Sept. 15 (Bloomberg) -- Europe’s economies are rebounding at different speeds, complicating the European Central Bank’s efforts to put the region back on a more stable footing.

Even as the global economy recovers and Germany and France return to growth, the European Commission yesterday cut its forecasts for Spain and Italy. Deutsche Bank AG says some of the economies that were once motors of growth and job creation across the 16-nation bloc may stay mired in recession next year.

The risk is that a recovery in the largest euro nations will prompt the ECB to tighten policy before smaller countries like Spain or Ireland are ready, hobbling economies already struggling with slumping house prices and surging unemployment. That will make it harder for governments and consumers to pay interest on their mounting debt, potentially pushing their borrowing costs higher.

“The ECB will have to normalize rates from next year and it will hurt countries like Spain and Ireland which will still be in recession and burdened by piles of debt,” said Gilles Moec, an economist at Deutsche Bank in London. He forecasts the ECB will double its benchmark interest rate, currently at a record low of 1 percent, by the end of 2010.

Spain and Ireland, whose households are already among the most indebted in the euro region, will contract 0.9 percent and 1.5 percent in 2010 and will also post the bloc’s biggest budget deficits, says the Organization for Economic Cooperation and Development. Germany and France will both expand 0.2 percent.

Bond Investors

The ZEW German investor confidence index, which aims to predict developments six months ahead, today rose to the highest level in more than three years. Euro region wage growth also accelerated more than expected in the second quarter, the European Union’s statistics office in Luxembourg said.

Diverging fortunes could prompt investors to demand more to hold the debt of weaker performers. While spreads have narrowed this year, the extra interest investors want to buy Spanish bonds rather than German equivalents is still five times what it was at the start of 2008. The Irish yield spread is 10 times what it was two years ago.

“The ones that were swimming naked will be seen to have been swimming naked,” said Alex Allen, chief investment officer at London-based Eddington Capital Management Ltd., a fund of hedge funds, which manages about $155 million. He’s shunning the bonds of countries such as Spain, Greece and Portugal, partly because they will “have worse GDP figures and their spreads will widen back out.”

Increase Bets

ECB President Jean-Claude Trichet said this month that the euro region as a whole is probably pulling out of the worst recession in its history. Some companies are also sounding more optimistic, with ASML Holding NV, Europe’s largest maker of semiconductor equipment, on Sept. 10 raising its sales forecast. ThyssenKrupp AG, Germany’s largest steelmaker, said last month sales volumes for some products have bottomed.

Economists are starting to increase bets that the ECB will raise rates and withdraw emergency measures next year to head off the risk of inflation or further asset bubbles down the line. While Trichet isn’t signaling he’s willing to tighten policy just yet, Banc of America-Merrill Lynch and Morgan Stanley say the bank will start increasing its benchmark as early as June.

ECB Executive Board member Juergen Stark on Sept. 4 outlined some of the mechanisms by which the central bank would withdraw stimulus if necessary. A day earlier, Trichet said it would be taken back “in a timely fashion” when needed.

Closer Examination

Central bank officials, who say they look at the euro region as a whole rather than setting policy for individual countries, may nevertheless have to examine national economies more closely this time before raising rates.

Spain and Ireland are suffering the collapse of decade-long economic booms that marked them out from the rest of the euro region. Unemployment in Spain, which at its peak created half the new jobs in the euro region, is heading for 20 percent. The Irish government will tomorrow announce the details of a so- called bad bank set up to clean up 90 billion euros of loans that went bad during the country’s housing bust.

“The more economic divergence of economic conditions we have, the more problematic it will be for the ECB to pull the plug on the liquidity injections,” said Laurent Bilke, an economist at Nomura International in London.

Consumer Debt

Government and consumer debt in some economies may also prompt some ECB officials to think about the lopsided impact of rate increases. Consumer debt in Ireland and Spain is more than 80 percent of GDP, compared with 59 percent in Germany and 49 percent in France, according to Societe Generale.

“Anything above 80 percent rings alarm bells,” says Societe Generale’s European Chief Economist James Nixon.

Gaping deficits will provide further problems. Jose Luis Rodriguez Zapatero’s government, struggling in the opinion polls, is raising taxes to cut its deficit from 10 percent this year to 3 percent in 2012.

In Spain, “fiscal consolidation will delay the recovery,” Deutsche Bank said in a note published Sept. 11. In Ireland, taxes have already risen and Greek Prime Minister Kostas Karamanlis, campaigning for a third term, has called for spending cuts.

That all suggests that the decline in Spanish and Irish bond spreads reflect the upswing in market sentiment rather than improved prospects for Europe’s worst performing economies.

“Right now all valuations are being very, very skewed by the tone in risk markets,” said Vishal Pathak, an interest-rate strategist at BNP Paribas in London. “The real economy is having little bearing right now on the valuation of spreads.”

To contact the reporter on this story: Emma Ross-Thomas in Madrid at erossthomas@bloomberg.netGabi Thesing in Frankfurt at gthesing@bloomberg.net

Last Updated: September 15, 2009 10:00 EDT