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Eurozone Doubts for Banks

Author: Christopher Alessi
January 9, 2012

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Following a brief holiday respite from the ongoing sovereign debt crisis, in part due to an infusion of capital into the financial sector by the European Central Bank, the eurozone is once again facing rising borrowing costs, a fragile financial sector, and a weakening euro. On Friday, yields on ten-year Italian and Spanish government debt climbed, forcing the ECB to intervene (WSJ) in those countries' secondary bond markets. A day earlier, European bank shares--most notably, that of Italy's UniCredit--plummeted, while the euro fell to $1.28, its lowest level in over fifteen months (NYT).

What's at Stake

Italian ten-year interest rates have again jumped above 7 percent, a level considered unsustainable by markets. Unlike Greece, Ireland, and Portugal, Italy's economy is too large for the EU and the International Monetary Fund to bail out. If Italy--which holds $2.6 trillion in public debt and is the eurozone's third-biggest economy--were to default, it would likely trigger the collapse of the single currency.

Despite low-interest, three-year loans that the ECB started providing European commercial banks at the end of December, investors have remained loathe to buy more sovereign debt in Italy, Spain, and even France. At the same time, many European banks are facing a potential liquidity crisis (Reuters). Doubts over the ability of the continent's banks to put aside funds to address bad loans, while raising billions in fresh funds to meet EU capital requirements, has pushed bank stocks lower and rattled investor confidence in Europe's financial sector--with potential knock-on effects for the U.S. and global economies.

The Debate

Italy, Spain, and other at-risk eurozone states have moved to implement strict budget cuts to try to reassure investors that they are getting their financial houses in order. At the same time, these severe austerity measures are undermining growth, just as Europe faces a likely recession (VOA) this year.

Some analysts question whether this approach will help the eurozone out of its current economic malaise. Charles Wyplosz, an economics professor at the Graduate Institute of Geneva, recommends that European leaders halt tax increases and spending cuts, and instead encourage consumer spending (NYT) to boost growth in their beleaguered economies.

Policy Options

French President Nicolas Sarkozy and German Chancellor Angela Merkel are meeting in Berlin on Monday to hash out the details of a new treaty agreed on last month by most EU members to establish a fiscal union, which will require the coordination of national budgets across member states.

However, doubts remain over the legality of the agreement (DerSpiegel)--which falls outside the overarching EU Lisbon treaty--and whether it is politically bold enough to reassure markets (FP). Daniel Gros, director of the Center for European Policy Studies, says "the eurozone has enough savings to finance all of the deficits," while boosting investor confidence. But, he adds, it would require the economic and political will (Project Syndicate) of the ECB and wealthy northern states like Germany to guarantee the debt of struggling southern economies.

Background Materials

Confidence in the dollar and the euro continues to falter, threatening the international monetary system, writes Barry Eichengreen Foreign Affairs.

The eurozone, once seen as a crowning achievement in the decades-long path of European integration, is buffeted by a sovereign debt crisis of nations, explains this CFR Backgrounder.

Germany should use its position as a "hegemonic" power to stabilize the eurozone, argue Matthias Matthijs and Mark Blyth in Foreign Affairs.

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