Europe hit by downgrade speculation

January 13, 2012 - 1:38 PM
Italy Financial Crisis

Italian Premier Mario Monti attends a debate at the lower chamber in Rome, Thursday, Jan. 12, 2012. Monti says he would support a new tax on financial transactions so long as it applies to the European Union as a whole. Speaking after meeting Wednesday with German Chancellor Angela Merkel, Monti indicated his preference for such a tax for the whole 27-nation bloc, rather than just the 17 countries that use the euro as their currency. (AP Photo/Gregorio Borgia)

ROME (AP) — The euro hit its lowest mark in over a year Friday on fears of a widespread European downgrade, in a sour end to what had been one of Europe's brightest weeks since the debt crisis intensified.

Earlier Friday, Italy had capped a strong week for government debt auctions, seeing its borrowing costs drop for a second day in a row as it successfully raised as much as €4.75 billion ($6.05 billion).

It had been a rare week of good news for Europe's financial system. On Thursday Spain and Italy completed successful bond auctions. Meanwhile, European Central Bank president Mario Draghi noted "tentative signs of stabilization" in the region's economy.

However markets across Europe fell in afternoon trading Friday on reports that rating agency Standard & Poor's was poised to downgrade the debt of several countries in the eurozone and talks in Athens between the Greek government and private investors failed to reach agreement on a crucial debt swap.

In late afternoon trading in Europe, the single currency hit a 17-month low of $1.27 on concerns about the downgrade, while investors dropped their higher-risk investments in European stocks and bonds for more secure US Treasuries.

A credit downgrade would escalate the threats to Europe's fragile financial system. It could drive up the cost of European government debt as investors demand more compensation for holding bonds deemed to be riskier than they had been. Higher borrowing costs would put more financial pressure on countries already contending with heavy debt burdens.

For the Friday Italian auction, investors demanded an interest rate of 4.83 percent to lend Italy three-year money, down from an average rate of 5.62 percent in the previous auction and far lower than the 7.89 percent in November, when the country's financial crisis was most acute.

While Italy paid a slightly higher rate for bonds maturing in 2018 which were also sold in Friday's auction, demand was between 1.2 percent and 2.2 percent higher than what was on offer.

The results were not as strong as those of bond auctions the previous day, when Italy raised €12 billion ($15 billion) and Spain saw huge demand for its own debt sale.

"Overall, it underscores that while all the auctions in the eurozone have been battle victories, the war is a long way from being resolved (either way)," said Marc Ostwald, strategist at Monument Securities. "These euro area auctions will continue to present themselves as market risk events for a very protracted period."

Italy's €1.9 trillion ($2.42 trillion) in government debt and heavy borrowing needs this year have made it a focal point of the European debt crisis.

Italy has passed austerity measures and is on a structural reform course that Premier Mario Monti claims should bring down Italy's high bond yields, which he says are no longer warranted.

Analysts have said the successful recent bond auctions were at least in part the work of the ECB, which has inundated banks with cheap loans, giving them ready cash that at least some appear to be using to buy higher-yielding short-term government bonds.

Some 523 banks took €489 billion in credit for up to three years at a current interest cost of 1 percent.

Peter Schaffrik, head of European rates strategy for RBC Capital Markets, said the ECB had helped scale back fears prevalent late last year of an imminent European financial collapse.

"A good deal of credit should be assigned to the ECB, which has been, and will be, we argue, supporting the European financial system, its sovereigns, and to some degrees the European economies via significant liquidity injections and lower rates," Schaffrik wrote in a note to investors.

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David McHugh in Frankfurt contributed.