european debt crisis, page-22

What I think is that europe's politicians and central bankers, attempting to distance themselves from the rolling debt crises engulfing their neighbours, have provided useful geographical clarifications.

Before succumbing to last year's bailout by the European Union and International Monetary Fund, the Irish government assured the world that Ireland was not Greece.

Portugal is now telling everyone that it is neither Greece nor Ireland. Spain insists that it is not Greece, Ireland or Portugal. Italy insists it is none of the above, as does Belgium, which also wants the world to know it should not be confused with Italy.

The Russian writer Leo Tolstoy wrote that: ''All happy families resemble one another, every unhappy family is unhappy in its own way.'' The same applies to beleaguered European countries.

Greece had a bloated public sector and an uncompetitive economy sustained by low euro interest rates.

Ireland suffered from excessive dependence on the financial sector, poor lending, a property bubble and a generous welfare state.

Portugal, which recently has been experiencing its own moment of vertigo, has slow growth, anaemic productivity, large budget deficits and poor domestic savings.

Spain has low productivity, high unemployment, an inflexible labour market and a banking system with large exposures to property.

Italy has low growth, poor productivity and a close association with peripheral European economies. Italy has started to rein in its budget deficit. Its banking system is relatively healthy but exposed to European sovereign debt.

Belgium is really two ethnic groups that share a king and high levels of debt (about �470 billion [$630 billion], 100 per cent of gross domestic product), and little else.

These European countries do have a few things in common. Among them are very high and potentially unsustainable debt levels and a reliance on foreign investors to purchase their debt.

The rising cost of borrowing makes high levels of debt unsustainable because of the cost of interest payments. Eventually, countries lose access to commercial funding, which is what happened to Greece and Ireland.

By the end of last year, the cost of funds for the relevant countries had risen, in some cases to punitive levels. Greek debt is trading at about 12 per cent. Ireland near 9.5 per cent, Portugal about 7 per cent, Spain at 6 per cent, while Italy is close to 5 per cent.

Rising rates result in unrealised losses on investor holdings of the debt. In total, banks have lent over $US2200 billion to the group of countries that have come to be known as the ''PIGS'' (Portugal, Ireland, Greece and Spain).

French and German banks have lent about $US510 billion and $US410 billion respectively. British banks have lent $US324 billion to Ireland and Spain. Spain, which may need financial support, has a $US98.3 billion exposure to Portugal as well as a $US17.7 billion exposure to Ireland.

Stronger countries that move to support weaker countries by financing bailouts do so at the risk of damaging their own credit quality and ability to raise funds. As concerns about the peripheral countries have risen, interest rates for Germany and France, which would have to bear the burden of supporting others, have risen.

Europe increasingly resembles a group of mountaineers roped together. As the members fall one by one, the survival of the stronger ones is increasingly threatened.

European leaders see markets as the cause of the problems. But unsustainable levels of debt remain the heart of the problem.

The EU and IMF are hoping that the bailouts of Greece and Ireland will restore confidence. Stronger growth, fiscal discipline and domestic structural reforms will allow the troubled countries to regain access to markets. While not impossible, the chances of this script playing out are minimal.

A more likely scenario is that the support measures do not work and Portugal and Spain find themselves under siege. As market access closes, they will need bailouts, straining existing arrangements.

Over the past week, Portugal and Spain have managed to issue debt successfully, giving investors confidence - temporarily - that the problems are manageable.

However, in Portugal's case, the debt carried a yield of 6.7 per cent. Portugal's 10-year bonds briefly reached 7 per cent earlier this month - a level investors demanded from Greece and Ireland shortly before both countries finally capitulated and accepted bailout packages.

This week's issues will do little to alleviate longer-term pressure.

If Portugal (debt �180 billion) was to require assistance, then it would reduce the available funds in the EU's bailout mechanism. Spain (with debt of more than �950 billion) is simply too big to bail out using the present facilities.

Under such a scenario, available options include greater economic integration of the EU, expansion of existing arrangements (established as the European Financial Stability Facility, or EFSF) or a decision to allow indebted countries to fail.

Greater integration would entail adoption of a common fiscal policy, encompassing strict controls on fiscal policy including tax and spending. It could also include the issue of eurozone bonds (''E-bonds''), lowering borrowing costs for peripheral economies and facilitating access to markets.

The likelihood of greater fiscal union in the near term is limited, as it is unlikely that nations will surrender the required economic powers and autonomy. The E-bond proposal, for up to 50 per cent of a state's funding requirement, is unworkable given large differences in credit quality and interest rates between eurozone members.

In any case, Germany takes the view that national governments should bear responsibility for their own decisions.

The cost of full fiscal union is prohibitive, between �340 billion and �800 billion, depending on the degree of fiscal imbalances. Much of this cost would have to be borne by Germany and richer economies.

If Portugal and Spain experience problems, in the absence of a full fiscal union, the only available actions are further EU support or default.

There have been proposals to expand the EFSF as needed. While Germany has opposed any expansion, it remains an option. Perversely, increasing the funding available to support troubled countries may signal that problems are imminent, with a resulting loss of confidence necessitating a bailout.

The European Central Bank can increase support for countries, in the form of purchases of bonds or financing eurozone banks to purchase them.

In an extreme scenario, the bank could simply print money, following the US Fed's lead, to support its members. Such action may not be permissible under its existing rules, requiring amendments to EU treaties. It would damage the bank's already tenuous credibility and be resisted by Germany and other conservative EU countries.

If the EU does not agree to fiscal union or continuing support, then pressure on Portugal, Spain, Italy and Belgium may reach a tipping point, making default or restructuring the likely end game. Presumably, existing programs, such as those for Greece and Ireland, would be suspended. Governments would announce debt moratoriums, defaulting on at least some debts. This would cause a domino effect of defaulting countries within Europe.

The defaults would affect the balance sheets of banks, potentially forcing governments, especially in Germany, France and Britain to inject liquidity into their banks to ensure solvency. The richer nations would still have to pay, but for the recapitalisation of their banks rather than foreign countries.

Politics now increasingly dominates European economics.

Commenting on the bailout of Ireland, the Irish Times referred to the Easter Rising against British rule, asking: ''Was what the men of 1916 died for a bailout from the German chancellor with a few shillings of sympathy from the British chancellor on the side?'' An Irish radio show played the new Irish national anthem to the tune of the German anthem.

In Greece, cutbacks in government spending have resulted in violent protests on the streets. Faced with cutbacks in living standards, Europeans are fighting back. The Rolling Stones' '60s anthem has been resurrected in Europe: ''Everywhere I hear the sound of marching, charging feet, boy/ Summer's here and the time is right for fighting in the street, boy.''

In many countries, governments, often unstable coalitions, are struggling to pass legislation, implement spending cuts or tax increases. In Ireland, the opposition parties have promised to renegotiate the bailout package if elected.

In Germany (the paymaster behind the EU) Europe's biggest tabloid Bild asked: ''First the Greeks, then the Irish, then � will we end up having to pay for everyone in Europe?''

In December, a meeting convened to discuss the situation provided a pointer to how events might evolve. At the meeting, the German view, set out by Chancellor Angela Merkel, prevailed.

It rejected any attempt to increase the scope of the existing bailout facilities. The E-bond proposal was quietly shelved. The EU agreed to formalise a new facility, the European Stability Mechanism (ESM), through a short amendment to the Lisbon Treaty. The new facility would be inter-governmental with any eurozone member having a national right of veto. The facility was highly conditional, capable of being triggered only as a last resort.

A key element was the requirement for ''collective action clauses'', effectively forcing lenders to bear losses. The provision, which must be included in all European government bonds after June 2013, would require the payment period to be extended in case of a crisis. If the solvency problems persisted, then further extension of maturity, reductions in interest rates and a write-off in the principal would occur. In addition, new bailout funds would subordinate existing debt and have to be paid back first.

It is clear the stronger members of the EU have decided to limit future liability in bailouts. The EU proposals implicitly recognise that over-indebted countries cannot sustain debt levels. The reduction of the burden will have to come through restructuring or default, with creditors taking losses.

Unless confidence returns rapidly or the EU changes its position, it seems restructuring or defaults by several peripheral sovereigns may be unavoidable. Investor concerns that the Greek and Irish did not solve the fundamental problems may be confirmed. The safety nets are seen as unlikely to be big enough to rescue larger countries if they require support. Investors will need to take losses, and large maturing debts mean the test is likely to come sooner rather than later.

The heavily indebted European states face $US2850 billion of maturing debt up to 2013. Portugal, Italy, Ireland, Greece and Spain have bond maturities of $US502 billion this year. In addition, private sector borrowers face maturities of $US988 billion of corporate bonds and $US200 billion of syndicated bank loans over the same period. The likelihood of low economic growth, failure to meet IMF targets, further banking sector problems and credit downgrades exacerbate the risk.

North America and Asia have been bystanders as the crisis developed. Increasing concerns are evident, as European problems now threaten global recovery.

China, which contributed about 80 per cent of global growth last year, has expressed concern about Europe. Trade between China and the EU, its largest export market, totals $US470 billion annually, contributing a trade surplus of �122 billion for China in the first nine months of last year. Any slowdown in Europe would affect Chinese growth.

China is also a major holder of euro sovereign bonds. China has indicated preparedness to use some of its $US2700 billion of foreign exchange reserves to buy bonds of countries such as Greece and Portugal.

A slowdown in China would affect commodity markets and exporters such as Australia and South Africa.

A continuation of the European debt problems would severely disrupt financial markets. Losses would create concerns about the solvency of banks. In a repeat of the events of September 2008 (when Lehman Brothers filed for bankruptcy protection and AIG almost collapsed) and April/May last year (before the Greek bailout), money markets could seize up. This would feed through into the real economy, undermining the weak recovery.

Unless resolved, the European debt problems will affect currency markets and the global economy. Any breakdown in the euro, such as the withdrawal of defaulting countries or a change in the mechanism, would result in a sharp fall in the new currencies. This would, in the first instance, result in large losses to holders of debt of those countries from the devaluation.

Depending on the new arrangements, the US dollar would appreciate, halting the nascent American recovery. This may compound global imbalances and trigger further US action to weaken the dollar. Further rounds of quantitative easing are possible, setting off inflation and large capital flows into emerging markets.

The risk of protectionism, currency and trade wars would increase. A break-up of the euro would hurt Germany, which has been growing strongly. A return to the mark, or more realistically, a euro without the peripheral countries, may result in a sharp appreciation of the currency, reducing German export competitiveness.

As Australia's Reserve Bank noted in its December minutes: ''The deterioration in the situation in Europe over the past month had increased the downside risks to the global economy. How this would ultimately play out, and the implications � were difficult to predict. It was possible that conditions could settle down, as they had after the episode of financial instability in May. Alternatively, an escalation of the current problems was not out of the question. If this prompted a fresh retreat from risk-taking in global financial markets, it would probably have more impact � than any trade effect.''

Events since the announcement of the bailout package last year have been reminiscent of 2008. Then, optimism following bailouts of Bear Stearns and other troubled US banks proved premature.

With each successive rescue and the re-emergence of problems, the capacity and will for further support will diminish. The rescues of Greece and Ireland are reminiscent of US attempts to rescue its banking system, with more and more money being thrown at the problem.

The strategy was defective, preventing the creative destruction required to restore the system to health. The actions may have doomed the economy into a protracted period of low growth, laying the foundations for future problems.

At the time of the Greek bailout, the real question was: ''If �750 billion isn't enough, what is?''

Actually, credit for this piece should go not to me, but to that perennial doomsday merchant - Satyajit Das. It's a good read whether you agree with it or not.