Europe's debt crisis rears its ugly head

@CNNMoneyInvest April 24, 2012: 10:05 AM ET
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After going dormant for a few months, the debt crisis in Europe has returned to the fore.

NEW YORK (CNNMoney) -- If you thought the debt crisis in Europe was over, think again.

The nearly three-year old crisis appears to be entering a new phase as the respite in global financial markets, which came after the European Central Bank flooded the banking system with cash, has faded.

The focus has once again shifted to politics, long a source of agita for investors, with elections in several key nations set to change the balance of power in the eurozone.

As the economy slides toward recession, there is renewed debate over the wisdom of austerity, which Germany has made a priority, versus policies aimed at boosting growth.

This debate could decide the outcome of elections in France, Greece and now possibly the Netherlands. It could also determine the fate of Portugal, Spain and Italy, which are all struggling to regain credibility in the bond market.

"The emergence of these new coalitions will make crisis management more acrimonious," wrote Eurasia Group analysts in a note.

While policy makers have taken steps to contain the crisis, many of the longer term problems have yet to be resolved.

Meanwhile, the uncertain political and economic outlook is making investors nervous, putting pressure on the ECB to do even more to stabilize the financial markets.

Here are a few things to keep an eye on in the weeks ahead.

Merkozy's days are numbered

In France, socialist candidate Francois Hollande narrowly defeated incumbent Nicolas Sarkozy in the first round of the nation's presidential elections last weekend.

Hollande is favored to win the final round of voting on May 6, although the race could be tighter than expected.

France and Germany have been the main players in the response to the crisis to date, so much so that Sarkozy and German Chancellor Angela Merkel have become known as "Merkozy."

The Merkozy doctrine, such as it is, has been to demand austerity measures from eurozone nations that have requested bailouts from the EU and International Monetary Fund.

The two leaders have also been pushing for more political and economic "integration" as the main proponents of the "fiscal compact" that euro area leaders signed late last year.

Hollande, however, has suggested that he would renegotiate the fiscal compact before recommending that France ratify the proposed budget rules and penalties.

He has also called for more growth-oriented policies, suggesting that Hollande could have a complicated relationship with Merkel, who favors spending cuts.

Budget fight breaks Netherlands government

Meanwhile, the Netherlands has emerged as another source of political uncertainty after an impasse over budget cuts caused the nation's prime minister to resign.

Prime Minister Mark Rutte resigned after far-right party leader Geert Wilders withdrew his support for cuts needed to meet EU budget rules.

It was not immediately clear what will happen next, but Wilders and other Dutch politicians have reportedly called for elections as soon as possible.

The political turmoil raised worries that the Netherlands, one of the few AAA-rated eurozone nations, could have its credit rating downgraded.

Greece is still in bad shape

Amid a shrinking economy and deepening austerity, Greek voters are scheduled to elect a new government on May 6.

Greece has been run by a caretaker government since Prime Minister George Papandreou resigned late last year, under pressure from France and Germany.

Lucas Papademos, the interim prime minister, orchestrated the largest sovereign debt default in history and secured a second €130 billion bailout program during his six months in office.

To qualify for the bailout, Greece was required to enact a raft of austerity measures and agree to a program of structural reforms that will be overseen by the IMF for the next few years.

Greece has already endured years of austerity, which many economists say has worsened the nation's recession. In addition, Greece's debt load will still be very high and may require further restructuring even if it completes the reforms under its bailout program.

This suggests that Greece will either be forced out or will decide to abandon the euro currency union later this year, according to Capital Economics.

Domino effect: Portugal, Spain and Italy

After Greece, investors see Portugal as the most likely candidate for another bailout.

Portugal's borrowing costs shot higher earlier this year amid fears the nation could seek to restructure its debts. Investors were also rattled after Standard & Poor's downgraded Lisbon's credit rating to junk in January.

In its most recent review, the IMF said that Portugal was "broadly on track" with the €78 billion bailout program the nation tapped nearly a year ago.

While the Portuguese economy is comparatively small, the nation's woes have highlighted the challenges facing larger eurozone economies, such as Spain and Italy.

Spain recently disclosed that its 2011 budget deficit was much larger than expected and warned that the government may not meet its fiscal targets for 2012.

Prime Minister Mariano Rajoy, in power since December, has proposed a €27 billion austerity program. But the Spanish economy, which is suffering from high unemployment and problems in the banking sector tied to the real estate market, has slipped back into recession.

While the authorities say Spain can avoid a bailout, yields on Spanish bonds have risen sharply recently as investors fear the nation will require some sort of external support.

Investors are also worried about Italy, the eurozone's third-largest economy, despite progress made by Prime Minister Mario Monti on labor and other market reforms.

The concern is that if Spain needs to be bailed out, there will not be enough money left over to support Italy in the event that Monti's reforms fall short.

Monti, who was appointed after Silvio Berlusconi stepped down late last year, has also been pushing back against austerity and emphasizing the need to stimulate growth as Italy's economy has stagnated for years.

ECB's options are limited

The ECB stepped up its efforts to prevent a credit crisis late last year when it offered European banks unlimited access to cheap, long-term loans.

In two separate operations, the ECB pumped over €1 trillion into the banking system.

ECB president Mario Draghi has said the goal was to help banks struggling to fund themselves amid concerns about exposure to sovereign debt. But the flood of liquidity also appeared to help drive down borrowing costs for troubled eurozone governments.

As yields move back into the danger zone, investors are again looking to the ECB to save the day.

There is speculation that the ECB could resume limited purchases of government debt under its controversial securities market program.

Some analysts have also suggested that the ECB could move to full-blown quantitative easing, a strategy used by the Federal Reserve, to help boost the economy.

However, such steps would violate the ECB's mandate, which is to maintain price stability, and the bank has already stepped way out of its comfort zone. In addition, intervening in the bond market raises thorny questions of "moral hazard."

Instead, Draghi has stressed that governments must push ahead with fiscal consolidation and reforms to increase economic competitiveness.  To top of page

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