Fashioning rescue not easy for euro zone

LONDON (MarketWatch) -- Investors are pressing for a bailout of Greece and possibly other debt-burdened southern European nations, but big questions still surround how policymakers might go about fashioning any such rescue plan, economists said.

"Going forward it seems that the market won't rest until we get what is increasingly likely to be an E.U. bail-out for the peripheral nations," said John Reid, strategist at Deutsche Bank, in a research note. "It's difficult to know what form such a bail-out will take but it seems that E.U. politicians will act at some point in the next few days, weeks or months."

The euro accelerated its recent plunge last week to hit an eight-month low versus the dollar below $1.37 as concerns about the potential for sovereign default spread across the southern euro zone. The euro stabilized versus the dollar Monday, but strategists said the single currency remained vulnerable to further crisis-inspired selling. See currencies.

The cost of insurance against default on Greek, Portuguese and Spanish government debt soared last week. The yield premium demanded by investors to hold southern European debt versus benchmark German bunds has also jumped, further reinforcing worries about debt service costs.

Greek and Spanish default fears appeared to ease somewhat Monday, with credit insurance costs easing slightly from historically high levels. However, shares of Greek lenders including National Bank of Greece took a fresh downturn on worries about their ability to get funds in the market. See Europe Markets.

Portuguese debt insurance costs continued to climb, however, reflecting unease over a parliamentary vote last week to boost regional aid spending.

The move stands in the way of pledges by the Portuguese government to slash its deficit.

Public sector workers are striking in Greece in protest of massive budget cuts. Uncertainty over the Spanish government's ability to get the cooperation of public unions and powerful regional governments in its deficit-cutting efforts also looms.

News reports say officials on the European Commission, the executive arm of the 27-nation European Union, have privately indicated they would back a bailout. But German remarks indicate such a move would be a tough sell in Berlin, observers said.

"Greece has to realize that when you break the rules over a long period of time, you have to pay a high price," German Finance Minister Wolfgang Schaeuble told reporters in Iqaluit, Canada, at the weekend meeting of Group of Seven finance ministers and central bankers, according to news reports.

At the same time, Luxembourg's Jean-Claude Juncker, who chairs the group of euro-zone finance ministers, effectively warned the International Monetary Fund to steer clear of Greece business cards.

"We told our partners we had to solve the problem ourselves," he said.

Although the Maastricht Treaty, which set the criteria for monetary union, carried a no-bailout clause, experts have widely noted that the recently ratified Lisbon Treaty carries an exception that allows for assistance in the case of "exceptional" circumstances.

"While we can certainly thinks of lots of reasons why the Germans probably would accede to a request for a pan-European bailout ... the one thing that is equally apparent to me is that whenever we've looked for the Germans to cave on this kind of stuff in the past, the Germans have tended to hold the line," said Simon Derrick, chief currency strategist at Bank of New York Mellon.

European stocks managed to look somewhere other than Greece, Spain and Portugal early Monday, but don't bet on that lasting.

The German Bundesbank's unwillingness to ease interest rates in 1992 was blamed for the British pound's ejection from the European exchange-rate mechanism, a framework that pegged exchange rates within the euro zone. The Bundesbank also refused to relent in 1993 as the French franc came under pressure, forcing a re-fashioning of the ERM's currency bands.

Moreover, Berlin seems focused on "a very clear social contract drawn up between the German government and the German populace that they wouldn't bail out the rest of Europe, and I don't in my heart of hearts think that's changed," Derrick said.

For now, European officials appear reluctant to indicate a bailout, said Richard McGuire, fixed-income strategist at RBC Capital Markets.

That's partly because they want to avoid the "extreme moral hazard" implicit in promising a bailout, he said. Also, they appear to hope that market forces will further help push national policy makers to undertake the heavy lifting needed to put their budgets in order.

"Crucially, however, the bailing out of one country would immediately see the market speculate over the bailing out of another. This both stands to underpin the euro-zone authorities' reticence to provide such a backstop while highlighting the likelihood that, were such assistance to be offered, it would not be localized," he said, in a research note.

As a result, the establishment of a centralized fund that could be tapped by troubled member states could prove more appealing than a bridge loan from one member to another, he said, but noted that the political hurdles involved in "such an implicit fiscal centralization" would make it difficult to set up any time soon.

Fashioning rescue not easy for euro zone

09:18 - 2010-Feb-8