmakers to support a further euro15 billion in painful government spending cuts.

As the commissioner for economic and monetary affairs, Rehn is in charge of making sure that euro zone nation's debts and deficits aren't spiraling out of control. Together with eurozone governments, he would also have to sign off on an Irish request to get money from Europe's euro750 billion emergency fund - a possibility investors think is increasingly likely.

But current market concerns go beyond governments' immediate ability to slash their budget deficit. More and more analysts are wondering how countries like Ireland and Portugal can get their economies growing fast enough to pay off their debts.

"The focus is now shifting from fiscal consolidation towards economic growth," said Carsten Brzeski, chief economist for ING in Brussels.

Europe's highly indebted countries find themselves in a downward spiral of budget cuts and economic stagnation.

Ireland's debt is expected to reach 98.6 percent of gross domestic product this year, while Portugal will face a debt pile of 83.3 percent of economic output. Greece's debt level depends of the revised figures for its 2009 deficit - which are due to be released next week - but most economists expect the country's debt to stand at about 120 percent of GDP by year-end.

To keep their debts from surging further, governments are slashing spending, laying off public sector workers or raising taxes. Yet those actions in turn are likely to dampen economic growth.

A stagnating or shrinking economy reduces tax receipts and makes it almost impossible for governments to produce the substantial budget surpluses needed to chip away at their debt - perfecting the vicious circle. "It's very hard to get out of there," said Brzeski.

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Ireland's GDP already fell 1.2 percent in the second quarter, Greece's economy shrank by 1.8 percent, while Portugal hobbled along with 0.3 percent growth. The European Union statistics agency's first estimate of third-quarter GDP this Friday may be a harbinger of more pain.

A decision by EU governments last month to create a mechanism that would force private investors to bear some of the pain the next time a eurozone government runs out of money is creating more market jitters.

Rehn's team at the European Commission is supposed to come up with a plan for how such a mechanism would work by December. But for the moment, there is "complete uncertainty over what the mechanism will look like," said Daniel Gros, Director of the Brussels-based Centre for European Policy.

Investors are worried about losing part of their money in the case of a sovereign default, even though current proposals from several economists would only allow for an orderly default on debts issued once the mechanism is in place - most likely not before 2013.

In that case, "it will not be possible to involve private creditors until 2025," given the maturity of many bonds, said Gros. "That seems to be difficult to swallow for some" countries.

Requesting money from the European stability fund would only buy governments more time - and somewhat lower funding costs. But it wouldn't reduce their overall debt, putting them in a precarious situation when the facility expires in 2013.

Irish Prime Minister Brian Cowen insists his country has enough cash on hand to fund the government budget through June 2011.

But if yields remain at their current levels until then, he might have no choice but to ask for help from the European stability fund - a process that is likely to take up to six weeks.

What will happen to Irish, Portuguese and Greek debt once emergency funding runs out on June 30, 2013, remains up in the air. Even if a European crisis resolution mechanism would allow for an orderly default on new bonds, uncertainty over how to deal with the debts will likely rattle markets for some time.

"The question is what then happens in reality," said Gros. "Everything is now possible."

(This version CORRECTS New version. Corrects time element, paragraph 1. Adds analyst comment, background. This story is part of AP's general news and financial services.)

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