Bond spreads in the euro zone

The single currency's medical chart

Aug 3rd 2011, 18:31 by The Economist online

THE euro zone's disease has taken a strange turn since the last summit on July 21st. The medicine that leaders prescribed immediately improved the situation of countries in the emergency room, ie, Greece, Ireland and Portugal, which have all received bail-out loans. But it worsened the condition of those outside hospital who had started to fall ill.

This contradictory effect is apparent from our charts showing the direction of yields on sovereign bonds, which move inversely to the price.

The “spread” over 10-year German bunds is the standard measure of perceived risk. It is the premium, or additional interest, that markets demand for holding the debt of a euro-zone country compared with the bonds isued by Germany, deemed the safest.

Until last month's summit, the worry was focused on whether Greece would be able to repay its debts, and whether its sickness would infect bigger countries. Leaders of the euro area decided greatly to extend maturities on Greece's rescue loans and to cut the interest rate it pays. Ireland and Portugal got the same prescription.

In addition, Greece got a bit of local surgery, in the form of a slight “voluntary” haircut on private creditors. Many think wholesale amputation is what is really needed to save Greece. But for now the aspirin and antibiotics have brought down the fever somewhat, as is apparent in the left-hand chart, Ireland and Portugal are faring better too.

By contrast, the spreads of Italy and Spain (right-hand chart), already sickly, have continued to rise, reaching the highest level since the adoption of the euro. Why is the cure not working? One reason is that these two countries have not asked for, and have not been given, the medicine of emergency loans, so they are still struggling on their own. Another is that the measures promised to contain the spread of the disease – giving the euro area's main bail-out fund, the European Financial Stability Facility (EFSF) greater powers to intervene early in a crisis (see my earlier posting here) – have yet to be approved by national parliaments, which are on holiday. Finally, even if the EFSF's drugs are made available, there are not enough supplies in stock to deal with an economy as large and indebted as that of Italy. It may not even be enough for Spain.

The lending power of the EFSF is being increased to its full headline figure of €440 billion. But many think it needs to be bigger still – five times larger, says one leading financial analyst (see here). The bigger the crisis, it seems, the bigger the dose of cash required. But the question is this: as more countries fall ill and are unable to support the EFSF, who will be left to bail out the euro zone? Already questions are being asked about the creditworthiness of France, the AAA-rated country with the highest debt ratio in the EU.

The measures taken by the euro zone might have had a chance of working had they been adopted six, or even three months ago. But now the infection has got out, and it is fast developing resistance to the standard drugs.

To help you keep track of the state of the epidemic, we hope regularly to update these charts. Watch this space, and our dedicated page on the euro-zone crisis. Readers might also want to keep tabs on our debate on the future of the euro, which is just ending.