Why is Europe’s sovereign debt crisis escalating once more?

Following bailout packages from the EU and the International Monetary Fund for three of the “piig” states – Portugal, Ireland and Greece – bond markets are now turning on the remaining two peripheral countries, Italy and Spain.

The yield on 10-year bonds of both have risen to “unsustainable” levels, coming close to the critical 7 per cent level which precipitated bailouts in other countries. This is leading to concerns they will have difficulty raising money and will face a liquidity crisis.

But what happened to the latest rescue package?

Last month, a wide-ranging series of measures aimed at solving Europe’s sovereign debt crisis once and for all was agreed upon by the 17 members of the euro zone. These measures included empowering the European Financial Stability Facility counter movements in the bond markets by buying bonds in the secondary market to prevent any further bailouts, and forcing private investors in Greek debt to get involved in the bailout through a mechanism known as private sector involvement.

However, much like that old adage of the stock markets, “sell in May and go away”, Europe’s politicians came to an agreement in July, but failed to follow it up with implementation.

The markets soon showed their displeasure by selling out of Italian and Spanish debt, forcing the yield spreads to rise. According to one trader in Switzerland, market sentiment is now at “apocalypse level”.

What might happen next?

It is now likely implementation of Julys agreement will happen sooner than envisaged, given the uncertainty in the markets. Yesterday, European Commission president José Manuel Barroso called on the heads of state of euro zone countries to ensure actions needed to implement these measures “are taken without delay”.

An alternative could be to resurrect the European Central Bank’s asset purchase programme, or to issue a euro zone bond, but this could force too big a burden on Germany.

Will implementation work?

It is hoped that, by allowing the financial stability facility to act pre-emptively, it will prevent the need for additional bailouts – particularly as Spain and Italy are considered too expensive to bail out. However, while Barroso may have declared the treatment of Greek bonds “exceptional”, the fear is that private sector involvement measures will spread to investors in the debt of other peripheral countries. So, until involvement is clarified (and investors believe it confined just to Greece), pressure will remain on the sovereign debt of peripheral countries.

Moreover, the situation has worsened due to uncertainty as to whether the rescue package in the US is sufficient, and whether it might lose its AAA rating. Italy and Spain can fund themselves in the short term by issuing short-dated paper, but the sovereign debt crisis is far from over.