Euro area approaching a deadly trap

I feel a bit bitter taste in my mouth observing how Greece, once the cradle of European civilization, juggles with default. Decades of corrupted governments’ rule and irresponsible spending backed by financial magicians brought the country into situation, when nobody is quite sure what is going on.

Well, someone could say: “Who the hell cares?” Yes, Greece is known mainly for gyros, Attic ruins and beaches. Far from the centre of European, not to say the world economic playground. Well, not anymore. Current problems of Hellenic Republic may have a severe impact on the whole Euro area and the gun powder barrel can be ignited in next months.

Euro area is approaching a trap – a trap called interest rate change. As most of the central banks, ECB chopped the deposit facility down to historic minimal 0.25%. This means interest rates on government bonds fell down too, giving governments an opportunity to grab cheap money to cover latest tremendous fiscal deficits. However, big economies (mainly Germany, as you can guess) are gliding away from the dangerous waters of recession and are about to start pressing the ECB soon. Extremely low interest rate fuels renewed bubble and inflation growth – something not desired at all.

Now imagine what would happen, if the rate is increased. Greeks, who have problem to raise cash now, in time of extremely low interest rates, will found it even harder to do so, when the Euro interest rate will jump up. Greek Eurobonds are sold now about for about double price (promised yield for an investor), compared to German Eurobonds. It would mean that just the costs of national debt will bite a huge piece of Greek budget cake, sending the country further into debt spiral.

If Greece theoretically defaults, it will have immediate impact on all other Eurobonds (which are considered to be the world top elite league), especially on those of smaller and/or more volatile economics, like Spain, Portugal, or Italy (I find the term PIGS pretty offensive). Their cash raising will become much more expensive, forcing countries to spend much more of precious funds on debt expenses. And the disease will spread further and further.

And there is also a second part of the interest rate story which is a bit omitted – real estate markets. We can’t forget real estate industry was at the beginning of the crisis and most of the developed countries’ markets were hit in more or less serious way. I work with a bunch of Canadian realtors, who have now quite happy smiles on their faces, since the Canadian market rebounded early.

One of them, the renowned Toronto real estate agent Elli Davis, explained to me: “Low numbers of foreclosures and generally healthy credit situation of Canadian households prevented housing market from collapse. However, the low interest rate was the key factor which drove real estate market out of the decline within few months. With unemployment under control and BoC promising to keep the rate down till summer 2010, people felt confident enough to start purchasing properties again.” And I can add that real estate market is now pulling the whole Canadian economy up.

On the more seriosuly hit Europe’s markets a different song is sung. Just imagine Spain, a country struggling with 19% unemployment. The local real estate market burst like a pinched balloon. And it’s not only Spain, but also Portugal and Ireland. Real estate is the core of their troubles and (considering dismal numbers of unemployed citizens with minimal income) low interest rate is the only thing which keeps them breathing for now. Euro Interest rate growth can knock them definitely to the ground.

ECB will be soon under two pressures – to keep the interest rate down, or not. To let the smaller economies with their expensive debts and breathless real estate markets bite the dust, or risk that Germany and other Euro leaders will experience another deadly bubble? There is no correct answer, but ECB will have to decide one day. In the meantime, a Greek default would force an unwanted day of reckoning on all Euro economies.

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