Analysis: Euro zone gives investors three more months to sweat

By Paul Taylor

BRUSSELS (Reuters) – Despite an agreement on funding a future rescue mechanism, the euro zone faces three more months of uncertainty over Portuguese politics, Irish banks and a Finnish election as it struggles to contain a debt crisis.

None of these may be show-stoppers for the 17-nation single currency area — the euro has barely moved on the prospect of more delay — but they guarantee investors and EU finance ministers a bumpy ride in the weeks ahead.

This week’s European Union summit was meant to draw a line under the 16-month-old crisis by adopting a “comprehensive package” of tougher budget discipline rules, structural economic reforms and strengthened financial backstops.

The leaders got well over half way before national politics and the worsening position of Ireland’s shattered banks got in the way.

“The incremental news we got last night from the European summit is, as expected, relatively little and appears to be neutral to what we think is already discounted in markets, with some disappointment on Ireland,” Goldman Sachs economists Francesco Garzarelli and Dirk Schuhmacher wrote in a note.

What could prevent the delay becoming an own goal is the prevailing bullish market mood which a triple disaster in Japan and turmoil across the Middle East and North Africa has failed to derail.


The fall of Portugal’s minority Socialist government after parliament rejected its latest austerity measures increased the likelihood of Lisbon requiring an EU/IMF bailout but pushed back by at least two months the day when it can negotiate one.

Portuguese 10-year bond yields jumped to over 8 percent after a pair of ratings agencies cut Lisbon’s credit rating by two notches.

Lisbon is believed to have enough cash to meet its 4.3 billion euro debt redemption in April, pointing to June as crunch time.

The European Financial Stability Facility has easily enough money to cope with a Portuguese bailout, estimated to require 60-80 billion euros over three years.

But despite the commitment of all the main political parties to respect Portugal’s deficit-cutting targets, markets may become more nervous if there are further ratings downgrades or the prospect of an indecisive election outcome.

Spain appears to have done enough in terms of budget consolidation, labor and pension reforms and bank restructuring to avoid being dragged down by instability in Portugal, hence the initial calm market reaction.

If that holds, EU finance ministers may have grounds to conclude that they have successfully contained the debt crisis to three peripheral countries — Greece, Ireland and Portugal.

Spanish Prime Minister Jose Luis Rodriguez Zapatero said on Friday he will take new measures to strengthen the economy as Spain continues to fight off market concerns over its debts.

“Spain is being well-funded by investors and is managing its economy and communications with the market much better,” said Gary Jenkins, head of fixed income at Evolution Securities. “It’s in good shape but I would have said exactly the same things about Ireland 12 months ago.”


Ireland’s deepening banking woes may present a more immediate cause for anxiety.

New Prime Minister Enda Kenny put off an attempt to renegotiate the terms of last November’s 85 billion euro Irish bailout until he receives final results of stress tests on the banks next Thursday, tests likely to show a bigger funding hole.

Euro zone officials expect Ireland will need more money from the EFSF to shore up its banks, raising pressure on Kenny to make concessions to France and Germany on a common European corporate tax base, despite domestic opposition.

German Chancellor Angela Merkel has said repeatedly that if Ireland wants a lower interest rate on its bailout loans, it will have to offer something in exchange.

The risk is that Kenny may try to play a game of chicken with Dublin’s euro zone partners, threatening to burn senior bondholders in Irish banks, who include German and French financial institutions.

The European Commission and the European Central Bank are determined to avoid bondholders being forced to take losses, fearing the precedent would cause a systemic threat to the European financial system.


The other wild card which has held up a final deal to beef up the euro zone’s rescue funds is the rise of the populist True Finns party ahead of an April 17 general election in Finland.

The True Finns have opposed increasing national guarantees given by AAA-rated euro zone countries to raise the effective lending capacity of the EFSF, demanding that the EU funding deal be renegotiated.

With the Finnish parliament dissolved, a decision can only be taken by the next legislature, in which the True Finns may end up holding a pivotal position. Latest opinion polls put them in second or third place, with support rising.

That is one reason why EU leaders gave themselves until the end of June to approve the method for increasing the EFSF’s lending power, but euro zone officials are still confident that Finland will ultimately agree on higher guarantees.

As the euro’s persistent strength underlines, most market analysts believe euro zone governments have done enough to stabilize the currency area and avert any systemic risk.

But longer-term uncertainties remain over the solvency of Greece and Ireland, and the ability of governments and parliaments to sustain years of austerity policies in the face of public anger. Greek debt may still have to be restructured.

“The euro has survived a critical test but there is lots of homework to be done. Members states face many years of work to atone for past sins,” German Chancellor Angela Merkel, Europe’s reluctant paymaster, said after the summit.

“This is a comprehensive package which I think is a big step forward. Whether it will be sufficient, only time will tell,” she added.

(Editing by Mike Peacock)

Analysis: Euro zone gives investors three more months to sweat