ECB rate hike may push weak states over edge

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Portugal has finally admitted it needs aid from the European Union, having resisted asking for help for months.

Jose Socrates, the head of the country's caretaker government, last night said his country would ask for a bailout due to high debts and difficulty raising money on the international markets.

The announcement comes with the European Central Bank is almost certain to raise interest rates today, in a move that will put more stresses on peripheral eurozone economies such as Portugal. The expected rise, for 1 to 1.25 per cent, has long been signalled by the bank's president, Jean-Claude Trichet, in order to curb inflation.

Meanwhile, Ireland is openly seeking a re-opening of its November deal; and Greece is edging towards a restructuring, or default, in the face of its intractable difficulties, ones so formidable that not even another EU/IMF injection of money may resolve them.

Among many signals passed at red on Portugal' s journey to financial collapse, analysts point to the way the Lisbon government yesterday had to pay the market more to take on its short-term debt than might have been available from an international rescue package. This financially irrational decision can only be explained by the fact that Portugal is under a caretaker administration pending elections on 5 June.

The yield demanded by investors to take on the fresh Portuguese six and 12-month treasury bills spiked to record highs – ahead of big redemptions at the end of next week and in June. Portugal paid more to borrow for six months than it costs Germany for 30-year bonds. The yield on 10-year bonds went above 10 per cent this week, effectively "pricing in" a default or rescue, and at similar levels to those that preceded the Irish and Greek bailouts.

Portugal's banks are urging the administration to apply immediately for a "bridging loan" to provide finance before a new government is able to negotiate a formal package, presumably after 5 June. The Portuguese banks hold large quantities of the country's sovereign debt, and are said to be reaching the limit of their exposure, even with support from the ECB.

Despite early pledges to the contrary, the ECB has successively debased collateral criteria to reach the near-junk status enjoyed by Portuguese and Irish debt, and is thought to harbour large quantities of each. Portugal has seen three savage downgrades by the credit ratings agencies of its sovereign debt in a week, and Ireland and Greece have also suffered from a worsening outlook among the agencies.

The problems with an ECB rate rise are threefold. First, they automatically increase the cost of servicing bank and sovereign debts among the stressed peripheral economies. Second, they will tend to depress economic growth in those countries in the usual way associated with a monetary tightening, though now exacerbated by a continuing credit crunch and busted banking systems. Third, it adds to the general expectation, encouraged by ECB officials, that the central bank would like to exit its ad hoc emergency liquidity support for "addicted" private banks and, indirectly, sovereign states.

Analysts at Capital Economics highlighted the way that a large share of southern European home-owners have mortgages with floating interest rates, and so a monetary tightening will feed through to households perniciously.

Ben May, a European economist at Capital Economics, warned: "If interest rates were to rise in line with market expectations, their impact would be greatest in the periphery and may prompt a further escalation of the region's fiscal crisis."

For now, the risk of contagion to Spain – potentially fatal for the euro – seems contained. Dominique Strauss-Kahn, managing director of the IMF, told the Spanish paper El Pais yesterday: "I don't believe that the Spanish government needs any type of financial aid. Over the last few months, Spain has been put in the same bag as other countries, such as Greece, when they are clearly not in the same situation."

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