Europe's debt crisis: 5 things you need to know

September 26, 2011: 5:03 PM ET
German Chancellor Angela Merkel wants greater 'convergence' among all EU members.

German Chancellor Angela Merkel wants greater 'convergence' among all EU members.

NEW YORK (CNNMoney) -- It's been about 18 months since the sovereign debt crisis in Europe began attracting attention in global financial circles.

In that time, the crisis has grown into the biggest challenge the European Union has faced since the adoption of the euro as its single currency 12 years ago.

Greece, Portugal and Ireland are on life support. Italy and Spain are exhibiting worrying symptoms. Germany and France, the healthy ones, are suffering from a global economic malaise.

As the situation appears to be coming to a head, again, here are five key issues to keep an eye on.

1. Stability fund is not very stable

In July, European political leaders announced a set of proposals to address the crisis, including a second bailout for Greece, which was teetering on the verge of default.

The centerpiece of the agreement was the proposed reform of the European Financial Stability Fund. The fund was set up last year to facilitate low-cost loans for struggling EU members including Portugal and Ireland.

Under the proposed reforms, the €440 billion fund would be able to buy bonds issued by distressed euro area governments directly from investors in the secondary market.

It would be able to do this for nations that do not have an existing bailout program, such as Italy and Spain. Both nations are struggling with unsustainable levels of debt and dim economic prospects.

The revamped fund would also be able to provide lines of credit to nations that need to shore up under-capitalized banks.

The proposed overhaul must be approved by the individual governments of all 17 counties that use the euro. Euro area leaders have said they plan to implement the changes by mid October.

But the bigger question is how effective the stability fund will be, even with its new powers. In particular, investors are concerned that there may not be enough money in the fund if Spain or Italy need to be rescued.

Alternatively, policymakers and investors have been discussing ways to enhance the effectiveness of the fund without raising its price tag.

The push to reform the stability fund also faces significant political headwinds in many northern European nations, where the idea of providing additional support for countries that overspent is deeply unpopular among voters.

So far, six countries have ratified the changes, including France, Italy, Spain, Ireland, Luxembourg and Belgium.

This week, the overhaul is expected to be passed by lawmakers in Slovenia, Finland, Germany and Austria.

2. Greece and Italy are on a knife's edge

In addition to expanding the stability fund, euro zone leaders agreed to provide another 109 billion euro package of low-cost loans for Greece.

Like the stability fund reforms, the second bailout must be approved by all individual euro area governments.

The move initially eased concerns that Greece would default on its debts. But those fears resurfaced in September amid signs that Athens may not meet some of the conditions necessary to obtain its latest installment of bailout money.

Greece is in talks to secure the sixth round of funding from last year's €110 billion bailout, worth €8 billion. Without those funds, the country is expected to run out of the cash it needs to pay all of its bills by mid October.

On Sept. 21, the Greek government announced a series of job cuts and pension reductions following intense negotiations with its bailout providers at the International Monetary Fund, European Commission and European Central Banks.

The cuts will enable Greece to meet its budget targets for this year and next, the government said, paving the way for the release of its next dose of bailout money.

As part of the second bailout for Greece, banks and investors agreed to accept a 21% writedown of the value of Greek government bonds on their books.

But there has been increasing talk about the need for Greek bondholders to take even larger "hair cuts," as the writedowns are called.

Meanwhile, investors have also been growing worried about Italy.

The third-largest economy in Europe, Italy is considered too big to fail. While the nation has a relatively small budget deficit, Italy has debts equal to nearly 120% of its gross domestic product.

At the same time, Italy's decade-long economic slump is not expected to end anytime soon, making it difficult for the nation to pay off its debts.

Italy has proposed a series of austerity measures aimed at reducing its debt burden. But investors remain nervous about the government's ability to implement the unpopular belt-tightening.

3. Banks are under heavy pressure

The debt problems in Greece and Italy are threatening to spill over into the European banking system.

According to the IMF, European banks face a €200 billion credit risk stemming from direct exposure to government debt issued by Greece, Portugal, Ireland, Spain, Italy and Belgium.

Including exposure to banks based in those troubled economies, banks face a total credit risk of €300 billion, the IMF estimates.

The IMF and others have called on European banks to raise more capital to provide a buffer against potential losses on distressed sovereign debt.

Shares of several major European banks, including many French financial institutions, have plunged to their lowest levels since the 2008 crisis.

In addition to the threat of losses on sovereign debt, investors are concerned about banks' ability to raise funding as key pools of liquidity have dried up.

EU officials have also maintained that stress tests conducted in July prove that European banks have sufficient capital.

And there is always the ECB, which has already provided some relatively small loans to European banks. But given the challenging stock market and concerns about a pullback in interbank lending, banks in Europe appear to have few options to raise capital.

4. Economy is in the dumps

Economists say the weaker members of the eurozone will not be able to repay their debts and live without bailouts until economic activity resumes in a big way.

That seems unlikely given the outlook for economic growth in Europe and around the world.

The ECB recently lowered its forecast for economic growth across the eurozone for this year and next.

The central bank now expects growth of only 1.4% and 1.8% in 2011, and between 0.4% and 2.2% in 2012.

Both are down from earlier forecasts, and the risks to that gloomier outlook are now to the downside, rather than balanced as the ECB had previously said.

In the second quarter, overall economic activity among the 17 nations that use the euro grew only 0.2% compared with the first quarter, according to Eurostat.

Germany, the region's economic powerhouse, reported a paltry 0.1% increase in second-quarter gross domestic product, compared with a more robust 1.3% in the first quarter. But economists say Germany is still on track for modest growth in 2011.

The German economy is heavily dependent on exports and has benefited from rapid growth in emerging nations such as China.

As activity cools in those markets, the outlook for Germany has dimmed. The slowdown raises troubling questions about the long-term outlook for the eurozone.

5. Fate of eurozone is at risk

The crisis has brought to light problems that many analysts say will require a fundamental change in the way the European Union operates.

The eurozone nations have enjoyed the benefits of a shared currency and uniform monetary policy since about 1999. However, aside from certain unenforced budget targets, the group has never had a common approach to fiscal policy.

The lack of coordination has resulted in a situation where stronger members of the union are now being forced to help support less competitive members that have spent beyond their means.

If they don't, many analysts say the euro project may not survive the crisis in its current form.

The fear is that either weak members of the currency union will go bankrupt and be forced out, or stronger members will become unwilling to prop up fiscally challenged neighbors and strike out on their own.

European leaders have said repeatedly that they will do whatever it takes to preserve the euro, arguing for a more uniform approach to spending and taxes across the European Union.

But moving towards greater fiscal integration raises serious questions and could involve rewriting EU treaties, something that may take years to achieve. In the meantime, investors have been calling for the creation of a so-called Eurobond, which would be backed by all 17 euro area nations.

Issuing a common form of debt would ease borrowing costs for the weaker members of the union. But it would also drive up rates for the stronger nations and could jeopardize their credit ratings.

The European Commission is exploring different Eurobond options in preparation for an official proposal. But EC officials have cautioned that issuing a new form of debt is not a long-term solution to Europe's debt crisis.  To top of page

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