Relief in Spain, tension in Greece for euro zone

The embattled euro zone cleared a major funding test on Thursday when Spain romped through a key bond sale, while signs pointed to only a mild recession for the 17-nation bloc.

Talks between Greece and its creditors remained deadlocked, however, threatening to derail a needed bailout and keep the region's all-consuming debt crisis on the boil.

Ireland passed the latest review of its European Union-International Monetary Fund bailout, although it faces difficulty keeping its deficit reduction going if its economy sours.

A Reuters poll of economists pointed to the euro zone wallowing in a mild recession until the second half of this year, but contracting by just 0.3 percent for the year compared with a forecast three months ago of 0.9 percent.

At the same time, the IMF is expecting the euro zone economy to contract by 0.5 percent in 2012, according to draft document reported by the Italian news agency ANSA.

Neither figure is comforting, but both suggest a downturn is seen as shallow and probably short.

European Central Bank President Mario Draghi, speaking in Abu Dhabi, repeated his view that the euro zone economy is fragile.

"We see a softening business cycle in Europe with significant downside risk. We also see some tentative signs... but I have to be quite cautious here... some tentative signs of stabilization of economic activity at low levels," he said.

"All this is subject to downside risk, in other words it can get worse."

One key risk is if the debt crisis intensifies, pushing borrowing costs to unsustainable levels and driving a further wedge between the robust northern euro zone economies such as Germany and The Netherlands, and the debt-laden south.

Cheap Money

Spain's auction of benchmark 10-year bonds was a major test of investor appetite in the peripheral euro zone country. Short-term auctions last week had been successful but Thursday's sale was for longer-dated bonds.

It raised more than forecast at 3 billion euros, at a yield of 5.403 percent, a drop of more than 1.5 percentage points since the same bond was last sold in November.

The sale signaled that markets have largely shrugged off last week's salvo of euro zone rating downgrades from Standard & Poor's, an impression reinforced by a strong bond sale in Paris.

"These results are bullish for both Spain and the broader periphery and stand to further underpin the ongoing 'risk-on' tone... For now.. the glass half-full brigade have the upper hand," said Richard McGuire, rate strategist at Rabobank in London.

Euro zone bond auctions have been largely successful since the ECB offered nearly half a trillion euros of cheap, three-year loans to push investors towards buying government bonds and lowering borrowing costs.

"We start seeing also a fall of the longer-term part of the yield curve as well. I think that by and large this measure has really avoided a serious funding crisis that European banks might have to face," Draghi told reporters.

Little Progress in Greece

Greece remains the fly in the ointment, with Athens locked in negotiations with creditors on a deal to reschedule its debt and avoid an uncontrolled default.

Nearly a week after talks hit an impasse, the two sides remain bogged down over the coupon, or interest payment, that Greece must offer on new bonds under a debt swap.

Athens and its foreign lenders offered a coupon of just over 3.5 percent during a two-hour meeting on Wednesday, but bondholders rejected that as too low, one source said. They were angling for a coupon of at least 4 percent, one source said.

A senior Greek official also played down speculation that terms of a deal had been nearly pinned down, saying: "Nothing has been concluded yet."

The two sides must thrash out a deal within days to pave the way for Greece to receive a new infusion of aid and avoid bankruptcy when 14.5 billion euros ($18.5 billion) of bond redemptions fall due in late March.

Kept afloat by bailout loans, Greece faces the threat of having to leave the euro zone and slumping into further economic and social misery if it fails to come to grips with its debt, including securing a deal with the private bond holders.

Greece's central bank governor made an urgent appeal to his countrymen and their leaders to implement reforms or risk being pushed into an ignominious euro zone exit.

"If we ignore reality this time, the outcome will be a given: the country will become economically and politically isolated," Bank of Greece Governor George Provopoulos said.

[Source: By John Stonestreet and Deepa Babington, Reuters, Madrid and Athens, 19Jan12]

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