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Bank balance sheets risk more eurozone bailouts

The recent eurozone debt crisis, which started in Ireland, was more perilous than the Greek episode earlier in 2010. Risks of contagion and longer-term threats to the euro’s survival as a single currency are much more severe than previously thought. The euro is not in immediate danger – the emergency has mercifully subsided, but new eurozone crises can be expected in 2011.

While Greece was a classic case of profligate public spending and failed attempts to hide the true size of fiscal deficits, the attack on Ireland was due to an overblown banking sector that is still holding on its books too many clearly overvalued mortgages.

When the UK’s recession was at its worst, the Irish authorities were forced to underwrite their banks in order to protect depositors, effectively transforming bank liabilities into potential sovereign debt. But when German prime minister Angela Merkel recently raised doubts about the strength of the guarantees given to eurozone banks, she inadvertently helped unleash major speculative attacks on Irish sovereign debt.

Germany’s idea that private sector bondholders must share in losses incurred by banks is sensible; there is no reason why taxpayers should bear all the losses. But the timing and tone of the German plan triggered wider turmoil and set in motion dangerous contagion that engulfed other nations.

Long-term dangers

Speculative attacks on Irish sovereign bonds, causing sharp rises in yields, affected initially only Portugal and Greece, small and relatively weak nations in the eurozone’s periphery. But debt crises triggered by weak banks cannot be contained for long. The assaults spread quickly and perilously, engulfing large economies such as Spain and Italy.

As yield spreads over German bonds rose to historic highs, the markets feared an avalanche. Belgium, a country usually seen as a member of the core, was also attacked. When even France, the second largest and most important member after Germany, was affected by speculative rumours, it became clear that the eurozone is facing serious long-term dangers.

The markets’ initial reaction to the bailout package for Ireland, totalling €85bn (£72bn), was a brusque rebuff. Calm was only restored when the European Central Bank abandoned its previous misguided plan to start withdrawing liquidity support and started instead to purchase on a big scale sovereign bonds issued by periphery economies.

The market mood has now improved, but the next attack could be much more aggressive. In 2010, eurozone governments agreed, after much wrangling, rescue packages for Greece and Ireland. If absolutely necessary, they may reluctantly mount a salvage operation for Portugal.

But if this proves insufficient, the eurozone will find it very difficult to continue with its present membership and institutional arrangements. Suggestions that a permanent mechanism will deal credibly with future debt crises are being treated with scepticism.

It is too early to write the euro’s obituary. For the time being, a euro breakup will be more costly than continuing with the messy rescues seen in 2010. But as the costs escalate, risks of reaching a point of no return will increase.

Bailing out Spain would almost certainly be prohibitively expensive, while salvaging Italy is truly inconceivable. Spain’s GDP is more than 80 percent larger than the combined GDP of Greece, Ireland and Portugal. Italy’s GDP is more than 40 percent bigger than that of Spain.

Rescues on this scale are clearly unaffordable. But the underlying problems can only be tackled with political agreements on fiscal co-ordination and by nations sharing the burden. Since such agreements cannot be secured, further flare-ups are going to prove unavoidable.

Growth prospects

In spite of the troubles facing the eurozone, global growth prospects have improved over the past month. Growth estimates for 2010 were raised noticeably, due to better-than-expected figures for the third quarter in a number of major economies.

Forecasts for 2011 are also slightly higher. There is evidence of a manufacturing revival powered by China, India and by European economies such as Germany. But it is premature to talk of a sustainable recovery.

US indicators remain mixed, with better-than-expected GDP but disappointing job figures. US jobs rose only 39,000 in November, a much worse outcome than most analysts predicted. The US unemployment rate rose to 9.8 percent, the highest since April.

The eurozone debt crisis has not yet hit its real economy, but sharp divergence between the core led by Germany and the weak periphery will dampen growth.

The UK performed much more strongly than expected in the second and third quarters of 2010. But the economy faces serious challenges, as the fiscal austerity plan starts being implemented more forcefully from the beginning of 2011. The next few quarters will be risky, but the UK economy is more robust than many feared earlier in 2010.

Official interest rates in the developed economies will remain at their current very low levels and only start rising in Q3 2011.

The Federal Reserve will continue with its additional $600bn (£380bn) quantitative easing (QE) announced last November. The UK may also increase QE if the economy weakens after VAT increases to 20 percent in January. In contrast, China and India are expected to tighten policy, and increase official rates in the next year to counter inflationary pressures.

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