Investing

The Contagion Battle Which Could Last A Year

The spreads on what it costs to insure the sovereign debt of Spain and Portugal have continued to widen. The borrowing costs for each country are now at  levels which neither can probably sustain for any long period. Nouriel Roubini, the widely followed economist, suggested that Portugal take bailout money soon to avoid a protracted struggle.

New analysis shows that the Spanish bank system is in enough trouble that it could ruin the government’s financial future. Experts believe that banks in the country may need to refinance over $11o billion each year. Capital markets investors are likely to consider putting money in those banks to be too risky.

Spain and Portugal have set austerity plans in the hopes that they will bring down large deficits and convince outside investors that they are financially viable without the need for bailouts. Large and powerful investors who do not believe this have almost certainly begun to short the sovereign paper of the two countries, which will put more pressure on their plans to remain financially independent.

Spain and Portugal also do want to lose their financial independence to other EU nations and possibly the IMF. The countries that support most of the investment in the troubled fortunes of their neighbors are Germany and France–especially Germany.  German Chancellor Angela Merkel argues that financially crippled nations should follow onerous fiscal rules. These rule would be set, in large part, by Germany itself.

So, Spain and Portugal are in a race against time, and that race could last a year. Its duration depends on how much money each has in its treasury, how many financial obligation they can defer and the extent to which investors can be convinced they can remain financially independent. Ireland lost that battle even though it insisted it had adequate capital to fund itself through the middle of 2011. Did Ireland give up before it had to? Perhaps so. It was under unrelenting pressure from most of  Europe and outside investors.

Now, the question is how long can Spain and Portugal maintain their sovereign financial states. The national debt crisis in Europe will die down eventually, but that will depend on whether Portugal and Spain can show the marketplace that they do not need capital and are prepared to pay high interest rates — at least for a while —  for the money they need to finance their deficits. If one of the countries stumbles, it is likely to be Portugal, which is considered the weaker of the two. That would make keeping a firewall around Portugal critical to putting an end to the idea that contagion could take down all of Europe’s teetering nations.

There has been some mention that China could be a source for capital. Stranger things have happened in international finance and the People’s Republic does have more than $2 trillion in currency reserves. A Chinese investment in Portugal would help break the hold that Germany has on the financial future of Europe. That might mean more to China than the risk of an investment in a financial weak nation. China sees Germany as its global trade foe, nearly as much as it does the US.

The battle over contagion is not over. If Spain and Portugal can hold out and buy time, the struggle may not be resolved this year as the markets suppose it will be. Should Spain and Portugal avoid a bailout by their neighbors, the fear of a wild-fire in Europe could end early next year.

Douglas A. McIntyre

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