Five key questions facing the eurozone members

As the eurozone crisis continues to batter markets today, we highlight the five key challenges facing the continent.

1

Can the eurozone balance growth and austerity?

A key challenge, and one that has never been addressed properly by Germany, is whether the eurozone can balance the needs and profiles of very different economies.

Since the creation of the single currency more than a decade ago, this question has hung over the continent, but the answer may be unpalatable. The truth is Germany has been content to pay for the other countries as long as its own economy powers ahead, benefiting from a currency which is ‘cheap’ relative to the country’s own strength.

For peers though, the euro is hurting. Greece looks set to leave as it cannot compete, and other economies are likely to follow, with Spanish unemployment surely unsustainable at 25%.

Austerity hurts, probably too much for most countries to stick with it, and with politics now coming to the forefront, the electorates in peripheral countries look set to have the final say.

2

Will the ECB hand out another LTRO?

The ECB has already supplied European markets with around €1trn of cheap loans but more is expected.

It may come sooner rather than later if last week’s banking woes in Spain and France are anything to go by, with the cross-holdings of debt among financial institutions the key concern once again.

The ECB has the firepower to save the day, just like the Bank of England in the UK, but whether it has the political will – and the sign-off from Germany – is another matter.

3

Will Madrid bail out its banks or be bailed out itself?

It is a question which will become more important, following last week’s move. Bailing out Bankia has at least shown Spain is willing to stand behind its banks, and the bullish statement that came with it may have eased investor worries.

However, the harsh reality is that Spain needs to shell out a further €100bn-€250bn this year to maintain a core tier one capital ratio at its banks of 9%, the amount required by the ECB. It can probably do this once, but if the eurozone crisis worsens it could be a stretch too far.

The ECB could step in itself to bail out the country, but given Spain’s size and importance in Europe, this would be a one-off deal.

 

4

Will Greece default inside or outside the euro? Is it priced in?

A scenario that seemed less likely earlier this year, after comments from Germany that Greece would not be allowed to default, has now turned into a case of when, rather than if. Greece spooked investors last week when it failed to agree a new coalition government, but is a default priced in?

Certainly Greek bonds are priced for a withdrawal, with yields at 25%, but more important is the impact on other nations. If a withdrawal turns out to be plausible and Greece’s exit is a success, it could spell the end of the currency itself if other members follow suit.

 

5

Why is the euro still so strong?

Confounding investors for the last year has been the continued resilience of the euro against other major currencies. The ECB’s own form of QE, failing economies, and riots in the streets have not been enough to harm its strength. But last week – after Greece’s election debacle – the signs of strain finally proved too much, with the euro falling below $1.30 for the first time in three months.

 

This article was first published on Investment Week

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