THE Greek debt crisis has spread to Spain and Portugal in a dangerous escalation as global markets test whether Europe is willing to shore up monetary union with muscle rather than mere words.
Julian Callow from Barclays Capital said the European Union might need to invoke emergency treaty powers to halt the contagion by issuing an EU guarantee for Greek debt. "If not contained, this could result in a 'Lehman-style' tsunami spreading across much of the EU," he said.
Credit default swaps measuring bankruptcy risk on Portuguese debt surged 28 basis points on Thursday to a record 222 on reports that Jose Socrates was about to resign as prime minister after failing to secure enough votes in parliament to carry out austerity measures.
Parliament minister Jorge Lacao said the political dispute had raised fears that the country was no longer governable. "What is at stake is the credibility of the Portuguese state," he said.
Portugal has been in crisis since the Maoist-Trotskyist bloc won 10 per cent of the vote last year. This is rapidly turning into a market crisis as well as investors digest a revised budget deficit of 9.3 per cent of gross domestic product for 2009, much higher than expected. A €500 million ($791 million) debt auction failed on Wednesday. The yield spread on 10-year Portuguese bonds has risen to 155 basis points over German bunds.
Daniel Gross, from the Centre for European Policy Studies, said Portugal and Greece needed to cut consumption by 10 per cent but such measures risked street protests.
In Spain, default insurance surged 16 basis points after economist Paul Krugman said "the biggest trouble spot isn't Greece, it's Spain". He blamed the Economic and Monetary Union's one-size-fits-all monetary system, which has left the country with no defence against a shock.
The Finance Minister, Elena Salgado, reacted angrily to the EU economics commissioner, Joaquin Almunia, who helped trigger the flight from Iberian debt by saying Spain and Portugal were in much the same mess as Greece. She said the comparison was simplistic and imprudent. "In Spain we have time for measures to overcome the crisis," she said.
It is this assumption that is now in doubt. The budget deficit rose to 11.4 per cent last year, yet the economy is still contracting.
Jacques Cailloux, Europe economist at Royal Bank of Scotland, said markets wanted the EU to spell out how it would shore up Club Med states. "They are working on a different time horizon from the EU. They don't think words are enough: they want action now. They are basically testing the solidarity of monetary union.''
Mr Callow of Barclays said EU leaders would come to the rescue in the end but Germany had yet to blink in this game of "brinkmanship". The core issue is that the EMU's credit bubble has left southern Europe with huge foreign liabilities - Spain at 91 per cent of GDP and €950 billion; Portugal 108 per cent (€177 billion. This compares with 87 per cent for Greece (€208 billion). By this gauge, Iberian imbalances are worse than those of Greece and the sums far greater. The danger is that foreign creditors will cut off funding, setting off an internal EMU version of the Asian financial crisis of 1998.
Jean-Claude Trichet, president of the European Central Bank, gave no hint yesterday that Frankfurt would help these countries, either through loans or a more subtle form of bail-out. He said euro members drew down their benefits in advance when they joined EMU and enjoyed ''very easy financing'' for their current account deficits. They could not expect help if they got into trouble later.
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