April 2010

The economies of Greece, Portugal, Italy and Spain—nicknamed the “Club Med” of the European Union (EU)—are not nearly as large as its richest member, Germany. Yet the economic, political and civil strife that rocked Greece this spring raised questions about the durability of the EU and the potential effect it could have on European interest rates and the euro.

These four EU members, plus Ireland, have overspent for years, failing to keep their budget shortfalls to 3% of gross domestic product, as the EU’s Maastricht Treaty requires. But relatively low borrowing rates and easy lending terms meant their fiscal excesses drew a blind eye from other EU members and investors. Now, after the financial fallout from last year, that has changed.

“It’s easy to avoid seeing the cracks under the rug when everything is fine. But now, we are seeing more normal pricing for issuing debt, and suddenly it matters how easily they can roll over their debt,” said Victoria Marklew, country risk manager with Northern Trust. “Investors will say if Greece has debt troubles, who else in the eurozone has problems.”

Why should investors care? Interest rates—paid or received—are a central issue. Buyers of government or sovereign debt issued by the Club Med and possibly other EU countries might demand higher interest rates in return for assuming a greater perceived risk of default by the issuers. “The big reason it’s important is that it can make it more expensive for everybody in the EU to issue debt,” she added.

It’s also no surprise about the belt-tightening measures these nations—Greece in particular—must take to shrink their deficits. Assuming the eurozone manages to muddle through, the Club Med countries will have to engineer massive changes in their economies simply to become more competitive, moves that Marklew said will be a big drain and negative for their economic activity possibly through 2011.

For investors, the ongoing concern is whether those efforts might shove some of the EU’s fragile economies into a double-dip recession that could reverberate throughout the eurozone and even affect the value of the euro.

Besides the possible direct impact on interest rates, Greece’s woes shined a harsh light on EU policies, forcing the EU for the first time to wrestle with how to deal with a member verging on default. Eurozone leaders finally agreed to a safety net whereby Greece could receive coordinated bilateral loans from other eurozone countries, plus additional cash from the International Monetary Fund (IMF), if it faced “severe difficulties.”

Although that pledge initially helped soothe nerves about a eurozone collapse, “the devil will be in the details,” Marklew added. “So I’d expect repeated bouts of market instability over the next couple of years, with a constant risk of renewed crisis fears if it appears that fiscal targets are in danger of being widely missed.”

The IMF and eurozone countries agreed to a €110 billion rescue for Greece in exchange for harsh budget cuts. However, some national governments still needed to provide final approval for the rescue as of the time of publication.

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