The euro plunged further into crisis yesterday as investors sold off Spanish, Portuguese and Belgian government bonds in record numbers on renewed fears that those nations would follow Greece and Ireland into the financial emergency ward, undermining confidence in the single currency.
The spreading contagion suggests that the markets now view the break-up of the euro as a realistic possibility, and that "shock and awe" efforts to shore up individual economies with huge bailouts have not succeeded in insulating their neighbours from infection. Spain, in particular, is regarded as being "too big to save". Should Spain eventually need assistance it would also imply a much larger UK bilateral loan than the £8bn offered to Ireland – perhaps £20bn or £30bn.
The extra "risk premium" demanded by investors to hold Spanish government debt hit new highs during trading yesterday, and the cost to Madrid of raising money over a three-month period is the same as that demanded from the German government over a five-year term, reflecting an extreme level of nervousness about the Spanish state's ability to repay its debts. The looming possibility of Spanish insolvency would dwarf the problems of Greece, Ireland and Portugal combined.
There were also what analysts called "clear signs of stress" across the European financial system, as banks were forced to turn to the European Central Bank for emergency funding. The ECB has so far lent some €531bn (£449bn) to European financial institutions at ultra-cheap rates of interest, effectively a life support system that the ECB president Jean-Claude Trichet believes is unsustainable. As so many nations' banking systems are state-guaranteed or nationalised, this also adds to the pressure on governments across the EU to find a more permanent solution to the crisis.
Slovakia's Finance Minister, Ivan Miklos, yesterday become the latest European figure to question the euro's long-term survival, saying that "the risk of a eurozone break-up is very real". Slovakia joined the single currency last year. On Tuesday, the German Chancellor, Angela Merkel, reflected the deep anxiety felt in Germany about events when she commented that the euro was in an "exceptionally serious" position. Herman Van Rompuy said last week that the European Union itself was in a "survival crisis". Or, as Chancellor Merkel has put it: "If the euro fails, Europe fails." A poll of economists conducted by Reuters revealed that an overwhelming majority expect a bailout next for Portugal.
But it is Spain that offers the single greatest challenge to the future of the euro. Many fear that even the resources of the €750bn European Financial Stability Facility, the vehicle for the current round of bailouts, will be insufficient to stem the tsunami of money flowing out of these stricken countries. So far the bailouts of €110bn and €80-€90bn for Greece and Ireland respectively have been big enough to meet their financing needs for the next two to three years. But such an exercise for Spain would mean finding a "whopping" €420bn, say analysts at Capital Economics. It could be more, however; Spain's banking system, hit hard by the bursting of a property bubble, has liabilities of €3,464bn, compared with €1,658bn in Ireland.
Jennifer McKeown, a senior European economist, added: "Such concerns are understandable, given Spain's resemblance to Ireland. Public borrowing there surged during the recession after a property-fuelled boom. Its banks are fragile and sky-high unemployment and falling house prices point to a risk of further huge defaults on domestic loans. Meanwhile, Spain's weak competitive position leaves little scope for it to export its way out of the economic gloom."
With Belgium shaping up as the next "domino" to fall, the contagion of the euro crisis has spread from the peripheral and southern nations for the first time to a northern economy at the heart of the European Union.
Q&A: How did it come to this – and what happens next?
Q: Why is the euro threatened?
A: Because it is still politically feasible for members of the single currency to drop out of it – especially if exiting is a less painful solution to their problems. Or the only possible solution. No one could foresee South Wales or West Virginia opting out of the pound or the dollar, even if having their own money might help them sell their products outside their "borders".
Q: So why don't the Greeks, the Irish and others just leave the euro now?
A: It is not a painless solution. If they adopt a "new drachma" or "new punt" their overseas debts, many denominated in euros, will automatically be revalued upwards, making them even more difficult to pay off. People's savings would be devalued and devastated. In those circumstances a national default would become a reality in Europe, something hitherto confined to Africa, Latin America and Russia. It would be humiliating, make borrowing very expensive, and might be even worse than defaulting within the euro.
Q: Why is that option not mentioned?
A: Because it would suggest any member state could run up unsupportable debts without restraint, and would thus drive down the integrity and value of the euro for its existing members. Borrowing costs throughout the zone would probably rise, and a domino effect would leave virtually every nation vulnerable to further market attacks, once the precedent had been set. Still, it might be a least-worst option.
Q: What is "contagion"?
A: Mainly precedent; once one nation has been bailed out, the hunt is on for "who's next?" Hence the domino effect. Europe's banks are closely related, operating across borders – think of the Spanish Banco Santander's ownership of Alliance & Leicester, Bradford & Bingley and Abbey in the UK, or the Royal Bank of Scotland's Ulster Bank subsidiary lending in Ireland. They all lend to each other, so if one set of banks encounters trouble it spreads. EU member states are usually each others' largest trading and investment partners; if one suffers they all do.
Q: Any other threats?
A: The Germans. So far their commitment to the European project has outweighed their devotion to sound money, low inflation and fiscal rectitude. However, if their "loans" to Ireland, Greece and the others may turn out to be "gifts", they could be faced with a tough choice. When the euro was launched the Germans were reassured by the "Maastricht Criteria", enshrined in Treaty form, that limited national borrowings and debt levels. Such constraints are now trashed. Besides, Germany's pockets are not bottomless.
Q: Haven't we forgotten somebody?
A: Yes, Jean-Claude Trichet, president of the European Central Bank. He has been keeping the Irish, Spanish and Portuguese banks alive for months by lending them cheap money ("liquidity"). The ECB has also bought Irish government bonds. Mr Trichet made little secret of his desire to bring this artificial system to an end. Even if he wanted it to go on, it couldn't: the euro would be sold off massively if the central bank tried to print trillions of euros to pay off bank and national debts. Knowledge of the ECB's desire to switch off the life support system didn't help the Irish banks' chances of survival.
Q: Can't the bailout fund pay for all the problems?
A: No. large as it is, most observers say that Spain's difficulties would probably overwhelm the €750bn European Financial Stabilisation Fund, and Italy would certainly be far too big to save. The EFSF is becoming stretched. After the Greek crisis earlier this year it was set up to be a "shock and awe" deterrent that, like nuclear weaponry, was so terrifying to the markets that it would never be used. As we see, the market is capable of outgunning even those potent munitions. In this case the IMF would have to stump up funding, and it would be taken out of the hands of the eurozone. Thus even the EU itself could lose its sovereignty to a body underwritten by the US. The French would find that fate unacceptable.
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