Fear mounts of new credit crunch in Europe

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Fears of another credit crunch are building in Europe, as Spain's move to consolidate four banks shows debt problems are weighing heavily on the financial sector.

The Bank of Spain organized the merger of four regional savings banks known as cajas in a bid to strengthen their overall financial position. Spain's smaller banks suffer from heavy exposure to the slumping real estate sector and construction industry, in addition to rising loan losses amid one of Europe's harshest economic declines. The merger will create Spain's fifth-largest lender, with €135-billion ($178-billion) of assets, and comes just days after the central bank seized control of CajaSur, a failing bank in Cordoba controlled by the Roman Catholic Church.

Nervous investors Tuesday pushed the euro down to its lowest level since 2001, hammered bank shares and trimmed 2 to 4 per cent off most of the benchmark European stock indexes.

In Italy, meanwhile, a €24-billion austerity package approved late Tuesday is the latest in a string of broad government-spending cutbacks spreading throughout the continent and threatening to derail the modest rebound in economic activity.

Subject to parliamentary approval, Italy plans to freeze government-worker pay for three years and cut compensation for highly paid public servants. Other measures are aimed at reducing bureaucracy and cracking down on those falsely receiving disability benefits. In total, Italy's planned cuts would reduce the country's budget deficit to below 3 per cent of GDP by 2012 - in line with euro zone rules - from 5.3 per cent in 2009. The cutbacks would also help address the country's debt load of 115 per cent of GDP, the highest of the 16 countries that use the euro.

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While the Spanish government's message was that it is moving quickly to shore up the country's 45 savings banks through forced mergers and support from a €99-billion restructuring fund, investors took the four-way deal as evidence that the entire European banking sector is coming under stress once again.

"I was thinking today that maybe the immediate knee-jerk reaction is - yikes! - is this the start of another banking crisis?" Mike Lenhoff, chief strategist for British investment manager Brewin Dolphin, said in an interview. "Does this increase counterparty risk for the banks and hence push up the spreads even further for Libor [London interbank offered rate]"

Indeed Libor - the rate at which banks lend short-term money to one another - climbed Tuesday for the 11th day running. A rising Libor means banks are becoming increasingly concerned about the quality of bank assets used as collateral. The three-month rate was last at about 0.536 per cent, its highest level since last July and more than double the March figure.

The Libor rate could go as high as 1.5 per cent in the next few months, Citigroup analyst Neela Gollapudi said in a report last week. The rate for European banks, judged to be riskier than their U.S. counterparts as the debt crisis rolls across the continent, has been rising the fastest.

Investors were spooked not just by the state of Spain's banks, but the state of the overall economy. Spain's unemployment rate is 20 per cent and rising, the result of the bursting of Europe's biggest property bubble.

On Monday the International Monetary Fund, the sponsor with the European Union of a €750-billion bailout fund for EU countries that cannot roll over their debt, said Spain faces "a dysfunctional labour market, the deflating property bubble, a large fiscal deficit, heavy private-sector and external indebtedness, anemic productivity growth, weak competitiveness and a banking sector with pockets of weakness."

Along with cuts to some public servants' salaries, Italy's austerity package includes a hefty reduction in transfer payments to regional and local governments. Government spending cuts are spreading across Europe. On Monday Britain's new coalition government unveiled £6.25-billion ($9.6-billion) of spending cuts - a prelude to far deeper reductions expected later this year, when chancellor George Osborne is to unveil an emergency budget. Germany is reportedly on the verge of eliminating €10-billion a year of spending through 2016.

In spite of the spending cuts, which are designed to bring outsized deficits down to the EU's 3-per-cent limit, and bank reform in Spain, debt and equity investors are using any bit of bad news, real or perceived, to flee.

"The encouraging part of the news flow is that under extreme pressure, it seems that European governments have started to address their problems," UniCredit debt strategist Philip Gisdakis said in a note to clients. "The bad news is that due to the reforms, markets will turn more negative before they will improve. Harsh austerity measures and a reform of the [Spanish] banking system in the midst of a deflating property bubble is definitely not supporting growth."

In a recent interview Jose Manuel Amore Alameda, an economist and partner at Madrid's AFI, an economic and financial services consultancy, said the Spanish government is deluding itself into thinking it can grow its way out of the debt crisis. "The government is banking on a return to growth," he said. "That's nonsense. It won't happen unless the labour market and the banking sectors are reformed."

With files from Associated Press

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Italy swings the axe

Government sets budget cutbacks of €24-billion ($32-billion) for 2011-12.

Cuts would reduce deficit to 2.7 per cent of GDP in 2012 from 5.3 per cent in 2009.

Salaries for civil servants are frozen for three years; high-ranking government officials face wage cuts.

Measures introduced to attack tax evasion and fraudulent use of government benefits.

Cuts must be approved by parliament and could face political backlash.