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Europe’s Debt Crisis Is Over. Probably. Or Maybe Not. September 1, 2010

Posted by Yilan in EU, Yunanistan.
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Is the worst of Europe’s debt crisis over? Or is there more pain coming? Markets aren’t giving a straight answer.

Investors seem to have regained their confidence in the euro: Europe’s common currency has largely stabilized at around $1.27 per dollar, after falling to a four-year low of $1.1876 in early June. The pan-European STOXX 600 Index, meanwhile, has only lost 1% this year, with German stocks dropping a paltry 0.5%. The Dow, by contrast, is down 4% in the year to date.

This may reflect shifting attitudes about the world’s economic prospects. Japan is in the doldrums. Worries about the U.S. economy are mounting. And yet Germany, Europe’s biggest economy, saw its fastest rate of growth in 20 years in the second quarter. A recent survey suggests the 16-member euro zone’s recovery continued in August. (The bloc expanded at an annualized 3.9% rate in the second quarter, compared with the U.S.’s 1.6% rate.). And as the WSJ’s Brian Blackstone notes Tuesday, Italian bank UniCredit is actually revising its third-quarter GDP estimate for the euro bloc higher, not lower.

At the same time, other parts of the European financial architecture are flashing red, signaling more trouble to come for the highly-indebted countries on Europe’s periphery. A key index showing the cost of insuring government bonds from Western European countries saw its worst monthly performance since it began trading about a year ago. Renewed fears about Ireland’s banks and Greece’s economy have pushed their credit-default swaps closer toward record levels. (Investors buy these swaps to protect themselves against government defaults.) It now costs about $350,000 a year to insure $10 million of Irish government bonds against default for five years, according to data provider Markit, compared with less than $200,000 on Aug. 3, a jump of 75%. The record for Ireland is something close to $400,000.

So, how will these conflicting signals be resolved? Analysts at Brown Brothers Harriman figure that the euro is headed for a serious fall. Like the U.S., the euro zone may see its growth slow significantly later this year, especially if weaker Asian demand takes steam away from German exports. Weak growth in Greece, Ireland, Portugal and Spain are likely to drag down Europe’s overall output, making the euro less attractive. But the counter-argument is that investors largely know what they’re dealing with now when it comes to Europe. Credit markets are already “pricing in” a Greek debt default and more pain for Ireland, whether rightly or wrongly. And what’s driven bond market spreads wider in August has been worries about the U.S. — not just Europe.

A lot depends on the U.S. economy’s ability to keep chugging along. If the recovery continues at a reasonable pace, the euro zone — especially countries closely tied to the U.S. through trade like Ireland — could actually benefit by comparison. But if the U.S. slides back into the doldrums, Europe’s recovery could be hindered, putting the likes of Ireland and Greece in jeopardy.

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