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« SK OptionTrader Continues to Outperform Other Gold Trading Vehicles | Main | Endeavour Silver Corporation Revenues Jump 85% »

Spain and Italy teeter on edge

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THE CRISIS in the euro zone has entered a new phase. Yesterday's relative calm on the markets notwithstanding, this phase increasingly looks like one in which fundamental change will be needed to save the euro.

Europe's piecemeal approach to resolving its sovereign debt crisis has never worked. Now it is patently failing. Bailouts for three of the weakest economies in the 17-member currency union did not boost confidence in those countries. In fact, the opposite occurred. Greece, Ireland and Portugal are now considered by financial markets to be much more likely to default than they were when first given their respective bailouts.

If the approach being taken by euro area governments could, until as recently as last week, have claimed a partial success it was that the big-but-weak economies - Spain and Italy - had not suffered contagion. But that has now changed. Yields on the government bonds of the two large Mediterranean countries rose sharply on Friday and Monday. It would take only three or four more days like those to push their yields above 7 per cent - the tipping point which saw Greece, Ireland and Portugal being bailed out within weeks of passing this threshold.

It could happen even more rapidly. There is a big difference between the two countries which have moved towards the brink over the past week and the three already rescued. The latter three are minnows: collectively they account for just 6 per cent of the euro zone economy. Spain and Italy combined make up well over a quarter of it.

When measured by the size of their debts, the size of the problem they pose is greater still. As of the end of last year, the 17 euro area governments combined owed €7,837 billion - mostly to their respective citizens. Italy and Spain account for almost one third of that gargantuan figure. Multibillion tranches of such vast amounts fall due for repayment on a weekly basis. According to Italy's treasury, it alone must raise €175 billion over the remainder of 2011 to pay back loans falling due. Large and frequent repayments make these countries highly vulnerable now that fear of default has spiked upwards.

With Spain and Italy potentially just weeks away from being unable to borrow, Europe may be facing its moment of truth.

But despite the rapidly rising risk of a severe deterioration in the crisis, policymakers continue to fall short in their response. While it is easy for high-perch observers and commentators to bewail the short-sightedness of those on the ground making the decisions and doing the deals, it is difficult not to see Monday's meeting of finance ministers in Brussels as the most serious failure yet to take proportionate action. As Spain and Italy edged towards the abyss, ministers spent most of the day talking about Greece.

The back and forth on how to reduce its debt burden has gone on for weeks, with the main actors constantly at loggerheads. In one corner, and led by Germany, is the northern bloc of fiscally strong countries whose populations rail at bailing out badly managed economies. They insist investors take the hit they deserve for their bad lending decisions. In the other corner is the European Central Bank (ECB), which opposes any action that forces those institutions and investors to take losses on their Greek bonds for fear that it would trigger an unstoppable panic in financial markets.

Each time the northern bloc has come up with a new idea to impose losses on bondholders, it has faced the same immovable ECB object. The bank's head, Jean Claude Trichet, has even gone as far as to threaten to allow the Greek banking system collapse if other countries organised any kind of default of the country's sovereign debt. Despite Frankfurt's implacability, Greek debt restructuring is back on the table.

The renewed focus on imposing losses on Greek debt undoubtedly contributed to sudden and large jump in yields on Italian and Spanish government bonds on Friday and Monday. But it was not the only reason.

Italy's always-in-flux multiparty coalition is suffering strains. The combination of unprecedented euro area contagion and in-fighting in Rome on how its budget deficit should be narrowed panicked the now hyper-alert financial market herd. Mercifully, the stampede which took place on either side of the weekend stopped yesterday. But a characteristic of this crisis has been that once levels of nervousness have been ratcheted up, they don't calm down again.

With stress tests on European banks to be published on Friday, another stampede could be on the cards within days. Spain, having suffered a huge property crash and now enduring a jobless rate in excess of 20 per cent, is still the weakest link. It has a suspiciously undamaged banking system.

Although, and when compared to Ireland, lending to developers for massively overpriced land was much more restrained in that country, there are real fears that the Spanish banking system has suffered considerably bigger losses than have been admitted to date. Any revelations on Friday that exceed expectations could do for Spain.

Given all the fragilities and the failure of efforts to resolve the crisis over 18 months, the moment of truth is potentially very close.

Courtesy of The Irish Times.

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