BERLIN/PARIS (By Erik Kirschbaum and Daniel Flynn): Germany and France declared on Monday that Europe had taken decisive action to save the euro by rescuing Ireland and laying the foundations of a permanent debt resolution system, but markets were unconvinced.
Under pressure to arrest the threat to the currency before markets opened and prevent contagion engulfing Portugal and Spain, EU finance ministers endorsed an 85 billion-euro ($115 billion) loan package on Sunday to help Dublin cover bad bank debts and bridge a huge budget deficit.
They also approved the outlines of a long-term European Stability Mechanism (ESM), based on a Franco-German proposal, that will create a permanent bailout facility and make the private sector gradually share the burden of any future default.
"This is a measure which is not simply a single shot taken in response to an important crisis, it forms part of the absolute determination of Europe -- of France and Germany -- to save the euro zone," French government spokesman Francois Baroin told Europe 1 radio.
German Finance Minister Wolfgang Schaeuble said calm and reality should return to financial markets, where speculation against euro zone countries was "hardly rational."
And French Economy Christine Lagarde said "irrational," "sheep-like" markets were not pricing sovereign debt risk in Europe correctly.
But the deal failed to lift markets, the euro falling to two-month lows against the dollar as investors focused the debts of peripheral euro zone economies.
"I think it is almost impossible now to stop the contagion," said Mark Grant, managing director of corporate syndicate and structured debt products at Southwest Securities in Florida.
The cost of insuring Portuguese and Spanish debt hit record highs and investors demanded a higher premium to hold Belgian and Italian government bonds over German debt .
"Spain and Portugal (credit default swaps) are now at record wides, suggesting that contagion fears haven't been assuaged by Ireland's bailout," said Markit analyst Gavan Nolan.
Portugal is widely seen as the next euro zone "domino" at risk and business confidence for November added to the gloom. It fell for the second straight month on poor prospects for the economy due to austerity measures designed to calm investor concerns about its creditworthiness.
Nouriel Roubini, the U.S. economist who warned of an impending credit crisis before 2007, told the Diario Economico business daily that Portugal would likely need a bailout.
"Like it or not, Portugal is reaching the critical point. Perhaps it could be a good idea to ask for a bailout in a preventative fashion," he said.
Troubles in Portugal could spread quickly to Spain because of their close economic ties, and EU Economic Monetary Affairs Commissioner Olli Rehn warned Madrid might in any case need to take further austerity measures to trim its deficit if growth were lower than forecast next year.
Spain is seen as having to pay more to lure investors to Thursday's three-year bond offering, though five-year credit default swaps on BBVA and Santander tightened on Monday after widening aggressively last week.
NEW SAFETY NET MECHANISM
Under its bailout, Ireland was given an extra year, until 2015, to get its budget deficit down below the EU limit of 3 percent of gross domestic product, an acknowledgment that austerity measures will hit growth in the next four years.
Greece has been given a six year extension to 2021 on loan repayments linked to its rescue, said Finance Minister George Papaconstantinou, at the price of a higher rate of interest.
The new European Stability Mechanism could make private bondholders share the cost restructuring a euro zone country's debt issued after mid-2013 on a case-by-case basis.
The lack of detail in an earlier Franco-German deal on a crisis mechanism, agreed last month, and talk of private investors having to take losses, or "haircuts," on the value of sovereign bonds, helped drive Ireland over the cliff.
International Monetary Fund procedures would apply in the ESM. The IMF's "lending into arrears" policy stipulates that the Fund will lend to a country that is making good-faith efforts to come to an agreement with bondholders.
European Central Bank President Jean-Claude Trichet said the important points were that the IMF's doctrine would apply, the European Union would not get involved in debt restructuring itself and existing bondholders would not be hit retroactively.
Debt worries have driven the crisis for the past year, severely denting confidence in the 12-year-old euro currency and producing what amounts to a showdown between European politicians and financial markets.
The proposed permanent crisis resolution mechanism, to be finalized in the coming weeks, is intended to prevent Europe having to rush like a fireman from one blaze to another.
But it breaks several longstanding taboos:
- it effectively tears up the "no bailout" clause in the EU treaty, to which a exception had already been made for Greece;
- it creates a permanent rescue mechanism to replace the temporary three-year facility established in May;
- it accepts for the first time the possibility of a sovereign default in the euro zone;
- and it allows for the possibility of making private bondholders share the cost with taxpayers after mid-2013.
(Additional reporting by the Dublin and Brussels bureaus; writing by Paul Taylor and Jon Boyle; Editing by Ron Askew)
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