The future of the euro: part two

The euro celebrated its 12th birthday on 1 January in style: Estonia became the seventeenth member of the single currency. But against the backdrop of celebrations in Brussels and Tallinn, fears over contraction, rather than further expansion of the Eurozone grew in strength for the coming year.

Six months ago, Financial Director magazine highlighted dire warnings from leading economists that a break-up of the euro over the next five years was now the more likely outcome. As one pundit, ING's global head of financial markets Mark Cliffe, put it, the "unthinkable is now thinkable".

Half a year on and the single currency may still be intact, but doubts over its viability are not abating. "The odds of the survival of the euro are worse than we said in July," says Ian Bright, a senior economist at ING.

He bases this assessment on warning signs from financial markets, such as the soaring yields on bonds and credit default swaps for the zone's weaker peripheral economies, both keen weather vanes of market sentiment and belief in the currency union.

"We are looking at Spain where the ten-year yield is the highest since the introduction of the euro," he says. "It is starting to affect more than the small countries and when you start playing around with Spain and Italy you are talking about major league problems. We can say that with confidence."

Capital Economics, a consultancy firm run by former government adviser Roger Bootle, is sticking to its forecast that the chances of break-up are more than 50 percent. "We continue to think that some kind of Eurozone break-up over the next three to five years is probably more likely than not," says its European economist Ben May.

The reason for the gloomy prediction is that, despite managing to cobble together rescue packages for first Greece and then Ireland, there is little sign of the structural reforms they see as necessary to underpin the euro.

Stephen Lewis, chief economist at brokerage house Monument Securities and a longstanding opponent of the euro, says policy makers have failed to tackle the tough issues.

"The turmoil that has erupted in peripheral Eurozone bonds is a symptom of deeper-seated problems relating to governance," he says. After a lot of dithering, European policy makers in May provided Eurozone governments with a backstop in the form of the €440bn European Financial Stability Facility (EFSF) which expires in June 2013.

At their December summit, leaders signed up to the idea of a new permanent mechanism "to safeguard the financial stability of the euro area as a whole". But the proposed European Stability Mechanism (ESM), which requires a treaty change by the end of 2012 in order to be up and running by July 2013, has raised more questions than answers.

There are no details about how large the ESM will be or how a sovereign default will be handled in the intervening period. "Even to a casual observer, the ham-fisted, piecemeal efforts of Eurozone leaders to deal with the challenges that bond market turbulence has presented seem to confirm that policy-making mechanisms at the Eurozone level are inadequate," says Monument's Lewis.

There is growing speculation that unresolved debt issues could trigger a domino of crises in Portugal, Spain, Italy and even France that the ESM would fail to cover. At the same time politicians have unsettled the markets by talking about the need for private sector creditors to share the pain by bearing losses on their investments. When French president Nicolas Sarkozy and German chancellor Angela Merkel first raised the idea last autumn, it triggered a surge in yields that pushed Ireland to the brink of default.