National Bank of Greece ADR (fka NBGGY)

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Euro Zone Debt Crisis Threatens to Derail Euro in 2011

Despite the implementation of a comprehensive €750 billion rescue package in the the European Financial Stability Facility, concerns linger heading into the New Year. Can the Euro Zone stave off further bailouts and will bond markets stabilize in the New Year? A case-by-case study suggests that Spain and Portugal could be the next dominos to fall in 2011, and the Euro could remain on the defensive amidst further turmoil in the European Monetary Union.

The Greek Government Spending Dilemma and its Spread to Ireland

To understand what led to controversial bailouts for Euro Zone members, a bit of historical perspective is in order. In 2002, Greece’s economic reforms allowed it to drop its local currency in favor of the euro—giving the government far better access to low-cost borrowing. The Greek government subsequently went on a debt-funded spending binge, and under strain of massive debt obligations the country was hit particularly hard by the global economic downturn in 2008.Now under a €110 billion three year bailout agreement with the European Union and International Monetary Fund, Greece still has yet to see the light at the end of the tunnel. The country must deal with imposed austerity measures amidst an economic downturn to achieve deficit levels imposed by the European Union and International Monetary Fund.Greece’s economic woes induced contagion throughout the market, resulting in investors higher borrowing costs for other weaker European Union countries, such as Ireland.


The €67.5 billion bailout package for Ireland quickly turned from a preventable event to a matter of “fait accompli,” as the latest act in the European Union’s year-long drama to prevent its weakest members from getting overwhelmed by mounting debts. Ireland had moved aggressively to slash €15 billion from annual deficits in four years by slashing spending by €10 billion while increasing taxes by €5 billion (with the harshest steps coming in 2011), which was thought to save Dublin from seeking bailout funds. Yet the deficit grew larger dueto rising borrowing costs and the escalating costs of guaranteeing debt obligations of the country’s troubled banking sector. While the European Commission seems determined to shore up its troubled members, albeit contentiously , the outlook on the euro will remain dim as long as rates keep rising and the dominos keep falling.


Spain Credit Outlook Uncertain on Banks' Funding Needs


Spain has become a new target of the bond vigilantes following bailouts of Ireland and Greece, sending Spanish government securities to their biggest loss in seventeen years in 2010. Moody's Investors Service warned in recent weeks that it may downgrade its ratings on Spain's sovereign debt, adding that its banks have funding needs of up to €90 billion. Although funding assistance seems inevitable, many believe that Spain is too large for a bailout and debt restructuring is a more likely outcome. This scenario could have widespread consequences; notably, many of the bondholders that would face losses are European banks, which already face precarious economic situations.


If troubles continue to mount, Spain’s borrowing costs will likely rise, causing hardships for the country's banks and other local companies alike. The 10-year yield has already increased significantly, from under 4 percent in mid-October to its current level above 5.4 percent. Should fiscal difficulties in the euro-zone evolve into crisis in 2011, the euro will likely plunge as a result and the continuity of the monetary union may come into question. Although the sixteen-nation currency has already dropped from $1.40 in November to $1.30 in December, further downside is not out of the question if its fourth-largest member state falls victim to credit market turmoil.


Portugal Could Be the Next Domino to fall


As two of its European constituents have already fallen by the wayside, Portugal is lined up to become the next country overwhelmed by the sovereign debt crisis spreading through Europe. It needs to cut deficit to below 5 percent of GDP next year, from 7.3 percent in 2010. According to government projections, GDP growth is forecasted to slow to 0.2 percent from 1.3 percent in 2011. The International Monetary Fund has also chimed in; no growth will occur, and unemployment is expected to reach 11 percent by mid-2011.With government debt now at 83 percent of GDP, Portugal is facing a multitude of problems that could reach their boiling points in the next few months. Rating agencies are taking notice of these problems as Fitch downgraded Portugal’s long-term and local currency ratings to A+ (from AA-), stating that it would be “extremely challenging” to meet the budget cut requirements to move back towards solvency.


Markets have reacted too; the cost of borrowing continues to climb, signaling that lenders are nervous that Portugal will not be able to control is unmanageable debt problems. Estimates of a bailout package vary from pundit to pundit, but one sentiment holds regardless of who you ask: at least $50 billion will be required if Portugal is able to enact significant austerity measures, although up to double that amount could be required if the government isn’t able to meet its lofty goals.


Given such challenges to Portugal and Spain in the New Year, we believe that the Euro could remain on the defensive until further notice. Indeed, many DailyFX Analysts list a Euro/US Dollar short as one of their top trades of 2011.


DailyFX Research Team