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Analysis - Euro zone seems at a loss to stop the rot

PARIS (Reuters) - Despite public assurances of unity and determination, it’s not clear that euro zone finance ministers know how to stop the rot gnawing away at the 16-nation European currency area.

Ireland, the latest member to come under intense bond market pressure, agreed on Monday to discuss with an EU-ECB-IMF team how to stabilise its state-guaranteed banks but continues to resist applying for the kind of state bailout granted to Greece.

Even if, as seems likely, Dublin accepts an international rescue after more face-saving words, analysts increasingly doubt that will stop contagion spreading to fellow weakling Portugal and, more ominously, perhaps to the much larger Spain.

“In practice, hopes that Ireland can be ‘ring-fenced’ are unlikely to succeed,” Citi economists Juergen Michels, Giada Giani and Michael Saunders wrote in a note to clients.

In what can become a self-sustaining frenzy, investors bid up the borrowing costs of troubled countries on the bond market until they reach an unsustainable level when a government needs to raise money or roll over expiring debt.

The European Union stemmed the first wave of debt crisis in May with “shock and awe” tactics by rescuing Greece along with the International Monetary Fund and creating a $1 trillion financial safety net for other euro zone states in distress.

Six months later, the deterrent effect of the 440 billion euro (£375 billion) European Financial Stability Facility (EFSF), the main component of that contingency fund, which EU officials said they believed would never need to be used, seems to have worn off.

German Chancellor Angela Merkel and European Commission President Jose Manuel Barroso played down any sense of a renewed euro zone crisis this week, saying all the necessary instruments were now in place in case a country needed help.

But with typical European cacophony, the man who chairs EU summits and heads a task force on reforming euro zone economic governance, Herman Van Rompuy, undermined such soothing talk by saying the currency bloc was now in a “survival crisis.”


Markets are concerned not just by the scale of deficits, public and private debts and economic contraction or stagnation around the euro zone periphery, but also by Germany’s campaign for the EU to make bond holders share with taxpayers the pain of any future debt restructuring.

“The successful ring-fencing of Greece owed much to the fact that the EFSF was created at the same time, plus strong political commitments that no euro area sovereign would be allowed to default,” the Citi economists wrote.

“That commitment has been greatly weakened, given Germany’s recent insistence on the need for a sovereign default mechanism in the future.”

Assurances by the EU’s big five last week that this would only apply to debt issued after mid-2013 and all existing bonds were safe failed to calm investors trying to reprice the risk of peripheral euro zone government debt.

Berlin may have backed off from its call for private creditors to take a “haircut” on the value of their holdings of a distressed state’s debt, but months of uncertainty lie ahead before the EU agrees on a debt resolution mechanism and all 27 member states ratify the necessary treaty amendment.

Diplomats say Merkel cannot climb down from her core demand both due to domestic political pressure and because the German Constitutional Court may otherwise rule the existing EU rescues incompatible with the treaty’s “no bailout” clause.

Meanwhile, Austria’s threat on Monday to delay its share of the next tranche of emergency loans to Greece because Athens has not met the agreed deficit reduction target has highlighted the complexity of the euro zone-IMF bailout mechanism.

Recipients are potentially at the mercy of 15 individual governments -- some of them fractious coalitions with restive parliaments -- as well as being subject to decisions taken in Brussels, Frankfurt and Washington.

Slovakia, the newest and poorest member of the euro zone, refused to take part in the 110 billion euro rescue for Greece, declining to lend money to a country wealthier than itself.

The public backlash in wealthy, fiscally conservative Germany and the Netherlands against bailing out Greece is only likely to grow if additional states have to be assisted.


Each euro zone struggler’s case is different. Ireland and Spain had healthy budgets and below-average public debt before real estate bubbles burst in 2007-8, leaving huge private debts, mass unemployment and a gaping hole in government revenues.

Ireland has been dragged down by its banks’ reckless property lending, while EU stress tests in July showed Spain’s biggest banks remain healthy and Madrid has begun to isolate and resolve problems in its weaker savings banks.

Portugal has suffered an inexorable loss of competitiveness since in joined the euro at its creation in 1999.

Back-of-the-envelope calculations on the volume of emergency loans required for Ireland and Portugal suggest each could need up to 100 billion euros over three years, market analysts say.

The EFSF, and a more readily accessible 60 billion euro European Financial Stability Mechanism, should be able to cover those needs with the IMF lending up to a quarter of the total.

However a financial rescue for Spain, if that were to become necessary, would pose a challenge of a different dimension.

Some economists are urging radical action that seems politically unrealistic -- pre-emptive debt restructuring by the most indebted states, large-scale sovereign bond purchases by the European Central Bank or big fiscal transfers from richer to poorer euro zone countries.

In May, the EU briefly managed to get “ahead of the curve” in its response to the crisis. But there is little sign that its current course can restore confidence in the markets.

“Unless the EU changes track and agrees to make the EFSF permanent and the ECB steps up its purchases of the hard-hit countries’ government bonds, investors will believe that default is inevitable and demand correspondingly punitive interest rates,” said Simon Tilford, chief economist at the Centre for European Reform in London.

“Contagion to other member states will be all but inevitable. If, and when, it reaches Spain, the crisis risks spiralling out of control.”

Editing by Charles Dick