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The Eurozone's Next Crisis

Author: Roya Wolverson
January 13, 2011

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Portugal could become the next victim of the eurozone debt crisis, despite its successful auction of government bonds this week. Though the auction of $1.62 billion in longer-term government bonds fetched a lower-than-expected 6.7 percent interest rate from investors, many economists believe Portugal's high-priced debt repayments will prove too burdensome for its low-growth economy (WSJ). Portuguese Prime Minister Jose Socrates attempted to boost investor confidence by insisting he would not follow Greece and Ireland in seeking a bailout, but those efforts came against the Portuguese central bank's (Guardian) announcement that the economy will contract by 1.3 percent this year. Adding to unease is discord among EU leaders about whether to increase the eurozone's bailout fund (Telegraph) and extend its scope to include bond-buying and short-term credit to shaky countries.

A looming concern is that Spain, the eurozone's fourth-largest economy, would be next in line after Portugal for a bailout. With near-stagnant economic growth and 20 percent unemployment, Spain's request for outside financial help (Reuters) would test the limits of the $571 billion European Financial Stability Fund. Spain's bond auction (WSJ) this week was successful, and it has taken steps to reduce its fiscal deficit and enact structural economic reforms through privatization, public spending cuts, and a pension scheme overhaul. But should these fail and lead to a bailout request, Spain could run up against a conflict within the EU about the size of the rescue fund.

Last month, Germany and France opposed any increase in the size of the European rescue fund (Guardian). Germany may now be on board, but it remains unclear whether EU leaders can agree (FT) on this and other reform measures by their next summit in February. European Commission President José Manuel Barroso is pushing for the rescue fund--which now only applies to countries already locked out of capital markets--to be extended to countries like Belgium, which still have bond market access but are facing short-term funding problems.

Even if Europe finds a way to manage its country bankruptcies, says Harvard University's Kenneth Rogoff in the Financial Times, "there are no elegant solutions, and the possibility of political paralysis at just the wrong time is significant." With no end to political gridlock in sight, the future viability of the euro "can no longer be taken for granted," said Thomas Mayer, chief economist at Deutsche Bank, in an interview with the London-based Times.

The logjam is opening doors for patient international creditors like China. Europe's biggest trading partner, China has recently been buying Greek, Portuguese, and Spanish debt to buoy these countries' economies, the euro's strength, and by extension Chinese exports. Vanessa Rossi, senior research fellow at Chatham House, estimates that China already holds $1 trillion in European bonds (AP), about 10 percent of eurozone government debt.

The EU's increased dependence on China has larger political ramifications. The European bloc could acquiesce to Beijing's push to be designated a "market economy," for instance, which would make it more difficult for EU members to pursue trade disputes with China. (In trade disputes, China is now treated as an economy in which prices are influenced by the state, giving other countries more leverage in proving whether China is dumping or over-subsidizing.) Portugal and Spain have already supported this demand, while Greece, Italy, and others have been pushing the EU to drop its arms embargo with China. If more borrowing from the Chinese ensues, the Hudson Institute's Irwin Stelzer says China "just might be in a position to demand rather than patiently wait for a show of gratitude" from the struggling EU.

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In the New York Times, Paul Krugman says Europe's "current tough-it-out strategy won't work even in the narrow sense of avoiding default and devaluation."

A Wall Street Journal editorial says bailouts aren't working, because, "By removing the weakest members of the eurozone from the public markets one at a time, they expose the next-weakest to increased pressure. No one wants to be the tail in a game of crack-the-whip, and investors don't necessarily want to be exposed to the next country to fall into danger of default."

On the blog VOX, Guillermo de la Dehesa offers ten reasons why the eurozone bailouts should not extend beyond Ireland.

The Economist explores how European banks, built for a single currency zone, would adjust if the eurozone failed.

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