From Athens to America…

Is Greece the Lehman Brothers of the next crisis?

Rating downgrades for Greece, Portugal and Spain have triggered fears of a widespread sovereign debt crisis. While an IMF-backed European bailout package is being worked out, it may be a case of too little, too late and at best might help delay the disaster. Given the lack of a sense of urgency among European governments to stitch together a rescue package and the increasing estimates of the size of the bail-out, the financial markets have started pricing in a high chance of a default by Greece.

• What would a default by Greece on its debt obligations mean for Euro and EU (and for global financial markets)?
• Who is the next in line?
• Does UK face an imminent rating downgrade?
• Will the sovereign debt crisis spread beyond Europe?
• What happens to the ongoing global recovery?

The focus now is on the so-called PIIGS economies – Portugal, Ireland, Italy, Greece and Spain – the European economies running heavy debt burden and high deficit position. However, the growing risk aversion might trigger a sovereign debt crisis, where cost of raising money for the countries would increase. A general loss of confidence in the safety of sovereign debt will chill the financial system and would be disastrous for the still fragile recovery. See the position of debt and deficit for other major European economies.

Talking about the risks beyond the peripheral EU economies, virtually no rich country has a “sustainable” debt position. Whether it’s UK, US or Japan, none is running a tight enough budget or growing fast enough to stop the debt burden from rising. It may sound preposterous to compare Britain’s fiscal condition with Greece’s or to talk about the American economy in the same breath, but the stakes are too high to remain complacent.

While a default by Greece cannot be ruled out, it would be interesting to see how the events unfold over the next few months in Spain whose economy is much larger than Greece. If Spain comes out successfully, it would mean the sovereign debt crisis can be contained for now. In the longer run, position of high indebtedness of the rich nations would still be a major risk.

Eurozone rates raised to 4%, UK steady at 5.5%

The European Central Bank (ECB) last week raised interest rates for the eurozone to 4% from 3.75% - taking rates in the area to their highest level in six years.

Though the rate increase was widely expected, what was awaited eagerly was cues on further rate actions. At his news conference, ECB president Jean-Claude Trichet said that eurozone monetary policy is "still on the accommodative side", suggesting that more rate hikes may be in the pipeline.

The eurozone economies, especially Germany, have been growing strongly in 2007, unemployment in the eurozone is at its lowest level since the launch of the euro, while confidence is high and business activity is expanding.

Meanwhile, the Bank of England decided to keep its benchmark rate at 5.5%. Even as the bank freezes the rate and goes in a ‘wait and watch’ mode to assess the impact of the series of recent rate hikes, a rate rise later this year remains likely. UK rates have been increased four times since August last year in an attempt to rein in inflation. But price growth still remains strong. While consumer price index (CPI) inflation fell from 3.1% to 2.8% in April, the measure still remains well above the government's target of 2%.

ECB Expected to Raise Key Rate

The European Central Bank is expected to raise its key interest rate by a quarter of a percentage point to 4 percent when it meets today, taking the borrowing cost in the 13-nation euro zone to its highest level in six years. The corresponding benchmark rate is 5.25 percent in US and 5.50 percent in Britain.

Besides the rate decision today, on which there is a near unanimity, the markets will be looking for clues on future rate moves.

The euro zone economy has been growing at a healthy pace, unemployment is at its lowest level since the launch of the euro while business and consumer confidence are up. ECB has been calling for “strong vigilance" to keep inflation under control – a phrase considered by the market as a signal of continued rate increases, typically a quarter of a percent. Year-on-year inflation in the zone was 1.9 percent in May — unchanged from the previous two months, and around the ECB's guidelines of just under 2 percent. While there are concerns about inflationary risks, the ECB will also have to consider global developments such as the problems in the US housing market and uncertainty about Chinese stock markets.

ECB holds interest rate, may raise in March

The European Central Bank has decided to keep its key interest rates on hold at 3.5%, waiting to see if its last increase in December can keep inflation at bay and hinting that a hike may come in March. The ECB President Jean-Claude Trichet said "strong vigilance" was needed to avoid "risks to price stability" – a statement being seen by the market as a clear signal for a rate hike next month. The term ‘vigilance’ seems to have acquired a new meaning for the followers of Trichet-speak - each of the last six times Trichet used the word vigilance, a rate increase was handed down the next month.

The key eurozone economies have had a strong start to 2007. Unemployment has fallen in France and Germany, with consumer confidence remaining strong, despite Germany's decision to increase value added tax (VAT) from 16% to 19%. While growth is expected to remain strong, wage pressures are mounting. The latest round of pay negotiations in Germany will be keenly watched. Inflation in the euro zone was 1.9 percent in December for a third straight month, at its recommended level of just under 2 percent.

Meanwhile, Bank of England also held official interest rates steady at 5.25 percent after a surprise increase last month of a quarter of a percentage point.

Bank of England surprises with rate hike, ECB holds

Monetary policy and central bank actions need not always be boring. Bank of England has delivered an exciting story to the markets, by raising its base rate by another quarter-point to 5.25%. This follows two earlier hikes of same magnitude, as part of an effort to stem inflationary pressures – one in November last and another one in August, the hike in August being similar to the latest one in surprise element.

The European Central Bank, on the other hand, decided to hold rates steady while hinting at an increase later this quarter.

The Bank of England’s move is spurred by worries on creeping inflation which reached 2.7 percent in November — above the bank's target of 2 percent for the seventh month in a row. Given the expectations that inflation may rise further, the BoE's pre-emptive strike looks sensible. What surprised the markets is the timing of the move. It was widely expected that the central bank would wait until February, when it would take stock of the economy as part of its quarterly review of inflation prospects.

The ECB, meanwhile, left its benchmark rate unchanged at 3.5 percent, but President Trichet's comment that it would engage in "very close monitoring" of inflation risks is taken as a signal that a quarter-point hike could be on the cards for March. Annual inflation in the euro zone was at 1.9 percent in December, just below the ECB's target of about or below than 2 percent.

The ECB's forecasts for euro-zone growth this year are between 1.7 percent and 2.7 percent, up from 1.6 percent and 2.6 percent issued last year. For next year, GDP growth is expected to be between 1.8 percent and 2.8 percent. While Trichet said euro-zone inflation is expected to hover at around 2 percent this year and in 2008, analysts expect inflation to rise above the ECB's target early this year and lead to a rate increase in March. The ECB sets policy for 13 nations with more than 316 million people and a combined gross domestic product that accounts for more than 15 percent of the world's economy.