Tuesday, February 16, 2010

As the Eurozone Saga Continues...

With mounting resistance by the German public to the prospect of a Greece bailout, that solution appears a tad less likely now than as recently as the end of last week. Positions by the powers-that-be within the EU are stiffening, with tougher demands now imposed on Greece to bolster the credibility of its already announced measures by taking additional action.

The euro remains under pressure and that is unlikely to be alleviated unless specific reassurances, tantamount to a bailout, are announced in the coming days. With Germany and France (the countries that are de facto on the hook for any action to rescue Greece) have pointedly refrained from attaching any specifics to their initial, generic, promises that Greece "will not be left alone". As the gap between words and specifics persists, relatively unconventional ideas as to how to handle the crisis with Greece's debt are being proposed and receiving some attention.

One such suggestion is the one proposed by Martin Feldstein in an article in the Financial Times, which would imply allowing Greece to bring back the drachma as its currency for certain types of transaction, while maintaining the euro for others (link below).

Another suggestion that was, at first, viewed as nearly unthinkable, but no longer so, is to simply expel Greece from the eurozone and that could serve as the wake-up call for the other fiscally challenged countries (Portugal, Spain, Ireland, and, to a somewhat lesser degree, Italy) to put their house in order quickly. The EU, without openly saying so, appears quietly intrigued by the idea that cutting out of the Eurozone its weakest member may be one of the plausible outcomes and may not necessaily mean the disintegration of the euro system.

For the time being, global financial markets continue to punish the most fiscally irresponsible countries by driving their sovereign borrowing costs through the roof and the cost of credit default swaps on their debt near record-highs. After a period of lull for most of January, the Dubai debt affair is coming to the forefront again, with credit default swaps on Dubai World's debt rising sharply in recent days.

Against that backdrop, and despite the re-insertion of a distinct risk component into certain instruments, global financial markets are keeping, on balance, their cool. After suffering a setback stemming from Greece's troubles in the second half of January, stock markets both in the U.S. and Eurozone are making a partial comeback, speaking volumes of the long distance that the world of global finance has covered in the last 18 months or so.

The Eurozone's fiscal woes are often being cast as the inevitable hangover from the combined effect of a global economic downturn and financial crisis that exposed the weakest links among European countries. Moreover, the affair surrounding Greece's troubles may hold more unpleasant developments, as a possible default on that country's debt will have serious reverberations across banks in Europe that are holding mountains of such debt.

All of this may be so, but eliminating all pockets of potential blow-ups in the financial system around the world is not a realistic expectation to have, as the damage that the financial crisis has left behind will take a considerably longer period to heal. A far more sensible yardstick of where the global financial system stands today is whether it has regained its ability to absorb such disturbances, within an acceptable framework of noise-or, even turmoil- that is always inherent in financial markets even in the most normal of times. Based on that standard, the answer to that question is, so far, encouraging.

Anthony Karydakis

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