Europe's rocky road out of crisis

The emergency is over. At least, that's how the European Central Bank (ECB) sees it. While the Bank of England has so far refused to raise Britain's key interest rate from its current historic low of 0.5%, the ECB has decided that crisis-era interest rates are no longer necessary. Last week it raised its official interest rate for the first time since 2008 from 1% to 1.25%, citing inflation concerns.

But in the same week, we had other big news from across the Channel. On the edge of the eurozone, Portugal was finally raising the white flag. In order to keep paying its bills, it was forced to follow in the footsteps of Greece and Ireland, and ask the European Union for a bail-out that could reach as much as €80bn.

So why raise rates while whole countries are going bust? This throws up lots of questions. Are the likes of Portugal, along with Ireland and Greece, now being thrown to the market's wolf pack? Who will be next, how will it all play out and where will it leave investors?

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Why the interest-rate hike matters

At first glance, that ECB rate hike doesn't sound dramatic. For most of us, borrowing money at just 1.25% would be no great hardship. But the move is less about the size of the increase than the signal it sends to the markets. When the Great Recession began in 2008, official eurozone interest rates were slashed from 4.25% to 1%. They've been there at by far their lowest point since the euro was launched for two years.

Now, though, the ECB is saying that even if other central banks around the world are blas about rising prices, it's not. Eurozone inflation hit 2.6% last month, compared with the medium-term target of just below 2%. As the ECB seems to be almost the only major central bank in the world that worries about the value of its currency, a rate rise the classic response makes a lot of sense.

In addition, the eurozone central bank is making it very clear that what happens in Germany still matters more than what happens in the rest of Europe. The German economy is rolling along very nicely. February's industrial production grew by an impressive 1.6% compared with January's figure, which in turn was revised up. Both were much better than expected. In fact, the country's annual industrial production growth rate has reached a stunning record high of 14.8%.

But there's also some less positive news. German inflation at 2.1% is at a two-year high. That's making the ECB nervous. "After a decade of considerable restraint on the labour market front, German trade unions have launched a campaign for wage rises of up to 7%," says David Marsh in Financial News, "sparking claims from employers' organisations that [the unions] are living in cloud-cuckoo land."

So are more rate hikes in the pipeline? For now the central bank is hedging its bets on how much higher and how fast it will lift interest rates. Morgan Stanley reckons official rates will hit 2% by next spring, while Wolfgang Munchau in the Financial Times expects the ECB's key rate to reach 3% by 2013.

The pain in the periphery

Maybe they're right. But as Ben May at Capital Economics comments, "so far a strong Germany has done little to help the eurozone's periphery". And it's here that the financial strains are really showing.

One of the key commitments for a country joining the eurozone club is to sign up to the Maastricht Treaty. This covers among other things targets for budget deficits (the gap between state spending and the tax take) and national debt levels (how much countries owe). One of the Treaty's key pillars is that a eurozone member's national debt should be no more than 60% of its GDP. As the chart below shows, not only has this rule been flouted by a number of eurozone countries, but it's been happening rapidly too.

The most recent casualty is Portugal. It may not look as bad as other countries historically, but now it's run out of cash. The minority government resigned last month after parliament threw out its latest austerity plan. That led to several downgrades of the country's sovereign debt by credit-ratings agencies. Meanwhile, the yield on its bonds has been climbing steadily as investors have demanded ever-higher returns to compensate for the risk of buying them.

With Portugal needing to repay €4.23bn of borrowings this month but having only e4bn in cash reserves, a bail-out became a real necessity. Now the country's politicians are wrangling with each other ahead of a general election in June, while "officials from the European Commission, ECB and International Monetary Fund (IMF) will pore over Portugal's public accounts to decide on extra austerity measures they deem necessary for Lisbon to reduce its budget deficit in return for a three-year loan", reports Reuters.

In short, it's a right old mess and follows the earlier bail-outs of both Ireland and Greece. In Ireland, after the country's property bubble burst, the banks effectively went bust. When the state tried to stand behind them, it found the losses too huge to handle. Greece's problem was more straightforward it was simply spending too much and collecting too little tax. As the chart below shows, this has driven sovereign debt yields of all three to levels they can't have imagined in their worst nightmares.

A stronger euro could hurt

The ECB rate rise is unwelcome news, for two reasons. First, it's pushing up the value of the euro. Even a gradual series of rate hikes is likely to lift the near-term value of the single currency even further. That will make life still tougher for Portuguese, Greek and Irish exporters as they struggle to sell their goods in global export markets particularly as they're also up against competition from the powerhouse that is Germany. Yet without growth from this source, they'll find it even harder to grow their economies quickly enough to service their debts. That makes it all the more likely that they'll have to restructure their debts at some point in the future.

We'll get onto that in a moment. But the second point is that this isn't just about state borrowing. Eurozone peripheral countries also have plenty of debt-laden households who are struggling with their interest bills. Higher ECB rates are likely to be more than passed on by banks whose own finances are in a mess. This could push many of these households over the edge. That could lead to a wave of property repossessions, forced selling and tumbling property prices, which could turn into a vicious spiral. Very nasty.

What about Portugal?

But won't the Portuguese bail-out buy a bit of breathing space from the bond market? Sadly, no. Bail-outs don't make major over-indebtedness issues go away, they simply switch the problem from one set of creditors to another. If your debts equal your income, then paying upwards of 8% to borrow when your income isn't growing can't be done for too long.

Neel Kashkari of Pimco, which manages the world's biggest bond fund, is a former head of the US Troubled Asset Relief Programme (TARP), which helped stabilise the US banking system. He's very jittery about peripheral eurozone countries' debt. "The biggest systemic risk facing our financial system and the economy is runaway deficits and out-of-control spending," he tells Bloomberg. "Greece, Ireland and Portugal have more debt than their economies can afford." So "it's likely they'll restructure" bond-market-speak for repaying only part of their liabilities "or default".

The big question, says Kashkari, "is how do you do that in an orderly manner without causing chaos, and contagion to Spain and other countries?"

Spain the next domino

Spain is precisely what the euro-bears are most worried about right now. Spain's property bubble was as extreme as anyone's. House prices in real ie, inflation-adjusted terms rose by 106% between the start of European monetary union in 2000 and the 2007 peak. So far prices have fallen much less than in Ireland or indeed in the US. They had officially dropped by just 18% as of end-2010.

But in supply terms, Spain is similar to the US. With around a million vacant houses (per head, that's three times as many as the US), the country's property market will suffer from oversupply for years. That's likely to mean much bigger price falls on the way. Indeed, says Wolfgang Munchau in the FT, "I've yet to hear an intelligent reason why Spanish real house prices should be any higher today than they were ten years ago. So I'd expect all of that [106%] increase to be reversed."

The effect would be devastating. A toxic mix of falling house prices and rising mortgage payments (due to that ECB rate rise) would drive up the number of foreclosures. In turn that would undermine the balance sheets of the cajas, Spain's savings banks. They could need bailing out to the tune of as much as e100bn, according to some estimates.

Sure, Spain would still be technically solvent. Its public-sector debt to GDP ratio is only' forecast to climb to 72% by 2015, according to the latest forecast by Ernst & Young. That's still below the ratio levels of core eurozone members Germany and France. But as with other struggling eurozone countries public debt isn't the only problem. Spain's private debt/GDP ratio is already 170%. That's much worse than the UK or the US. And "the country's net international investment position the difference between external financial assets and external liabilities was minus e926bn at end-2010, almost 90% of GDP", says Munchau. As Spaniards have to borrow more, "the mix of high external indebtedness, fragility of the financial sector and the probability of further asset-price declines increase the probability of a funding squeeze", he continues. In other words, any fresh shock could scare investors into pushing up Spain's borrowing costs. "That means Spain will be the next country to seek assistance from the EU and IMF."

And after Spain?

Worse, debt contagion fears are unlikely to stop here. This could be "the calm before the storm", says Neil Shearing of Capital Economics. "Financial markets elsewhere in the region are vulnerable to an escalation of the euro-crisis." Belgium, for example, has strong links to emerging Europe (particularly the Czech Republic). And "attention will focus on Romania" with its "fractious political backdrop" and Hungary, where "the fiscal outlook has actually worsened considerably".

Here's the rub. The total exposure of foreign banks to Greece, Ireland, Portugal and Spain tops $2.5trn (£1.6 trn) once all forms of risk are included, according to the latest data from the Bank for International Settlements. Widespread bond restructuring' or, even worse, defaults, on the eurozone periphery, "could restart a banking crisis", says Ronald McKinnon at Stanford University.

We're getting into scary territory here. And all this could take many months to unfold. But at the very least, both stockmarkets and the euro could become highly volatile and that will throw up opportunities for sharp-eyed investors.