12/14/2011 07:37 EST | Updated 02/13/2012 05:12 EST

Euro drops below $1.30 for first time since January as debt crisis weighs on currency

FRANKFURT - The euro slid to an 11-month low and borrowing costs spiked Wednesday for heavily indebted Italy, as economic realities dispelled the last wisps of optimism left about an EU deal aimed at containing Europe's debt crisis.

The market verdict — that Europe's debt problems are still unsolved — comes after five days of accumulating questions about whether the deal's new limits on debt and added contributions to the International Monetary Fund will take full effect.

There's also the recognition that last week's summit deal:

— Doesn't reduce existing government debt levels;

— Doesn't do much to promote the long-term growth that would shrink those burdens;

— And didn't create a financial backstop big enough to convince markets that all European countries will pay their debts no matter what.

The euro traded below $1.30 for the first time since January 12, hitting a low of $1.2973. Some of that is loss of confidence in the assets of the 17 nations using the euro, but it's also the result of two quarter-point interest rate cuts from the European Central Bank. The cuts lower the return on euro-denominated holdings and can induce investors to move money elsewhere.

One of the reasons why the euro not fallen further against the dollar this year, despite the pressures heaped on it by the debt crisis, is that interest rates in Europe have been so much higher than those in the U.S., where the Federal Reserve has kept its main interest rate near zero per cent.

That interest rate differential has helped offset the concerns investors naturally felt as the European debt crisis raged and threatened to undermine Europe's banking system and the currency itself.

At Italy's last bond auction of the year, investors demanded even more money to lend to the eurozone's third-largest economy. Italy paid 6.47 per cent interest to borrow €3 billion ($3.95 billion) for five years at a bond auction, up from 6.30 per cent just a month ago.

The higher rates reflected investors' fears over the inadequacy of last week's agreement to keep eurozone governments from piling up more debt in the future. Italy has a staggering €1.9 trillion ($2.5 trillion) in outstanding debt, and its economy is too large for Europe to bailout, like smaller nations Greece, Ireland and Portugal have been.

Experts from the 17 nations that use the euro will start reworking the summit deal into a new treaty Wednesday evening in Brussels, which will be followed Thursday by a get-together of delegates, a European official said, speaking on condition of anonymity because the talks are confidential.

The new treaty aims to impose tighter rules on how much money eurozone governments can spend. Leaders agreed to include automatic limits in their national constitutions, which would limit deficits to 0.5 per cent of economic output in regular economic times. It also is expected to make penalties for overspending governments more automatic and force governments to spell out how they will reduce their big debts and what they are borrowing on the bond markets.

The debt treaty does provide some assurance that European governments are working together to address the euro's flaws in the long-term. But it will not be signed until March at the earliest, and a text must first win approval from the 17 eurozone governments and nine others that the EU hopes will sign. Britain has said it will not.

Issues remain, however, including how the new accord will interact with the existing debt provisions of the basic treaty of the European Union — which remains unchanged — and whether it can legally rely on EU institutions, such as the European Commission and the European Court of Justice, to enforce the new rules.

Governments and national parliaments are also likely to watch closely how much sovereignty they are transferring to Brussels or their fellow euro members and whether their own constitutions will be affected.

"The process of negotiating the final deal to suit all will only add to doubts about its relevance in the long run — meanwhile the immediate crisis continues," said Elisabeth Afseth, an analyst at Evolution Securities.

Also Wednesday, the German government announced it was reactivating its financial sector rescue fund, providing more evidence that European banks are facing real funding pressures and may not have enough capital.

Last week, the European Banking Authority said the continent's banks need to raise about €115 billion ($149 billion) to meet the new standard meant to protect lenders against market turmoil, including bad government debt. German banks need a total of €13.1 billion ($17 billion) in new capital to comply with the new requirements. The country's second-biggest bank, Commerzbank AG, has been told it needs €5.3 billion ($6.89 billion).

The key concept driving fears over Europe is that the proposed EU treaty didn't address the fact that Europe lacks a financial backstop big enough to support Italy and Spain, should they find themselves unable to borrow affordably. Countries must borrow regularly to pay off bonds as they mature — if they can't, they need a bailout or face default.

That's what happened to Greece, Portugal and Ireland — and why each received a massive bailout from the eurozone and the International Monetary Fund. Greece is already negotiating the details of a second huge bailout.

Last week's summit did come up with a commitment from EU governments to loan up to €200 ($264 billion) to the IMF, which in turn could help out the eurozone. Yet not all countries have made firm commitments to this, and there is some indignation in non-euro using, poorer countries in Eastern Europe that they were being asked to help pay for richer countries' mistakes.

Czech Prime Minister Petr Necas said he is personally against contributing the roughly 90 billion koruna (€3.5 billion; $4.6 billion) his country has been asked to give, but the decision is not yet final. In Slovakia, which uses the euro, the leader of a centre-right party in the government said he has an "overall negative" view of the plan.

Leaders did agreed to start a new €500 billion ($659 billion) euro backstop fund, the European Stability Mechanism, a year ahead of time in July, but again there are real questions whether it adds anything to Europe's firepower. Since Europe's existing rescue funds, which have the same financing caps, would expire once the ESM takes effect, the overall amount of eurozone money available to help out struggling governments will remain the same.

That leaves many economists saying that eventually the European Central Bank will have to step up its so-far limited purchases of government debt — because only that will keep borrowing costs down. That's because the ECB has the power to buy bonds with newly created money.

The bank however has held off, with ECB head Mario Draghi saying governments must cut deficits and take steps to improve growth themselves to win back bond market confidence and not rely on central bank bailouts.

Draghi must also contend with fierce opposition to printing money to fund large-scale bond purchases from Germany's Bundesbank central bank, which is part of the ECB.

Bundesbank head Jens Weidmann is a leading critic, saying that creating new money would violate the bank's legal mandate to fight inflation. While the Bundesbank on paper has only one vote on the 23-member ECB council, Germany is Europe's strongest economy and the main contributor to its bailout funds.


Steinhauser contributed from Brussels