Europe's PIGS don't fly

NEW YORK (Fortune) -- Bets against the fiscally unfit are multiplying, and there's no telling where they will stop.

So far, Dubai, Greece, Portugal and Spain have come under attack as investors demand higher interest rates on bonds sold by cash-strapped nations. For now, few observers expect to see defaults. But rising borrowing costs alone could exact a toll on already tepid economic recoveries.

What's more, even deeper-pocketed issuers such as the U.S. and the U.K. could be paying much higher yields by next year, as they struggle with political squabbles about rising deficits fueled by a massive price tag for bailouts and stimulus.

"It all depends on growth," said Jan Randolph, director of sovereign risk analysis at forecasting firm IHS Global Insight. "Economic growth is the great redeemer in these sorts of situations, but it's not at all clear that we can count on seeing enough growth in a lot of the heavily indebted countries."

Borrowing costs have soared over the past two months in Greece, and this week the deficit hawks have swooped down on two other southern European nations, Portugal and Spain.

Interest-rate spreads between these countries' bonds and those issued by Germany have widened this year, hitting record levels in Greece.

The tremors come as officials in rich countries struggle with pressures once associated with so-called emerging markets: investors demanding that governments slash spending at a time of falling tax collections, soaring debts and, in many cases, growing public unrest.

The worries in Greece, Spain and Portugal stem in part from the benefits the southern European nations derived earlier this decade from using Europe's common currency, the euro.

Their ability to issue cheap debt, thanks to the euro's association with Germany's sound-money policies, allowed them to borrow more than they could afford and sparked a boom in consumer spending, Randolph said. This also helped the high-saving, export-oriented economies of Northern Europe, by creating a bigger market for their goods.

"In a sense, the euro worked too well," he said. "The benefits masked the fact that these countries were losing competitiveness in terms of labor costs, and now that gap can't be avoided."

In response, Greece recently promised to sharply cut its budget deficit, from a current level of 12.9% to 3% by 2012. Spain, already facing 19% unemployment after the collapse of a massive housing bubble, says it will cut spending by $70 billion over several years.

But given the scale of the problems and the massive borrowing needs of nations around the globe, it's little surprise that default fears have failed to go away.

"There's nothing so far to show they've fixed anything," said Tim Backshall, chief strategist for Credit Derivatives Research. "What we've seen is a dramatic selloff as investors start to adjust to the lower expectations for the euro area."

While Backshall said he believes most of the selling in government bond markets has come from so-called real money investors who hold securities for the long term, the past week has brought an uptick of traders playing what's known as sovereign risk.

"Many hedge funds have spotted an opportunity in government debt markets where public finances have been under great stress," Randolph wrote in a recent note to clients. This trade involves "shorting the weaker credits against the stronger, playing on market fears and heightened uncertainty, while making money in the ensuing volatility."

That said, he thinks uncertainty will have to get much greater before there is a real risk of default in Greece, let alone Portugal, Spain or fiscally challenged Ireland. (Those noting the debt worries refer to Portugal, Ireland, Greece and Spain as Europe's PIGS, and to that group plus Italy as the PIIGS.) Randolph notes that during the 1980s, Ireland's bonds traded at similar spreads to Greece's now, without any default.

What's more, any possible default would deal a blow to the credibility of the euro itself. Economists don't expect the European Central Bank to stand idly by while a monetary union that took years to assemble disintegrates.

"I believe the EU cannot let either Greece or Spain default, any more than Canada would allow one of its provinces to default," said Maurice Levi, a professor at the University of British Columbia in Vancouver.

But then, few in February 2008 would have predicted the scale of devastation in the financial sector before governments finally stepped in. And even if sovereign defaults still look like a long shot, higher rates and stability worries alone can do their damage when economies are in a weakened state.

That point was driven home Thursday by a stock market selloff led by banks. Spanish banks BBVA (BBVA) and Santander (STD) each plunged more than 9%. Falling spending and higher unemployment can wreak havoc on bank balance sheets, further impeding growth.

"The fundamentals in a lot of these places look pretty ugly," said Backshall. "There's a sense this probably isn't the end of this trade."