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The Gathering Eurozone Storm

Author: Christopher Alessi
September 13, 2011

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Credit rating agency Moody's downgraded (FT) two of France's largest banks--Crédit Agricole and Société Générale--and put the country's largest bank, BNP Paribas SA, on review for a rate cut on Wednesday. French bank shares, along with the euro, have experienced ongoing volatility as a result of their exposure to Greek sovereign debt (DeutscheWelle). Despite an agreement reached this summer by eurozone leaders to provide Greece with a second bailout package, many international investors and financial markets are predicting the country will default on its debt obligations.

U.S. lenders reduced their exposure (NYT) to French banks in an effort to rein in headline risk, and President Barack Obama urged European leaders to act to stem contagion to the continent's banking sector. In an unprecedented move, U.S. Treasury Secretary Timothy Geithner will travel to Poland Friday to meet with eurozone finance ministers (Reuters).

A Greek default could bring down the indebted economies of Spain and Italy. With French banks also heavily exposed to Italian debt, this would likely set off a European banking crisis that would threaten to unravel the entire single-currency zone. Economists and investors have cautioned that such a scenario could ripple through the U.S. banking sector and trigger another global financial meltdown.

"The crisis has the potential to be a lot worse than Lehman Brothers" (NYT), said hedge fund investor George Soros, referring to the collapse of the famed investment bank in September 2008 that set off a domino effect of faltering global banks. If such a banking crisis occurs, global leaders are ill-prepared to issue a coordinated policy response, argues the Financial Times' Gideon Rachman. "Without such leadership," he writes, "there is a rising danger of a drift into protectionism and currency wars."

Debate is heating up within Europe over how to save the eurozone and avoid a global banking catastrophe. Many officials have argued for the acceleration of fiscal integration (WSJ) as a way to prop up Greece and preserve the euro. France and Germany recently asked European Council President Herman Van Rompuy to draft a framework for closer fiscal coordination, which he will present to eurozone leaders in October. Obama waded into the debate (Reuters) by calling on the EU to "coordinate monetary integration with more effective coordinated fiscal policy."

However, there are growing calls by conservatives within Merkel's center-right coalition to let Greece default (Reuters) and, potentially, leave the eurozone. Despite Merkel's warning that it is in Germany's interest (DeutscheWelle) to keep Greece in the eurozone, Der Spiegel reported that German Finance Minister Wolfgang Schäuble is working on contingency plans for the continent in the event of a Greek default."Merkel and Schäuble are facing up to the inevitable and thinking the previously unthinkable: Greece is going bankrupt, and not even its withdrawal from the monetary union can be ruled out anymore," the report noted.

Still, many analysts and observers think the banking liquidity situation is already ballooning and demands a swift and direct response. In an interview with Bloomberg, Pacific Investment Management Co. CEO Mohamed El-Erian indicated that the IMF and World Bank--set to meet jointly in Washington September 23--should work with European banks to stave off sovereign debt contagion."We're getting close to a full-blown banking crisis in Europe," El-Erian said. Even more urgently, Sir Howard Davies, former chairman of the UK's Financial Services Authority, told BBC: "In the next couple of days, the French government will have to recapitalize their banks."

Background Materials:

"Counting the Cost if EMU Fails," Alan Wheatley, Reuters

"Berlin Rift on Debt Crisis," Philipp Wittrock, Der Spiegel

"Euro Faces Another Hectic Week," EurActiv

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