Pimco’s El-Erian Says Public Finance Shock May Deepen (Update3) - Bloomberg.com

March 11 (Bloomberg) -- Mohamed A. El-Erian , whose company runs the world’s biggest mutual fund, said deteriorating public finances may affect the global economy more than is currently realized.

Governments may have to raise Taxes and slash spending to cope with swelling deficits after borrowing unprecedented amounts to stave off the global financial crisis, said El-Erian, 51, who shares his job title with Bill Gross . A failure to carry out fiscal measures in time would raise the possibility of governments seeking to eliminate excessive debt through inflation or default, he said.

Pimco has said debt strains in Greece, Portugal and Spain underscore its view that 2010 will be a year of slower-than- average growth, and predicts there will be a shrinking global role for the U.S. economy.

Shunning Spain

Investors should avoid Spain’s bonds as the Euro region’s highest levels of joblessness stifle the Country’s ability to cut its budget deficit, according to Invesco Ltd. and Bank of America Corp.’s Merrill Lynch unit.

Spanish debt isn’t yielding enough to compensate Investors for buying the bonds of a Country with the Euro region’s third- largest budget deficit, according to Axel Blase , a fund manager in Frankfurt who helps oversee Invesco’s $423 billion in assets. Investors receive a 70 basis-point yield premium for holding Spanish 10-year bonds rather than German bunds, compared with 310 basis points for Greek debt .

While attention focused initially on Greece, Spain may take years to recover from the recession, according to Johan Jooste , a strategist at Merrill Lynch Wealth Management in London.

“It’s going to take a very long time -- half a generation -- for them to fix the structural issues they have,” Jooste said. “Rather than a spectacular Short-term blow up, a more likely outcome is a death-by-a-thousand-cuts-type scenario.”

Greece’s Struggle

Greece, which had the European Union’s widest budget deficit at 12.7 percent of output last year, has struggled to convince investors it can bring the Shortfall within the bloc’s limit of 3 percent. The government last week announced spending cuts and Tax increases totaling 4.8 billion Euros ($6.55 billion), the third round of austerity measures this year.

The worst of Greece ’s financial crisis is over and other European nations won’t follow in its path, former European Commission President Romano Prodi said.

“For Greece, the problem is completely over,” said Prodi, who was also Italian prime minister, in an interview in Shanghai yesterday. “I don’t think there is any reason to think the euro system will collapse or will suffer greatly because of Greece.”

The euro has weakened 4.7 percent against the dollar this year as Greece’s struggle to rein in its budget deficit eroded confidence in the European currency.

French President Nicolas Sarkozy said March 7 the 16-nation euro region must support Greece, which has more than 20 billion euros of debt maturing in April and May, or risk destroying the currency. German Chancellor Angela Merkel has so far refused to give the green light to any aid package.

‘Less Levered’

Gross advised investors in a commentary published in January to seek investments in “less levered” Countries such as China, India and Brazil whose economies are not as prone to “bubbling.” He called the U.K. “a must to avoid,” while recommending Germany and Canada.

The increasing debt burdens of countries including the U.S. mean many nations classified as advanced economies now may have weaker prospects than emerging economies, El-Erian wrote in Financial Times’ article.

“Countries will thus be forced to make difficult decisions relating to higher Taxation and lower spending,” El-Erian said. “If these do not materialize on a timely basis, the universe of likely outcomes will expand to include inflating out of excessive debt and, in the extreme, default and confiscation.”

Sales Tax

Japan’s Finance Minister Naoto Kan last month said the government will start debate on overhauling the Sales Tax in March to help repair the country’s finances.

President Barack Obama on Feb. 12 signed a bill into law that raised the federal debt limit by $1.9 trillion to $14.3 trillion and placed new curbs on spending in an attempt to prevent this year’s record deficit from becoming worse.

Gross’s $214 billion Total Return Fund handed investors an 18 percent gain in the past year, beating 53 percent of its competitors, according to data compiled by Bloomberg.

The company, based in Newport Beach, California, had $1 trillion in assets under management as of Dec. 31. It is a unit of Munich-based insurer Allianz SE.

To contact the reporter on this story: Garfield Reynolds in Sydney at greynolds1@bloomberg.net .