Euro crisis spreads – and Italy could be next

Whether you are on a Greek island, the Spanish coast, the Algarve or even driving through France, you will see the effects that bailing out over-borrowed governments is having; buildings half-built, people out of work, rising prices and the odd riot. But for the best, and perhaps most dangerous view of Europe's future, the place to be is in Italy.

Here the crisis is deepening, and unless the contagion is halted, economists warn the single currency could crumble. "The dominos are falling one after another," says Jacques Cailloux, an economist at Royal Bank of Scotland. Spain risks following Portugal, Ireland and Greece, whose government debts have been downgraded to junk level, he warns.

"The correlation of Italy to Spain has picked up recently. There are also some emerging signs that France could be affected. We expect the crisis to continue deteriorating and threaten the entire euro area."

So far only Europe's peripheral countries have faced difficulties refinancing their debt. But Italy is a core nation – the third biggest economy in the eurozone, in the world's top 10 economies and has similar population size to Britain and France. To bail out a country that large would require huge contributions from the dwindling list of governments still able to afford payments. James Carrick, an economist at Legal & General, says: "While it is common to split the euro area into two camps – core vs periphery – one large core member appears fragile. Like Spain, Italy is vulnerable to a vicious circle of cost cuts."

The EU, IMF and European Central Bank, together with governments and national banks, are seeking ways to arrest the crisis before it engulfs Italy and extends northwards. But despite Rome's parliament agreeing a ¤40bn austerity package on Friday, Cailloux says rows between the different factions are making a bad situation worse.

The IMF last week publicly criticised the ECB for its lateness in lending more to Greece. The two bodies disagree on whether private lenders should accept losses and on whether Greek bonds are acceptable collateral. Germany's Bundesbank is critical of the IMF's policy and some EU governments are reluctant to boost the bailout fund. A planned weekend meeting of eurozone ministers was cancelled because of lack of agreement.

The Italian finance minister Giulio Tremonti is in open war with his Prime Minister, Silvio Berlusconi. After returning early from Brussels to handle last week's crisis, Tremonti declared: "If I fall, so falls Italy. If Italy falls, so does the euro."

Cailloux warns: "Policymakers show no sign of catching up with reality. A euro-wide policy response is required to address the powerful contagion channels that are threatening the stability of the whole region. There are solutions available but the cost is rising with mishandling."

Euro group ministers last week agreed to make the planned ¤440bn bailout fund more flexible but Cailloux says the cost of rescue will actually be ¤2,000bn. That would mean increasing the guarantees from governments to between ¤3,000bn and ¤3,450bn – far more than the annual gross domestic product of even the euro's strongest member, Germany.

The cost of such a fund would be put both political and financial strains on Europe's richer countries, but it would also mean seeking impossible contributions from countries such as Spain that are seen as recipients of funds rather than donors.

The European Financial Stability Fund has already committed ¤17.7bn to Ireland and ¤26bn to Portugal, but Cailloux estimates further bailouts to those countries and Greece could cost another ¤60bn. And, he warns: "Spain, in our view, is a ¤350bn affair while Italy could be as much as ¤600bn. It is pretty clear in our view that neither the size of the EFSF nor that of the European Stability Mechanism seems adequate for the current situation.

"These institutions' lending capacity needs to grow rapidly and substantially. It is necessary that the size is scaled up to allow a lending capacity of around ¤2trn to deal once and for all with the uncertainty surrounding the capacity of Europe to support its member countries. It is unlikely that the IMF financial contribution could be scaled up on the same terms as was initially agreed as this would be too onerous. Europe would likely need to go it alone on this."

The enlarged rescue fund could cost Germany an extra ¤727bn – more than a quarter of its annual domestic product – on top of its existing ¤212bn of guarantees. A country that entered the financial crisis in surplus would thus have debt of 110 per cent of its GDP, making it as bad as Italy. France could see its maximum liability soar from ¤159bn to ¤705bn, giving it a 112 per cent debt/GDP ratio.

Such contributions would threaten the credit ratings of not only France but Germany and the Netherlands too. "This eventuality makes all Euro group bonds, except Germany, speculative investments," says Cailloux

The Independent

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http://www.independent.co.uk/news/business/analysis-and-features/euro-crisis-spreads-ndash-and-italy-could-be-next-2314889.html



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