Thursday, January 13, 2011

Top Stories To Watch In 2011: Growing Risk of Eurozone Contagion

Aside from the housing and state budget crises, the other big story to monitor in 2011 is the fallout from the evolving sovereign debt crisis on the other side of the Atlantic.

Citigroup has warned of a fresh wave of bank failures in Europe. These banks are heavily invested in the bonds of nations that may be unable to pay them back, which puts those banks at risk.

Professor Willem Buiter, Citigroup's chief economist, said the risk of contagion is growing in the eurozone.

"The market is not going to wait until March for the EU authorities to get their act together. We could have several sovereign states and banks going under. They are being far too casual," Buiter said.

That is a chilling prediction and it frames the magnitude of this debt crisis. Any sovereign failures would have massive reverberations around the world. And any large bank failures would be felt across Europe, and even in the US, since the banking systems are so interconnected.

Mark Schofield, Citigroup’s global head of interest rate strategy, said Portugal would need an EU rescue soon and that it was "highly likely that Spain will go the same way."

Moody's said it might downgrade Portugal's A1 rating by one or two notches on growth worries, but said the country’s solvency was “not in question”.

"Restructuring of some sovereign debt is inevitable. There is a chance that Spain could still make it, but the debt trajectory looks unsustainable if a broader EU-wide solution isn't found," Schofield said.

A bailout of Portugal's relatively tiny economy (49th) would be manageable, but would be very damaging to market confidence. And confidence means everything in global markets.

However, Spain has the world's 13th largest economy. If it needs a bailout, such a move would result in significant ripple effects reverberating through world markets. After Greece and Ireland, investors will be left asking, Who's next?

There is only so much money to go around. The bailouts cannot continue indefinitely, and the rich countries of the north cannot continue to carry the weaker nations in the south and on the periphery.

Earlier this year, German Chancellor Angela Merkel declared that this is the biggest financial crisis that Europe has faced in more than a half-century.

"The current crisis facing the euro is the biggest test Europe has faced for decades, even since the Treaty of Rome was signed in 1957," Merkel stated.

Watch this story over the coming months; it has the potential — even likelihood — of being one of the biggest stories of the year.

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