Will the euro survive Europe’s latest sovereign debt crisis?

November 19, 2010

IRELAND/Kathleen Brooks is research director at forex.com. The opinions expressed are her own.

Ireland’s banking crisis reached boiling point this week. The Irish authorities are still adamant the country doesn’t need a bailout and are trying to draw a distinction between a sovereign bailout (which Irish Prime Minister Brian Cowen, Finance Minister Brian Lenihan et al claim they don’t need) and banking sector support (which they most definitely do).

Regardless of the semantics, it seems highly likely that Ireland will receive funds from the EU and the IMF possibly by the end of the week. With Ireland likely to be the second member of the Eurozone to require financial assistance in six months, it brings into question the “no bailout” clause in the European Union treaty.

2010 has been the year when Europe’s grand project was fundamentally altered, but where does this leave its most precious commodity – the euro?

Some argue that the precarious financial position of the peripheral nations is evidence that the European project did not work. Interest rates that were too low caused debt bubbles in the fast-growing peripheral nations that eventually burst. Cleaning up the mess is costing billions of euros, the European Financial Stability Fund – which is designed to provide “temporary” financial support to member states in financial difficulties will guarantee 440 billion euros of liabilities. And austerity measures for these nations will crimp growth for many years to come.

While the fund may be able to cope with the claims of Ireland and Greece, it could not cope with those of Spain, another debt-laden southern European economy that is at risk from bond vigilantes once the focus shifts from Ireland’s woes. If Spain was to require financing in the coming months then it would come down to Germany, as the largest economic force in the Euro zone, to cough up more cash. Angela Merkel certainly doesn’t seem to have the political will to “donate” any more money to bail out its Eurozone peers, and if the funds are not there then a situation where Spain is “too big to bail” could break the Eurozone and cause the demise of the Euro.

But we believe this is an extremely unlikely scenario. So what is a more realistic conclusion to the current crisis in Europe? At the moment, it appears that Ireland will receive some form of financial assistance, which will reduce the near-term risks of an Irish default and should calm the markets. But on a more fundamental level, the Irish crisis has shown the political will in Europe to keep the Union afloat. Ireland has been pushed to accept financial assistance from all corners of Europe in an attempt to calm the markets and stop contagion in other fiscally challenged members like Portugal and Spain.

This suggests that although the way that Europe has coped with its first major challenge has been inconsistent and laden with confusion, there is an overwhelming desire to keep the monetary union intact. Thus, investors who believe that this is the death knell for the Eurozone will have to battle the political will of Brussels.

Secondly, Spain is a large economy and although it has suffered the bursting of its real estate bubble, it has other industries to try and pull it out of its economic malaise. As well as this, its financial position is clear, whereas Ireland’s financial liabilities are still technically unknown as more bad mortgages turn sour on Irish banks’ balance sheets. This should help Spain avoid a similar fate to Greece and Ireland in the capital markets.

Lastly, although the euro has come under some selling pressure during this most recent debt crisis, it hasn’t suffered a capitulation. The forex market is not pricing in the chance of a collapse in the euro any time soon. While there are major structural issues – including implementing strict fiscal rules and setting up an automatic default mechanism for member states – this is to be expected with a political union that is essentially only 10-years old.

Essentially the peripheral nations need to be more like Germany, and Germany needs to consume a little more. If Europe can get succeed in its own balancing act, then it could emerge from this crisis as the strongest of the major economies.

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