Spain and Italy threaten EMU stability

The Telegraph ^ | 1/8/08 | Ambrose Evans-Pritchard

[bruinbirdman]

A top French bank has warned that mounting strains within the eurozone will set off a sharp jump in spreads on Italian, Spanish, Greek, and Portuguese sovereign bonds this year, forcing major changes in government policy across the region.

BNP Paribas said a decade of lagging performance across southern Europe has left the region unable to compete with the eurozone's northern tier. A property boom fuelled by low real interest rates has disguised the slippage until now, but only at the cost of storing up greater trouble.

"Inflation, unit costs and current accounts are diverging. While tensions can be camouflaged during economic upswings, they will move to the surface during downswings. It is no coincidence that all failed currency unions were abandoned during times of economic stress," said the report, EMU Concerns.

"The markets are going to punish wrongdoing," said Hans Redeker, the bank's global head of currency strategy. "We think spreads over German Bunds could rise 50 to 60 basis points (bps) in Italy, and perhaps even higher in Spain because of the risks in the housing market."

A spread shock of this order would be greater than anything seen since the launch of the euro. It would amount to a stark reappraisal of the EMU project, raising the risk of a chain reaction as rising debt costs erode budget deficits even further.

Spreads were compressed to wafer-thin levels at the height of the credit bubble last year, falling to just 2bps in Spain and 18bps in Italy. They have since nudged up a further 8bps to 10bps in most of the Club Med bloc as investors turn more cautious.

"The politicians in Italy and Spain do not seem to realise how deep-rooted their problems are. We think the markets will force them to take action. They may have to cut real wages, and this could be unpleasant," said Mr Redeker. "These countries will want higher inflation in Germany to get them off the hook, but I doubt Germany is ready to do that. This is going to create friction within the eurozone. Euro weakness will be the inevitable result."

The southern states have lost about 30pc in labour competitiveness against Germany since 1998.

Analysts say each faces different problems. Italy has a bloated public debt of 108pc of GDP, now rising after a brief bout of belt-tightening to qualify for euro entry. Spending cuts have been half-hearted, leading to sovereign downgrades by Fitch and Standard & Poor's. A 60bp jump in spreads would cause Italy's debt service costs to shoot up, risking a debt spiral. Spain's debt is smaller, but the economy is swinging from boom to bust after an explosive rise in house prices. The country has a current account deficit near 10pc of GDP (Greece is at 13pc) - far above the danger threshold.

BNP Paribas said the eurozone's one-size-fits-all monetary system is fundamentally unstable, but stopped short of predicting a collapse of the EMU.

"Generally speaking, currency unions have been temporary if not followed by political integration such as the German customs union established in 1818 laying the foundation for the German Reich in 1871. The Latin and Scandinavian currency unions and the Gold Standard were blown to pieces by economic divergences during downturns," said the report. By contrast, the euro was launched in a rush ahead of political union, leaving it without a central treasury and social security system to cushion ups and downs across regions.

The bank said monetary policy could offer no relief at this point, and will now make matters worse. "The more economic divergences develop, the less optimal monetary policy will become. What might be too tight for some regions might be too loose for others within the EMU, increasing economic divergences even further," said the report.

Mr Redeker said there were echoes of Canada during the Quebec recession scare in the early 1990s, when spreads widened between different provinces. Canada held together, but investor angst led to a steep run on the Canadian dollar.

No major bank in the eurozone has ever published a report predicting the break-up of the EMU.

Morgan Stanley's former Europe economist set off a storm three years ago with a report suggesting that the system could split in two, while HSBC broke the taboo in 2005 by exploring whether or not Italy might benefit from ditching the euro. ("Maybe," it said). The study followed a call by two Italian ministers for a return to the lira.

[JerseyHighlander]

I can’t think of anything to add, but thanks for posting this, great food for the brain, the scenarios here are wild. The political system in Italy is already out of control, I can’t imagine the Italian electoral system being able to function if elite and public sentiment swings towards divestiture from the Euro currency.

[bruinbirdman]

Bankers love democratic capitalist free enterprise under the rule of law. They don't like socialism. When the EU was evolving they insisted that, if they were to go along, there must be a common currency. The "euro" has always been stealth capitalism. A socialist EU cannot long exist with a common currency and uncommon sovereignty.

yitbos

[USNBandit]

[RobinOfKingston]

Dang, I hate an unstable EMU.