ANALYSIS-Euro zone crisis redux? Not really
Friday September 17, 2010 08:30:10 AM GMT
By Paul Taylor
PARIS, Sept 16 (Reuters) - There are days when it looks like deja vu all over again for the euro zone.
But the debt crisis that shook the European single currency area in April and May, sparking panic on global financial markets, is unlikely to return with full force.
True, yield spreads between Greek, Portuguese and Irish bonds and benchmark German Bunds, and the cost of insuring those countries' debt against default, have returned to near the peaks they reached at the height of the crisis last April and May.
Concerns about spillover of bank liabilities onto government balance sheets, notably in Ireland, and a slowdown in economic recovery with a contraction in some peripheral euro area economies, are weighing on bonds and the euro.
But the creation of a financial safety net for the whole 16-nation euro zone in May after a IMF/euro zone bailout for Greece means there is no longer a fear of a systemic meltdown of the single European currency that existed earlier this year.
Investors now understand that there is a German chequebook underwriting the euro area, and that scalded governments across Europe are cutting their budget deficits and enacting long-resisted structural reforms.
"We have put out the main forest fire, but there are still some smaller fires around which could flare in a strong wind," said a European official, who spoke on condition of anonymity because he is in the thick of financial firefighting.
Prominent among those are revenue shortfalls in Greece and Portugal which raise doubts about their ability to meet deficit reduction targets this year, and huge unresolved bank liabilities in Ireland, officials and market participants say.
"We are still working our way through the last phase of the financial crisis and the sovereign debt crisis," said Marco Annunciata, chief economist at Italian bank UniCredit <CRDI.MI>. "There are similar concerns to what we faced in April and May, but nowhere near so serious because there has been the policy response of the EFSF and countries such as Spain have been courageous in taking structural reforms," he said.
UNCERTAINTIES ABOUND
Despite the creation of a 440 billion euro ($571 billion) European Financial Stability Facility (EFSF) as a backstop for any euro country which, like Greece, were shut out of credit markets, uncertainties still abound, making investors nervous.
The premium investors demand to hold 10-year Irish government bonds rather than German benchmarks remains near record highs at around 370 basis points and Portuguese spreads are only a little lower, while Greece faces a yawning premium above 900 basis points -- although it was even higher.
Of the so-called "peripherals", Spain seems to have re-established the most credibility. Its spread has narrowed significantly to around 175 basis points.
EU officials say Ireland and Portugal, the two states seen at greatest risk, are determined to avoid the political humiliation of going to the EFSF, which would impose draconian IMF-style austerity in exchange for loans on tough terms.
Ireland faces a possible final bill of more than 25 billion euros for sorting out nationalised failed bank Anglo Irish [ANGIB.UL], but the EU officials say Dublin is insisting it can borrow the funds it needs in the market.
The ever-rising Irish bill, and doubts about the reporting of sovereign debt exposure, have shaken investors' faith in July's EU-wide bank stress tests, which found that the 91 biggest EU banks needed only 3.5 billion euros in extra capital.
"There is still some residual uncertainty on how much more money will be needed to recapitalise the banking system. There's the risk of (public debt) restructuring in Greece, Portugal and Ireland," Annunciata said.
DOWNTURN
Fears of a lurch back towards recession in Europe have also fuelled a flight to safety among investors, as have doubts about the ability of governments to stick to austerity measures, pension and labour market reforms as they face public protests.
A startling rise in German GDP growth in the second quarter dragged the euro zone along with it but more recent data suggest much slower expansion in Europe's largest economy in the coming period, while its weaker peers still languish.
EU leaders have yet to agree on tougher sanctions for deficit sinners, let alone on more contentious German proposals for an orderly insolvency procedure for states, and low growth makes austerity even harder.
Moritz Kraemer, head of sovereign ratings at Standard and Poor's, noted that Portugal, Greece, Spain, Ireland and non-euro Britain were all on negative outlook, meaning there was historically a 1-in-3 chance of a further downgrade.
"We are certainly not in the situation of last April when sovereigns were being shut out of the market, but it takes time for governments to establish a track record of being willing and able to carry out the fiscal adjustment," Kraemer told Reuters.
The main shock to public sector debt would come from low economic growth, he said. "Consolidation is very hard if there's no real growth," he said.
It is also unclear whether European government debt is truly guaranteed against default, and for how long.
Despite Athens' vehement rejection of the notion, many economists believe Greece will eventually have to restructure its debt, projected to reach more than 140 percent of national output, and force creditors to take losses.
"Investors are confused. We were told initially there would be no bail-out. Then when markets started pricing in a default risk, we were told we should not be doing that because there is 'solidarity' in Europe," said Annunciata.
"No wonder markets are having difficulty repricing risk."
All those concerns suggest while the worst of the bloc's crisis has passed due to policy underpinning, investors still have numerous reasons to steer clear of its weaker members.
A senior interest-rate trader said the Greek crisis had severely curtailed institutional clients' risk appetite and this could limit demand for the bonds of Spain, Portugal, Ireland and even Italy, as well as Greece, over the next year.
The supply of government paper to refinance maturing debt and persistent high budget deficits could outstrip demand, creating significant tensions and high market volatility with possible contagion effects, he said. (Editing by Mike Peacock)
