Financial Regulatory Forum

ANALYSIS-Whatever happened to the euro zone crisis?

By Reuters Staff
August 9, 2010

By Paul Taylor

PARIS, Aug 9 (Reuters) – What a difference a few weeks make.

In early June, doomsayers were predicting the demise of the euro after a 110 billion euro ($145.2 billion) bailout for Greece and a $1 trillion financial safety net for the rest of the 16-nation single currency area failed to calm market panic.

European banks were hardly lending to each other, the euro had hit a four-year low against the dollar, and there was widespread talk that Greece would have to default on its debt.

“We are assigning a higher and higher probability to a break-up of the euro zone,” Gina Sanchez, director of equity and asset allocation strategy at Roubini Global Economics told a Reuters Summit on June 8.

“I don’t want to overstate that. It’s not our base case, which is they muddle through,” she said.

Among the grounds she cited for a possible collapse were a lack of political will to cut budget deficits and Germany’s reluctance to foot the bill for rescue packages.

Just two months later, the euro zone’s crisis has eased and there are signs of a return of investor confidence.

The euro has gained 10 percent against the dollar, economic recovery in the euro area is more robust than forecast although uneven, European stocks outperformed the S&P500 index of leading U.S. shares in July, and interbank lending has thawed following the publication of stress test results on European banks.

A healthy crop of first half corporate earnings, including at major euro zone banks, and a positive report card on Greece from the International Monetary Fund and the European Commission have fuelled a more optimistic mood.

The risk premium investors charge to hold the debt of peripheral euro zone states such as Spain, Portugal, Italy and Ireland has shrunk to the lowest levels since April. Spain’s borrowing costs tumbled in a 3-year bond auction last week and the cost of insuring Spanish and Portuguese debt against default has also tumbled on the Credit Default Swaps market.

Stress tests on European banks, scorned by many analysts as too soft when only 7 banks out of 91 failed, largely did the trick by providing detailed data to show most were in reasonable health and could withstand the main sovereign risks.

The European Central Bank has almost stopped purchasing euro zone weaklings’ government bonds, an emergency measure initiated to stabilise the bond market at the peak of the crisis in May.

RISKS EXAGGERATED?

The speed of the reversal in sentiment raises the question of whether risks of a euro zone break-up and a rolling government debt crisis were exaggerated from the start.

Undoubtedly, the euro jitters were amplified by enduring hostility to the single currency project in London — Europe’s biggest financial centre — and scepticism in the United States.

Unnerved by the European Union’s fractious and convoluted policy process and by domestic resistance in Germany, markets underestimated the political will of core governments to do whatever it took to stabilise the euro area.

They also seemed to grossly overdo the financial and political fragility of Spain, which was briefly seen as the next Greece and the straw that could break the euro zone’s back.

So has the crisis gone away or is it just taking a summer siesta?

ECB President Jean-Claude Trichet was rightly cautious when he said last week: “I do not declare victory.” Money markets are improving but have not yet returned to normal, he noted.

Smaller banks, notably in southern Europe, are still shut out of interbank lending as counterparties doubt their solvency.

Many other risks remain, including the possibility that as market pressure eases, governments may step back from painful but necessary bank restructuring, budget cuts and long-term economic reforms due to political and social opposition.

It will take years of unpopular cost-cutting reforms of pensions, labour markets, welfare benefits and the public sector to reduce bloated budget deficits and national debt piles.

Despite its impressive progress report, Greece may yet have to restructure its massive debt, forcing bond holders to take a “haircut”, many analysts believe, although this process could be postponed for 3 to 5 years due to the EU/IMF bailout.

The euro zone economic recovery is likely to slow as austerity measures curb public and private demand, making it harder to reduce unemployment.

Money market rates may spike as the ECB withdraws more of the ample liquidity it has pumped into the banking system.

Above all, the economic imbalances and sharp differences in competitiveness between northern European states led by Germany and Mediterranean euro zone countries remain unresolved.

The export-driven German economy is powering ahead while Greece languishes in an austerity-induced recession and Spain and Portugal struggle with anaemic growth while trying to curb their budget deficits.

Markets may no longer see an existential threat to the euro zone, but they see lingering problems which will make investors more wary and selective than in the currency’s first decade.

(editing by David Brough and Ron Askew)

((paul.taylor@thomsonreuters.com; +336 46487047; Reuters Messaging: paul.taylor.reuters.com@reuters.net)) ($1=.7577 Euro)

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