FRESH worries about the viability of the euro surfaced yesterday as the ECB became the first major central bank to hike interest rates from historic lows, raising the base rate from one to 1.25 per cent.
The Institute of Directors (IoD) said that a euro break-up is “probably the number one macroeconomic risk to the world economy at present”, adding that bailouts will be in vain if peripheral economies cannot improve their competitiveness quickly enough to avoid defaulting and exiting the euro.
Portuguese banks closed up but markets reversed part of an initial relief rally in Portuguese bonds yesterday: yields on Lisbon’s five-year debt fell to 9.65 per cent before ending the day at 9.85 per cent.
And Spanish economy minister Elena Salgado was forced to declare that further contagion was “absolutely ruled out” as Madrid sold €4.13bn of three-year debt.
Spain saw yields fall, but economists warned that the Eurozone crisis is far from over, with IoD chief economist Graeme Leach saying that the euro would now face a “day of reckoning” and that “five years from now, the euro is very unlikely to have survived in its current form”.
There are fears that Jean-Claude Trichet’s rate hike will expose the gulf between the Eurozone’s high-growth core in Germany and its cash-strapped peripheral economies where high unemployment, rising inflation and a hangover of mortgage exposure are piling pressure onto consumers.
Debt investors are still pricing in a high probability of default in Portugal, Ireland and Greece. Credit default swap markets see a 58 per cent chance of a Greek default; 37 per cent of an Irish default; and 33 per cent of a Portuguese default in the next five years.
But Brussels is still in denial about the possibility of restructuring: “It’s unmentionable for policymakers,” says Kevin Dunning of the Economist Intelligence Unit. “Their line is that restructuring is not happening… because they’re terrified of a new financial crisis.”
A default among any of the peripheral economies would almost certainly trigger the need for a recapitalisation of domestic banks due to their heavy exposure to sovereign debt.
And Europe does not have a plan for how to handle a default, with many sceptical that it will be possible to unwind a sovereign state in an orderly fashion without sending the single currency into turmoil, even after the establishment of a permanent bailout fund in 2013.
Policy Exchange’s Andrew Lilico has even suggested that the ECB itself could be in danger: “We are approaching the point at which a bank will become at risk that even I would support bailing out: the ECB,” he said.
As sovereign debt in the bailed-out economies matures, the EU will become liable for an increasing load of their debt, which means that any defaults will hit the finances of the Eurosystem directly.
“A restructuring of debt is a political decision,” says Dunning. “Ultimately, someone has to pay, whether it’s the Germans, the Portuguese or the ECB.”