Fear returns to the eurozone

Markets take fright at Hollande’s election lead as Dutch government steps down over budget impasse. UK Treasury seeks £16bncuts because of uncertainty

Europe’s economy took another dramatic lurch downwards yesterday as investors found fresh reason to doubt whether the Continent’s politicians will be capable of resolving the sovereign debt crisis that continues to plague the single currency bloc. Stock markets reacted badly to a deluge of disappointing economic data, the victory of the Socialist candidate François Hollande in the first round of the French presidential election and the collapse of the Dutch government.

Taking fright, Germany’s Dax index shed 3.4 per cent, while the CAC 40 in Paris slid by 2.8 per cent. In London, the FTSE100 index of leading shares closed down 1.85 per cent. Stocks on the other side of the Atlantic also fell, with New York’s Dow Jones index opening down 1 per cent yesterday. Mr Hollande has promised to renegotiate the EU's "fiscal compact", agreed last December.

This puts him on a potential collision course with the German Chancellor, Angela Merkel, who desperately needs the strict budget-reduction agreement to persuade her own restive parliament to approve continued financial support from Germany for other governments in the struggling eurozone.

The Netherlands became an unwelcome new focus for investor concern when the Dutch Prime Minister, Mark Rutte, tendered his resignation after the failure of his coalition government to agree on measures to slash the government's deficit, which came in at 4.7 per cent of GDP in 2011.

The specific trigger for the government's fall was the withdrawal of support for €16bn (£13bn) budget cuts by Mr Rutte's far-right coalition partner, Geert Wilders. This has raised the prospect that the Netherlands may miss its target of reducing its deficit to 3 per cent this year. Elections will now be held as early as June and the sudden injection of political uncertainty sent Dutch borrowing costs, which are among the lowest in the eurozone, up yesterday to 2.43 per cent.

The difference between German and Dutch borrowing rates stretched to its highest level since the beginning of the crisis in 2010. The credit-rating agency Fitch last week threatened to downgrade the Netherlands if it failed to agree on deficit reduction. This could have dire repercussions for the rest of the eurozone since the Netherlands is one of the major guarantors of the currency bloc's bailout fund.

"The uncertainty about the Dutch fiscal policy is tarnishing the status of the Netherlands as one of the few safe havens in the eurozone," said Ulrich Leuchtmann, of Commerzbank.

Fears over one of the eurozone's top bailout candidates, Spain, were also reactivated yesterday when the country's central bank estimated that the Spanish economy shrank by 0.4 per cent in the first quarter of the year.

This would put the beleaguered nation, which is presently grappling with an employment level of 23 per cent, firmly back in recession. The European statistics agency, Eurostat, also confirmed that Spain's budget deficit came in at 8.5 per cent of GDP last year, confounding hopes that the previous estimate of the Spanish Prime Minister, Mariano Rajoy, would prove overly pessimistic.

The Madrid government is seeking to reduce the gap between its expenditure and revenues to 5.3 per cent in 2012, but investors increasingly fear that this massive fiscal consolidation effort could merely push the Spanish economy further into recession.

The sense of alarm about the Continent's growth prospects – widely seen as essential if the eurozone is to escape this crisis – was compounded by a series of surveys of purchasing managers' indices, which reflect financial activity. The eurozone preliminary composite Purchasing Managers' Index, or PMI, fell to a five-month low of 47.4 in April, down from 49.1 in March. Any reading of below 50 signals contraction. Analysts had expected a modest increase. Even manufacturing activity in Germany, previously an island of strength in the eurozone, weakened, hitting a three-year low of 46.3 in April.

The Eurostat figures also showed that national debts are rising despite the austerity measures in member states. Though the 17 states reduced their collective deficits from 6.2 per cent of gross domestic product in 2010 to 4.1 per cent in 2011, total indebtedness for the zone still rose 1.9 percentage points to 87.2 per cent of GDP.

There was a strong message of further austerity to come from the British Government, too, yesterday. The Chief Secretary to the Treasury, Danny Alexander, used a speech to the Institute of Fiscal Studies to instruct Whitehall departments to identify £16bn more in savings in order to build up a contingency fund for unexpected new spending demands. The UK will discover tomorrow whether the British economy has returned to recession, when the Office for National Statistics releases its preliminary estimate of GDP growth over the first quarter of 2012.

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