Conal Gregory: Euro crisis fallout threatens to engulf banks in Britain

The stakes are high as European Chancellors convene. The future of the euro is in doubt. The solution will be a political, rather than an economic one as Central European politicians have invested too much to let the euro fall.

The crisis starts with Greece which is in urgent need of a second loan. This time, the Eurozone ministers largely favour seeking private finance, but almost certainly this would be regarded as a default.

In turn, a ‘default’ would mean European bankers would refuse Greek debt as collateral.

The major industrialised nations of Europe have their own agendas for handling the crisis and no consensus has yet emerged. Germany has a radical plan to extend the maturity dates of bonds but France favours rolling over 70 per cent of Greece’s debt.

The UK, although outside the euro, has been forced to assist. After the last General Election but before the coalition had taken seals of office, Alistair Darling committed to a bail-out fund. Known as the European Financial Stabilisation Mechanism, this means the UK taxpayer may have to fund more than £10bn of debt.

Labour’s signature to this deal was opposed by George Osborne and a leaked Treasury adviser note. While technically Darling may have had the power to sign, he lacked the moral authority. Now George Osborne is saddled with the problem.

Our help has supported Ireland and Portugal but not Greece. The latter is clearly having difficulty in establishing an austerity programme.

By comparison, Portugal has taken strong control of its finances, which makes credit ratings agency Moody’s decision to downgrade our oldest ally to junk bond status inexplicable.

The agency claims Portugal is likely to need a second loan after the £70bn in May. Yet its deficit fell to 8.7 per cent of GDP at the end of the first quarter, down from 9.2 per cent three months earlier. It plans to cut the deficit to three per cent within two years.

With the domino effect, Spain was regarded as the next country in line to have problems. However, Europe’s sovereign debt crisis has switched to Italy.

At a staggering 1.6 trillion euros, Italy has Europe’s second highest debt to Greece at an estimated 119 per cent of GDP. Silvio Berlusconi is committed to balance the Italian budget within three years but few believe he has the ability to implement economic reform.

The outlook here is bleak for those holding European equity income funds, notably pensioners and charities. They, understandably, require a steady stream of dividends particularly with interest rates at a record low of 0.5 per cent.

With inflation at 5.3 per cent (excluding mortgages), money invested in European equity income is being eroded.

Instead, investors should switch to a stronger geographical zone. Over the last three years, the top Asian equity income funds are up over 80 per cent while Eurozone ones actually show either no growth or actual losses.

A sudden bail-out for Italy will have yet further repercussions. Already, its debt forms the third largest bond market in the world (after the US and Japan) and this could mean major losses for banks, including those based in the UK.

The public money for a bail-out is inadequate to service Italy and so private funds will have to be encouraged.

Ted Scott, global strategy director at F&C Investments, says that with the threat of Italian insolvency looming ever larger, “it makes sense for the authorities to finally accept that Greece – and, by implication, other periphery countries – defaults on part of its debt”.

This should mean great value holiday deals in Greece for those coming from a stronger economy like the UK, but a major worry for those with property, such as a vacation home, there. It may be expensive to service any mortgage on such an asset.

The chance of Greece coming out of the euro and a “new drachma” currency emerging is most unlikely. While it could be argued that such a development would have economic success, the Eurozone’s political masters will not contemplate such a course. They have spent far too long inventing, constructing and now shoring up the euro to let it fail.

Many of Europe’s chancellors privately concede that too many states have been admitted to the euro without their economies being brought into proper alignment. Again, the political muscle overpowered the economists. The full solution will take some years to correct – time that Europe does not have and while other states, notably Turkey and probably Albania, are knocking at the door to come in.

Debt problems are not confined to Europe. The US is running out of money and has until July 20 to find a deal to ensure the national debt does not default.

President Obama will have to engineer a solution. The consequences of failure are too horrific to contemplate.

Read Conal Gregory in the Yorkshire Post every Saturday.

Conal Gregory is the Yorkshire Post’s personal finance correspondent.