Last rites for the euro?

"We know now what €100bn buys you these days," as Larry Elliott puts it in The Guardian. A relief rally "that lasts a morning". Last weekend, Ireland bowed to pressure from the rest of Europe and requested financial support from the European Union and the International Monetary Fund. With the threat of a run on its ruined banking sector growing by the day, the country had little choice. Ireland will be offered around €85bn, with Britain chipping in as much as £10bn.

The money will be used to fund the government deficit, and also to recapitalise the banks. The deal was meant to draw a line; it was supposed to prop up confidence in Ireland's finances, and stop the fear from spreading to other countries in the eurozone periphery (those rudely dubbed the PIIGS). But after the briefest of rallies, the euro resumed its fall and yields on Spanish and Portuguese debt in particular continued to climb.

Part of the problem is political. The aid package depends on the Irish government passing a budget, involving €15bn in further tax hikes and spending cuts over four years, in early December. But the government is close to collapse. If depositors and investors "start to doubt that the bail-out is definitely on the way", as Peter Thal Larsen points out on Breakingviews.com, "the crisis could quickly escalate".

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But more to the point, no one is really convinced that Ireland can pay back all of its debts, even with the latest aid package. This four-year fiscal squeeze amounts to around 10% of GDP, and aims to keep the debt burden from spiraling out of control. Yet it could get even worse. According to Capital Economics, there may need to be a further 10% of GDP's worth of tightening as the Irish government's growth forecasts are "far too optimistic".

See also:

• How to protect your wealth from the euro crisis
• Opinion: Britain should push for the break-up of the euro

The fact is that, for both Ireland and Greece (the eurozone's first casualty), says Bill Emmott in The Times, "only miraculously rapid economic growth will enable them to reduce their public debts, avoid drastic increases in their debt-servicing costs and dig themselves out of the holes into which they have fallen". Unfortunately, miracles are not "dependable tools of public policy". So the bail-outs have merely deferred rather than solved the countries' problems. "Some sort of debtrestructuring" a polite term for default to lower the debt burdens is likely eventually. And Ireland won't be the only one below, James Ferguson of Arbuthnot Securities looks at which other countries are in the firing line.

Spain the next domino to fall?

James Ferguson

Ireland and Greece are just the first euro dominoes to topple. Next on everyone's list, at least according to the cost of insuring against a bust using credit default swaps (CDS), is Portugal (see chart on the right). A bail-out for Portugal is still manageable. After all, the €750bn in rescue facilities available to the EU should be able to comfortably cover the debts coming due for renewal, as well as any additional funds required, from all three countries.

The problem is and always has been that Greece, Ireland and Portugal are merely an amuse bouche for the EU to blow the budget on, before we come to the entre (Spain) and the main course (Italy). Spain may be too big to fail, but it may also prove too big to save. Italy almost certainly would be. By many measures, including population, Spain is ten times the size of Ireland. It is also dogged by a 20% unemployment rate (more like 40% for the under-25s), questionable national statistics and fractious political relations between the federal government and the provinces.

Also, Spanish banks have the largest exposure to the Portuguese banking system. Portuguese banks are not yet quite as badly affected as in Ireland, but they're not far off. Although Portugal has so far avoided a property crash, the economy is plagued by poor demographics and one of the largest private-sector debt to GDP ratios of any country. The economy only grew on average by 0.4% a year over the last eight years.

No boom for Portugal has meant no bust. But dismal productivity growth has also meant that living standards have failed to catch up with the rest of Europe. With government debt estimated to hit 82% of GDP for 2010, a private-sector debt load among the biggest in the world, and an inability to generate productivity growth, it's perhaps no surprise that the two main Portuguese banks' senior five-year credit default swaps (CDS) have also soared.

The problem for Spanish banks is that, apart from all the problems they have with potential bad loans at home, they are more exposed to Portuguese debt than anyone else. If unsecured bondholders and other lenders to Portugal are to take a haircut, as the German chancellor, Angela Merkel, is increasingly insistent they should, Spanish banks would take an immediate hit. That could force the Spanish government to bail them out.

But that might not be possible. Spanish debt was only 36% of GDP back in 2007. But since then it has rocketed. It was 53% by the end of last year, and with the deficit not far off 10%, will be well above 60% by the end of this year. So chances are that Spain, like Ireland, could not afford to support its own banks in a Portuguese-led crisis, let alone its own, albeit slower burning, domestic one. Hardly surprising, therefore, that Spanish five-year CDS jumped to a new high after the Irish bail-out news over the weekend as the dominoes continue to fall.

Can this rot be stopped?

So far the EU is trying to prevent peripheral countries from defaulting by simply lending these countries the money. But it's obvious to markets that the heavily indebted countries which are now borrowing off emergency facilities, rather than the private sector, remain just as heavily indebted. The EU is solving a liquidity crisis, when what it is facing is a solvency crisis. If this sounds all too familiar to you, then it should.

Since the summer of 2007, but especially since the Lehman Brothers' collapse in September 2008, Western central bankers have been stepping in with 'temporary' liquidity for banks that had previously relied on wholesale interbank funding from the market. By October 2008 the sharper central bankers, such as our own Mervyn King, started to realise that the banks didn't just face a shortage of liquidity. The real problem was that they faced a shortage of liquidity brought about by lenders to the banks perceiving there was a shortage of capital. Central banks couldn't withdraw their support, because that would result in another crisis. Instead, they've been forced to pressurise the banks into gradually shrinking lending until bank deposits alone can cover the loan balance.

Something very similar now blights the PIIGS. Solving the near-term liquidity requirements of insolvent states doesn't make them any more solvent. Pushing dust under the carpet isn't the same as clearing it up. Overly indebted countries still need to cut spending to sustainable levels, just as their banking systems need to recapitalise while realising hidden legacy losses. If these goals aren't met, the dominoes will keep falling right across Europe. The problem is, as Julian Pendock of Senhouse Capital points out below, that the politics of the situation may make it impossible to achieve these aims without a serious crisis in the euro first.

Can the euro survive?

Julian Pendock

Eurosceptics point, correctly, to the fact that "one size does not fit all" when it comes to interest rates. These were set by the European Central Bank (ECB) for the benefit of low-inflation Germany, which in the early days of the euro was going through its own deflationary restructuring process. While rates of 3% might have suited the Germans, they were woefully low for the periphery countries in fact, in many cases rates were negative after taking local inflation into account. For example, Spanish interest rates fell from 12.7% in 1993 to 3.0% in 2005, while Ireland's fell from 10.5% in 1993 to 3.0% in 2005. This was known as the "convergence trade", as interest rates converged with those on German bunds.

Ireland, with its low corporation tax rate of 12.5% and an English-speaking workforce, boomed in the 1990s with good reason. But fuelled by low interest rates, housing turned into a bubble. Irish banks' assets peaked at an amazing 629% of Irish GDP in 2008. You cannot solely blame the euro for this and other countries' problems. I lived and worked through the Asian crisis; poor banking regulation and overexuberant lending in those countries was down to extravagance, lax regulation and crony capitalism.

However, while many have accused peripheral countries of some or all of these lapses, the euro made all these failings worse through its flawed structure a single interest rate for all, and no mechanism for supporting ailing members via fiscal transfers from other member states (unlike in the US). This is where the whole story becomes ironic. The euro was designed like this with no bail-out mechanism and no exit route so as to keep countries on the 'straight and narrow'. The situation that these countries find themselves in was designed to be ruinous in order to prevent them falling into it in the first place!

If they can't devalue their way out of trouble, the only path open to the troubled countries is a painful internal devaluation. This is where economics meets politics, which investors ignore at their peril. First of all, there is the issue of "bail-out fatigue". The German chancellor, Angela Merkel, should be riding high in the polls. Germany's economy has fared remarkably well as their supply-side reforms have paid off handsomely. Secondly, the euro is much weaker than a stand-alone deutschmark would be, to the great benefit of Germany's mighty exporters. However, Merkel's CDU party is suffering in the polls as German citizens, already exhausted from bailing out east Germany, are livid at having to bail out Greece, where the retirement age is considerably lower than that in Germany.

Yet a more immediate worry is 'austerity fatigue'. Austerity is not a one-shot deal, but a long, drawn-out process. The danger is that after several rounds of cuts, and with no light at the end of the tunnel, opposition politicians have an easy sell to weary and dispirited nations. They can argue that the country is spending more on servicing debt owned largely by foreigners than the countries are spending on education and health services.

In Ireland, the Greens have already left the coalition and are calling for a fresh general election. The EU believes this is not "particularly helpful". But the EU's attempt to prevent sovereign nations from having general elections is understandably being met with incredulity. An early insight into the political mood music can be gleaned from the fact that, according to professor Morgan Kelly at University College Dublin, the ECB oversight team in Dublin is known locally as "The Germans". Hence the paradox is that the nations funding the bail-outs, in order to sell the bail-outs to their own voters, may impose austerity terms that are too onerous for recipient nations to stomach politically. Certainly, there is a growing feeling that Ireland should have let its banks fail. In Portugal, a general strike suggests the same dynamics are emerging.

One must not forget what is at stake. French and German banks' exposure to PIIGS amount to €493bn and €463bn respectively, according to figures from the Bank for International Settlements. So it is in neither of those countries' interests to allow the PIIGS to leave the euro. For the time being, the direct costs of a bail-out (€170bn, assuming write-offs of 8% of periphery GDP), are less than those of breaking up the euro, given this massive exposure that the northern European banks have to the PIIGS. But should Spain be targeted next by bond vigilantes, all bets are off. The EU will not have the financial wherewithal to contain the crisis, the IMF would have to be called in, and the future of the EU in its current guise would be in doubt.