Will Greece Be Rescued Too?

Triggered by hopes of a comprehensive euro-zone deal and fresh central bank liquidity, equity markets have taken off this week.

But these measures are largely designed to prevent the sovereign debt infection from bringing down Italy and, therefore, the currency union. What happens to where the infection first flared up: Greece?

The upward trend in Greek yields even as they’ve dropped for every other crisis-hit euro-zone country suggests Greece remains more or less where it was before contagion caught hold across the single-currency region. The market says Greece will still default on its debt, and with private-sector creditors taking an even bigger loss than had been factored in by the latest EU deal.

There is no let-up to austerity. A semi-permanent state of austerity, GDP contraction, government deficits and lack of access to the credit markets will only feed popular resentment among Greeks towards the EU.

The only real alternative is for Germany and France to fully absorb a Greek default, including losses on debt held by the ECB, and to show willingness to a slower Greek economic restructuring, less austerity and more forbearance on Greek deficits.

Will this happen? I doubt it.

So the euro-zone continues to face the prospect that one of its member states will leave the currency union–whatever the technocrats in Brussels and Athens would like to believe.

The question then must be whether the structures and agreements the EU puts in place over the near term–including agreements on closer fiscal union and promises by the ECB to absorb shocks–will be enough to withstand what will almost certainly be a renewed bout of panic among investors about contagion and further withdrawals from the single currency.

A Greek withdrawal from the euro is likely to be followed pretty quickly after by Portugal’s exit. And then there might be one of the big dominoes.

Although all eyes are focused on Italy, Lombard Street Research’s Charles Dumas thinks that Spain is in a more difficult position. Although Spain’s government debt load looks better than that of most euro-zone countries, its banking sector has been crippled by the bursting of Spain’s huge property bubble. Once all the losses are recognized, they will inevitably fall on the Spanish government.

Will Germany put itself between the markets and Spain or Italy when the crunch comes, will it commit vast amounts of taxpayer money to prevent either of these countries from also being forced into default? That’s what investors seem to be banking on this week. I’d be less sure.