Stopping the rot: Eurozone contagion

The resurgence of Eurozone sovereign debt fears has driven the euro to two month lows against the dollar in the last two trading sessions and looks likely to keep the common currency under pressure in the days to come. Investors are right to be anxious about the implications of further negativity as Moody’s overnight risk warning on UK banks shows.

The fallout from the inevitable restructuring of Greek debt proves that it is not just sovereign states that will shoulder the burden - fears of writedowns and defaults stalk the markets once more. By implication the equity markets and the pound will suffer as risk downgrades for banks play out. Before this can happen, it is the euro that will be shorted as Greece moves towards default and Spain, Italy and Belgium vie for position on the Eurozone bailout grid.

The repercussions here stretch beyond the economic picture and challenge the philosophy of the euro itself. Will the European taxpayer’s tolerance of funding foreign bailouts reach its limit?

Perhaps a fourth round of bailouts could reveal the answer. In the meantime, risk warnings, credit downgrades and European unrest will keep the euro in the short seller’s crosshairs. With markets on geopolitical amber alert due to the Grimsvotn ash cloud, they will be susceptible to negative Eurozone news. The dollar will be the main beneficiary of this shift in sentiment, although UK importers should see improvements in pound to euro exchanges in the short term.

The recovery in the markets after Monday’s sell-off suggests to us that they aren’t willing to ditch risk when it is only Greece in the immediate line of fire.

However, elements of the Greek crisis are extremely concerning. There’s the risk that the EU/IMF won’t extend the next tranche of funds to Athens and also that the ECB refuses to take collateral from Greek banks, thus freezing them out of the capital markets.

Both would cause havoc across the financial world. If Greece doesn’t get the funds, then the state won’t be able to pay its wage bills. This could quickly lead to rioting and social unrest on a massive scale. As we have seen in the Middle East, popular uprising during times of economic stress can spread across regions very fast – leaving Spain, Portugal and Ireland vulnerable.

If Greek banks are forced to default, this would hurt German and French banks with Greek subsidiaries and probably cause their share prices to crash. Back in 2008 it was one investment bank – Lehman Brothers – that set off the financial crisis that caused a global recession. The same could happen in Europe: some Greek banks get into trouble and all of a sudden the whole banking sector is on the line. So while these scenarios are extreme, the markets are jittery and won’t go up or down in a straight line from here.

This is not just an isolated Greek debt problem. American banks, as well as European banks, have substantial exposure to Greek debt, so the implications of a default would be felt throughout the financial markets. Moreover, a Greek default would only be the beginning. We have already seen the grass roots of contagion; Greek concerns triggered rating agencies to downgrade the economic outlooks of both Italy and Belgium. A Greek default would also drive up the borrowing costs of other peripheral nations, pushing them into similar situations like dominoes. These Eurozone ripples could make their way across the pond sooner than some might think. With the US debt levels soaring, safeguarding investor confidence in sovereign debt is crucial.

Additional IMF/EU aid is an option, but an extension of maturities seems the most likely path. Haircuts must be avoided; they would inflict enormous losses on European banks that could realistically send the global economy back into recession.

Equities have tumbled since last Friday and safer assets are clearly benefiting from the current risk averse environment. The yellow metal has been a popular target but gold is currently well off its pre-correction highs. Despite the debt crisis and growing concerns over a global economic slowdown, risk appetite hasn’t shied away altogether.

There is some seriously negative sentiment towards the Eurozone at the moment and the British press is full of euro doom mongering, saying a break-up is inevitable and Greece will have to go it alone. In reality, the Eurozone is almost certain to survive. The political willpower is far greater than the economic reality.

This doesn’t mean, however, that the euro isn’t immune to a catastrophe. The elephant in the room though at the moment is Spain, which is going through a political upheaval and so doubts about their austerity drive have come to the fore. This time round it’s serious and investors are nervous which has been reflected by a weakening euro which has fallen from near $1.5000 to $1.4000 against the dollar. The reason why it’s serious this time is because when we saw Portugal succumb to an EU and IMF bailout the euro didn’t bat an eyelid and carried on climbing.

But we must not forget Greece, which is looking increasingly like it will eventually default on its debt – the ramifications of which will be severe, across the continent and around the world. European banks have huge exposure to Greek debt and such a sovereign default could trigger another banking crisis. That is not a happy prospect.