Moment of truth for euro zone as Spain and Italy teeter on edge


ANALYSIS:Ireland, Greece and Portugal just minnows in the overall scheme of European debt levels, writes DAN O'BRIENEconomics Editor

THE CRISIS in the euro zone has entered a new phase. Yesterday's relative calm on the markets notwithstanding, this phase increasingly looks like one in which fundamental change will be needed to save the euro.

Europe's piecemeal approach to resolving its sovereign debt crisis has never worked. Now it is patently failing. Bailouts for three of the weakest economies in the 17-member currency union did not boost confidence in those countries. In fact, the opposite occurred. Greece, Ireland and Portugal are now considered by financial markets to be much more likely to default than they were when first given their respective bailouts.

If the approach being taken by euro area governments could, until as recently as last week, have claimed a partial success it was that the big-but-weak economies - Spain and Italy - had not suffered contagion. But that has now changed. Yields on the government bonds of the two large Mediterranean countries rose sharply on Friday and Monday. It would take only three or four more days like those to push their yields above 7 per cent - the tipping point which saw Greece, Ireland and Portugal being bailed out within weeks of passing this threshold.

It could happen even more rapidly. There is a big difference between the two countries which have moved towards the brink over the past week and the three already rescued. The latter three are minnows: collectively they account for just 6 per cent of the euro zone economy. Spain and Italy combined make up well over a quarter of it.

When measured by the size of their debts, the size of the problem they pose is greater still. As of the end of last year, the 17 euro area governments combined owed €7,837 billion - mostly to their respective citizens. Italy and Spain account for almost one third of that gargantuan figure. Multibillion tranches of such vast amounts fall due for repayment on a weekly basis. According to Italy's treasury, it alone must raise €175 billion over the remainder of 2011 to pay back loans falling due. Large and frequent repayments make these countries highly vulnerable now that fear of default has spiked upwards.

With Spain and Italy potentially just weeks away from being unable to borrow, Europe may be facing its moment of truth.

But despite the rapidly rising risk of a severe deterioration in the crisis, policymakers continue to fall short in their response. While it is easy for high-perch observers and commentators to bewail the short-sightedness of those on the ground making the decisions and doing the deals, it is difficult not to see Monday's meeting of finance ministers in Brussels as the most serious failure yet to take proportionate action. As Spain and Italy edged towards the abyss, ministers spent most of the day talking about Greece.

The back and forth on how to reduce its debt burden has gone on for weeks, with the main actors constantly at loggerheads. In one corner, and led by Germany, is the northern bloc of fiscally strong countries whose populations rail at bailing out badly managed economies. They insist investors take the hit they deserve for their bad lending decisions. In the other corner is the European Central Bank (ECB), which opposes any action that forces those institutions and investors to take losses on their Greek bonds for fear that it would trigger an unstoppable panic in financial markets.

Each time the northern bloc has come up with a new idea to impose losses on bondholders, it has faced the same immovable ECB object. The bank's head, Jean Claude Trichet, has even gone as far as to threaten to allow the Greek banking system collapse if other countries organised any kind of default of the country's sovereign debt. Despite Frankfurt's implacability, Greek debt restructuring is back on the table.

The renewed focus on imposing losses on Greek debt undoubtedly contributed to sudden and large jump in yields on Italian and Spanish government bonds on Friday and Monday. But it was not the only reason.

Italy's always-in-flux multiparty coalition is suffering strains. The combination of unprecedented euro area contagion and in-fighting in Rome on how its budget deficit should be narrowed panicked the now hyper-alert financial market herd. Mercifully, the stampede which took place on either side of the weekend stopped yesterday. But a characteristic of this crisis has been that once levels of nervousness have been ratcheted up, they don't calm down again.

With stress tests on European banks to be published on Friday, another stampede could be on the cards within days. Spain, having suffered a huge property crash and now enduring a jobless rate in excess of 20 per cent, is still the weakest link. It has a suspiciously undamaged banking system.

Although, and when compared to Ireland, lending to developers for massively overpriced land was much more restrained in that country, there are real fears that the Spanish banking system has suffered considerably bigger losses than have been admitted to date. Any revelations on Friday that exceed expectations could do for Spain.

Given all the fragilities and the failure of efforts to resolve the crisis over 18 months, the moment of truth is potentially very close.

There are options which, if acted on, might address the underlying causes of the crisis. Crossing the default Rubicon with Greece could turn out to be "orderly", as its advocates suggest. If it did not trigger contagion, a significant write-down of Greece's debt burden - in any one of the number of ways mooted - would create a base upon which confidence could be rebuilt.

Another option is that the ECB could print money to buy government bonds. It did this in the wake of the first Greek crisis in May last year. It now holds €74 billion worth of bonds. But such a relatively small amount reflects the less than half-hearted approach with which the bank has exercised this power.

Given extreme German hostility to this form of monetary alchemy, and despite rumours yesterday that the ECB had bought Italian bonds, Frankfurt is not likely to ramp up its bond purchase programme.

But bond-buying does look to be back on the agenda in another form. The bailout fund established last year by the euro zone governments is likely to be tasked with buying up weak countries' bonds on the cheap (at its most simple, this would be akin to buying a friend's €100 euro IOU for €75 from its holder and giving the pal much longer to pay back the lesser amount).

This makes a lot of sense for the three small countries already bailed out because it lowers debt levels without triggering default. If it had been done sooner and with sufficient purpose, the crisis might not have reached the point it has now reached.

But there are limits to this approach if the crisis spreads. The European Financial Stability Fund has €440 billion at its disposal. It is already being tapped by Ireland and Portugal. If it was used to buy up significant amounts of Irish, Greek and Portuguese debt (of which there is more than €640 billion outstanding at face value), it would be in no position to bail anyone else out.

And that is the crux of the issue. Dealing with Greece, Ireland and Portugal is, and always has been, fiscally manageable for the other 14 euro area countries. Spain on its own would probably be doable. But Italy, with its mountain of debt heading toward €1,900 billion, is too big.

If these countries are unable to borrow, the only hope of preventing mass default would be for the euro zone to declare a fiscal union to back its monetary union. This would end contagion and do away with the weakest link problem. The euro area would be judged by those who lend to governments as a single entity. And because its aggregates - on debt, deficits and growth - are sound (and as good or better, for instance, than the US, which continues to borrow at ultra-low rates) the zone's sovereign debt crisis would almost certainly be ended at stroke.

That outcome would be unambiguously good. The same cannot be said for the political consequences. The euro zone would come to approximate a fully fledged state. Although a huge amount of detail would have to be worked out, fiscal union would almost certainly involve a euro zone finance minister and a permanent ceding of much sovereignty. This may be unpalatable. But if the crunch comes the choice is likely to be between this and an outcome which, at its worst, would be far greater than the recession suffered in recent years.


: On each maturing bond, big banks and insurance companies would invest 70 per cent again. The Greeks would receive 50 per cent, but they would have to pay significantly higher interest rates than today. 20 per cent would be reserved for a sort of guarantee fund, which invests in “AAA” bonds. 30-year bonds could not be traded for 10 years. Standard Poor’s says that the scheme would represent a Greek default.

DEBT SWAP:German finance minister Wolfgang Schäuble has proposed a one-off debt swap. Greece would, with technical support from the IMF, convert bonds into ones with seven years’ longer maturity. The plan faces resistance from the ECB.

BOND BUYBACK I:The rescue facility EFSF would lend money to Greece to buy back outstanding bonds at a discount. This would be a kind of voluntary debt reduction.

BOND BUYBACK II: This plan requires a change to EFSF rules. The fund would itself buy bonds on the secondary market. The EFSF could redeem the bonds later, without demanding the original value from Greece.

EURO BONDS: Ireland and Portugal have already received loans from the EFSF and Greece is expected to from 2012. If Italy also withdrew from the market, fewer countries would have to guarantee ever-increasing sums. That could lead to the introduction of a European debt agency, issuing common Eurobonds. These would mean a new level of EU co-operation and would increase the cost of borrowing for countries such as Germany.