Europe’s debt crisis: 5 things you need to know

German Chancellor Angela Merkel wants greater 'convergence' among all EU members.

NEW YORK  — It’s been about 18 months since the sovereign debt crisis in Europe began attracting attention in global financial circles.

In that time, the crisis has grown into the biggest challenge the European Union has faced since the adoption of the euro as its single currency 12 years ago.

Greece, Portugal and Ireland are on life support. Italy and Spain are exhibiting worrying symptoms. Germany and France, the healthy ones, are suffering from a global economic malaise.

As the situation appears to be coming to a head, again, here are five key issues to keep an eye on.

Stability fund’s instability

In July, European political leaders announced a set of proposals to address the crisis, including a second bailout for Greece, which was teetering on the verge of default.

The centerpiece of the July 21 agreement was the proposed expansion of the European Financial Stability Fund. The fund was set up last year to facilitate low-cost loans for struggling EU members including Portugal and Ireland.

Under the proposed changes, the fund would be able to buy government bonds directly from banks and investors. Importantly, it would be able to do this for nations that do not already have bailout loans, such as Spain and Italy.

The goal is to contain the crisis by limiting volatility in the sovereign debt markets, where nervous investors have driven borrowing costs for several struggling EU nations to record highs.

That would take some pressure off the European Central Bank, which has been buying government bonds as part of an emergency program.

But many analysts say there is not enough money in the 440 billion euro stability fund to be effective if Italy and Spain need to be rescued.

Europe’s controversial bond-buying program

Nein? Can more debt help Europe?

Over the next few weeks, the proposals will go before Parliaments in several eurozone nations, including some where voters are suffering from so-called bailout fatigue. The bailout and stability fund expansion would also need approval from the 17 nations that use the euro as their currency.

From Greece to Italy

In addition to expanding the stability fund, eurozone governments must unanimously approve Greece’s 109 billion euro package of low-cost loans.

The agreement has already shown signs of cracking.

Finland and Greece reached a controversial agreement in August for Athens to provide cash collateral against loans from Helsinki.

The move resonated with other eurozone nations that have relatively health economies, including Austria and Belgium, which also called for collateral.

Eurozone officials have chafed at the bilateral agreements, since they mean Greece would have to put up cash in order to get cash. Jean Claude Junker, president of the Eurogroup, said finance ministers are working on an alternative plan, but the situation remains murky.

At the same time, Greece has struggled to implement harsh austerity measures aimed at reining in budget deficits and meeting conditions for its bailout loans.

As Greece goes, so goes Italy?

Meanwhile, investors have also been growing worried about Italy.

The third-largest economy in Europe, Italy is considered too big to fail. While the nation has a relatively small budget deficit, Italy has debts equal to nearly 120% of its gross domestic product.

At the same time, Italy’s decade-long economic slump is not expected to end anytime soon, making it difficult for the nation to pay off its debts.

Italy has been struggling to impose austerity measures aimed at reducing its debt burden. But the process has been hampered by political infighting and public backlash.

Yet the Italian Senate voted Wednesday to approve a set of reforms, including a controversial value added tax on purchases.

The belt-tightening measures will be voted on by Italy’s lower chamber later this week.

Banks under pressure

Investors are afraid big European banks, which hold billions of euros in sovereign debt on their books, may be forced to take painful writedowns if governments cannot repay their debts.

Société Générale (SCGLF), one of the oldest banks in France, has been at the forefront of investors’ worried minds. The company’s stock price has plunged to its lowest level since early 2009, when the financial crisis was in full swing.

Some analysts say even German banks, such as Deutsche Bank (DB), would not be immune if the sovereign debt crisis spirals out of control.

“Who says that German banks, just because they are big, and just because they are domiciled in Euroland’s largest and most stable economy, are safe?” asked Carl Weinberg, chief economist at High Frequency Economics.

The troubles in the banking sector have raised concerns that Europe could suffer a credit squeeze similar to the one that crippled global credit markets in 2008.

While there have been some indirect signs that European banks are having trouble obtaining short-term dollar loans, the traditional indicators of stress in the banking system are not yet flashing red.

8 banks fail Europe stress tests

Volcker: 'Economy is not behaving appropriately.'

EU officials maintain that stress tests conducted in July prove that European banks have sufficient capital.

And there is always the ECB, which has already provided some relatively small loans to European banks. But given the challenging stock market and concerns about a pullback in interbank lending, banks in Europe appear to have few options to raise capital.

This dynamic has fueled fears that there could be a run on a major European bank if investors and depositors start to pull money out in a panic. In that case, governments may be forced to step in and take over.

But it’s not clear whether policymakers have the political will, and the cash, to bailout a major bank.

Economy in the dumps

In the second quarter, overall economic activity among the 17 nations that use the euro grew only 0.2% compared with the first quarter, according to Eurostat.

Germany, the region’s economic powerhouse, reported a paltry 0.1% increase in second-quarter gross domestic product, compared with a more robust 1.3% in the first quarter. But economists say Germany is still on track for modest growth in 2011.

The German economy is heavily dependent on exports and has benefited from rapid growth in emerging nations such as China.

Thanks a lot, Europe

As activity cools in those markets, the outlook for Germany has dimmed. The slowdown raises troubling questions about the long-term outlook for the eurozone.

Economists say the weaker members of the eurozone will not be able to repay their debts and live without bailouts until economic activity resumes in a big way.

Weighing a eurozone break-up

The crisis has brought to light problems that many analysts say will require a fundamental change in the way the European Union operates.

The eurozone nations have enjoyed the benefits of a shared currency and uniform monetary policy since about 1999. However, aside from certain unenforced budget targets, the group has never had a common approach to fiscal policy.

Is the euro doomed?

The lack of coordination has resulted in a situation where stronger members of the union are now being forced to help support less competitive members that have spent beyond their means.

If they don’t, many analysts say the union could break up, with one or more nations abandoning the euro.

European leaders have said repeatedly that they will do whatever it takes to preserve the euro, arguing that greater economic integration is the key to doing so.

Last month, French President Nicolas Sarkozy and German Chancellor Angela Merkel met in Paris to discuss, among other things, a proposed “golden rule” to require all euro area nations to commit to balanced budgets.

The goal, they said, is to promote greater “convergence” among the policies of the core members of the EU, such as France and Germany, with those of the more troubled nations on the union’s periphery.

The leaders also discussed greater coordination on corporate tax rates and the creation of a so-called financial transaction tax.

But officials have so far stopped short of explicitly calling for a uniform fiscal authority.

Investors have been calling for the creation of a so-called Eurobond, which would be backed by all 17 euro area nations. Issuing a common form of debt would ease borrowing costs for the weaker members of the union.

But it would result in higher rates for more credit-worthy nations, which are opposed to the idea.  To top of page

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