Euro zone periphery hammered on default fears

The euro zone's debt crisis deepened on Tuesday, with investors pushing the risk premium on Spanish and Italian government bonds to euro lifetime highs amid concern weaker member states may ultimately be forced to default.

European policymakers appeared at a loss to calm markets hell-bent on testing their determination to rescue countries like Portugal and Spain after approving an 85 billion euro bailout for Ireland at the weekend.

The borrowing costs of countries like Belgium and France also rose -- and the euro hit a 10-week low versus the dollar -- as investors looked beyond the so-called euro periphery and targeted core founding members of the bloc.

A Reuters survey of 55 leading fund management houses showed U.S. and UK investors had significantly cut back their exposure to euro zone bonds this month, piling into equities instead despite a weakening in global shares.

"The crisis of confidence in Europe can't be resolved quickly," said Rick Meckler, president of investment firm LibertyView Capital Management in New York. "No single event can put things back in order."

Markets are already discounting an eventual rescue of Portugal although the government in Lisbon denies, as Irish leaders initially did, that the country needs outside aid.

While a Portuguese rescue would be manageable, assistance for its larger neighbour Spain would sorely test EU resources, raise deeper questions about the integrity of the 12-year old currency area, and possibly spread contagion beyond Europe.

Citigroup Chief Economist Willem Buiter described the turbulence hitting the euro zone as an "opening act" and predicted that sovereign default fears could soon extend to Japan and the United States.

"There is no such thing as an absolutely safe sovereign," he wrote in a research note.

EURO SLIDES, SPREADS WIDEN

The euro has shed nearly 8 percent of its value against the dollar this month.

The yield spreads of 10-year Spanish, Italian and Belgian bonds over German benchmarks spiked to their highest levels since the birth of the euro in January 1999 and the cost of protecting against a euro zone sovereign default surged.

"There is no reason for concern, no risk," said Francois Baroin, France's budget minister and government spokesman.

Italian officials also scrambled to play down the risks for their economy, the euro zone's third largest, which some economists have labeled "too big to bail."

"Italy's public finances are going well, we are not among the countries at risk," said Treasury Undersecretary Luigi Casero.

Weakened governments in Italy, Ireland and Portugal have deepened the sense of crisis by sowing doubts among investors about their ability to act swiftly to bring their debt and deficits under control.

"It's very worrying because Spain is almost too big to be bailed out ... whereas Italy is too big to be bailed out," said Everett Brown, European bond strategist at IDEAglobal.

Portugal's central bank warned on Tuesday that its country's banks faced an "intolerable risk" if the government in Lisbon failed to consolidate public finances.

Although the minority Socialist government in Portugal approved an austerity budget for 2011 last week, it is struggling to meet its targets for deficit reduction.

Data released on Tuesday underscored economic divergences within the euro zone, which pose an increasing challenge to the European Central Bank and its one-size-fits-all monetary policy.

German unemployment fell in November for a 16th straight month while Italy's unemployment rate jumped to 8.6 percent in October from 8.3 percent the month before.

Greek retail sales plunged 9.9 percent year-on-year in September under the weight of crushing austerity measures agreed in exchange for its 110 billion euro bailout.

In addition to Ireland's bailout, European leaders approved on Sunday the outlines of a long-term European Stability Mechanism (ESM), based on a Franco-German proposal, that will create a permanent bailout facility and make the private sector gradually share the burden of any future default.

Although private bondholders will not be asked to share the cost of debt restructurings until after mid-2013 and then only on a case-by-case basis, the mechanism has stoked fears of future defaults and the likelihood of so-called "haircuts" down the road.

Eurointelligence, an online commentary service, said markets were growing increasingly concerned about the solvency of euro zone peripheral states after focusing mainly on their short-term liquidity problems in past weeks.

"We at Eurointelligence consider a default of Greece, Ireland and Portugal a done deal," they wrote on Tuesday. "The question is only now whether Spain can scrape through."