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Larger euro zone bailout could cost 500 billion euros

Source: Reuters - Tue 4th May 2010

Euro zone governments could end up footing a bill of half a trillion euros (430 million pounds) to rescue several countries if they fail to engineer a bailout of Greece that calms financial markets, economists estimate.

Until this week, the idea of a multi-country bailout of indebted European states seemed outlandish to many analysts. Negotiations underway to rescue Greece alone have run into big political obstacles within donor countries and Greece itself.

Publicly, euro zone officials say there is no need to discuss a widened bailout. Privately, several euro zone officials told Reuters that there were no international talks on the issue.

But growing instability in the markets is raising the possibility that more countries on the weak periphery of the euro zone - such as Portugal, Ireland and Spain - could eventually become unable to issue debt at affordable prices.

This could force the zone's rich governments to expand their emergency assistance in order to prevent a collapse of confidence in the euro currency, and to avoid debt defaults that would damage banks across the region.

"The contagion we are seeing at the moment to other euro zone countries should be taken very seriously. We start to see the dangerous crisis dynamics in which falling (bond) prices do not lead to rising demand but rather the opposite" said Allan von Mehren, economist at Danske Bank.

"At the moment we believe that you can rescue Greece for 120 billion, but it could be 500-600 billion if you add Portugal and Spain to that."


The prospect of a multi-country bailout appeared to draw a little nearer this week when bond prices in Portugal, seen by many investors as potentially the next "domino" after Greece, began showing Greek-style volatility.

The yield on two-year Portuguese government bonds jumped over two percentage points in three days, to 5.48 percent. The curve for Portuguese credit default swaps, which insure against a debt default, is inverted, a classic sign that investors fear the country could face a liquidity crunch.

Analysts think Portugal is healthier than Greece, and that it could still afford to conduct several bond issues in the market without dooming its fiscal austerity effort. Its two-year yield fell back to 4.61 percent on Thursday.

But the spike in its yield has prompted economists around Europe to try to work out the costs of a multi-country bailout in the event that the attempt to save Greece fails.

Sources familiar with the Greek bailout talks said officials aimed to announce the details of the scheme by Monday. Euro zone governments and the International Monetary Fund are expected to extend emergency loans worth around 100 billion euros over three years. The IMF might provide as much as a third of the total.

If agreement is reached, however, markets may remain nervous about Greece's ability to meet fiscal conditions attached to the loans, and about the political will of euro zone governments to support Greece over such a long period of time. So the market contagion could still spread further.

Economists estimate that if Portugal were entirely frozen out of the debt market, international donors might need to lend it 58.5 billion euros between 2010 and 2012.

That calculation is based on the country's long-term budget plans, submitted to the European Commission. It assumes Portugal would need to roll over 53 billion euros of debt during the period, and finance some 14.5 billion euros in primary budget deficits; it has raised 9 billion euros so far this year.

Ireland has only 19 billion euros of debt rollover needs between 2010 and 2012 but its primary budget deficits could add 31 billion. Dublin has raised 12 billion euros this year, leaving a notional funding gap of 38 billion euros through 2012.

The bailout would become much more costly if the euro zone's fourth largest economy, Spain, were to apply for aid as well.

Spanish debt maturities amount to 264 billion euros in the 2010-2012 period, and Madrid is expected to need another 154 billion euros to cover primary budget deficits. It has raised 71 billion this year, which would leave 347 billion to finance.

A three-year bailout of Greece, Portugal, Ireland and Spain could therefore cost 544 billion euros, or roughly 6 percent of the entire euro zone's gross domestic product in 2009.

"This is a big number but, even in a worst-case contagion scenario, the region has the fiscal capacity to backstop both banks and these countries" said David Mackie, economist at JP Morgan, who expects such a bailout would cost 8 percent of the GDP of the unaffected euro zone countries.


Some analysts think the euro zone could reduce the costs of a wide bailout by moving pre-emptively, before countries had lost access to the debt markets.

Instead of actual loans, donor countries might announce financing guarantees; these would help the recipient countries retain access, so that they could continue financing themselves and the donors would not have to shell out cash.

But if countries continued to struggle with their debts, the guarantees might be invoked.

And judging from the German public's opposition to helping Greece, it might be very difficult politically for euro zone governments to agree to expand their bailout, even to one extremely small country such as Portugal.

"I cannot imagine that - I don't think there is a readiness in Germany to pay not only for Greece but also for Portugal. It would be political suicide" said Carsten Brzeski, economist at ING.

Also, the European Commission and euro zone officials have stressed that the mechanism for Greece is a one-off solution.

The commission is to propose a permanent mechanism for handling such crises on May 12, possibly drawing on a German proposal for a European Monetary Fund. But actually creating the mechanism may require contentious changes to the European Union Treaty that would require many months.

Many analysts think that to safeguard the euro currency, a tremendous diplomatic achievement, the euro zone will ultimately do what it takes to support its weaker members.

"Obviously they would not be happy, but eventually they would probably do it - to safeguard the stability of the whole monetary union" said Juergen Michels, economist at Citigroup.

But at some point, the costs of a multi-country bailout could start to appear prohibitive, even when weighed against the costs of allowing one or more countries to default and perhaps leave the euro zone.

This point might be reached in the case of Italy, the euro zone's third largest economy. It has so far weathered the crisis well and drew solid demand on Thursday for its sale of 7.7 billion euros of government bonds. But its debt this year is expected to hit 117 percent of GDP, making it a potential victim if market turmoil worsens.

The rollover of Italy's debt alone is estimated at 724 billion euros in the 2010-2012 period.

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