World Braces For Test of Euro

Europe, facing a momentous Greek election after a week of mounting financial stresses, is preparing for what some financial analysts are calling its “Lehman moment”: the prospect that Greece could leave the euro currency union following Sunday’s vote.

Yet, European officials say that even an election that results in a Greek embrace of the euro and an acceptance of the terms of Europe’s March bailout of the country may only temporarily ease pressure on the euro zone, whose crisis-management strategy many analysts say lies in shreds.

Borrowing costs in Spain and Italy rose sharply higher in recent days despite efforts to insulate Spain, the euro zone’s fourth-largest economy, from the effects of Greek uncertainty by lining up a bailout request last weekend for as much as €100 billion to boost the capital of Spanish banks.

“We are back in the danger zone,” said Jean Pisani-Ferry, director of Bruegel, a Brussels-based economic think tank.

Financial markets rallied modestly Friday after unofficial Greek polls suggested the pro-European New Democracy party would claim victory in the national parliamentary elections Sunday. Officials expect a government led by the party wouldn’t insist on a radical renegotiation of the terms of the bailout. With a two-week blackout on polls, investors have little new data to help them guess whether Greek voters will support New Democracy or its rival, radical leftist Syriza party, which has insisted it would stick with the euro but rejects the bailout agreement.

Underlining Greece’s economic challenges, Europe’s biggest retailer, Carrefour, said Friday it was pulling out of Greece by selling its stake in a supermarket joint venture to its local partner, becoming the latest and largest company to get out of the struggling country.

While senior European officials insisted they didn’t anticipate a sudden Greek exit from the euro, major central banks have lined up measures to calm markets in case the election result unsettles markets and further depresses growth.

On Friday, European Central Bank President Mario Draghi, in an effort to calm investors, said that the ECB “will continue to supply liquidity to solvent banks where needed,” adding to the more than €1 trillion ($1.263 trillion) in three-year loans it provided to banks in December and February.

German Chancellor Angela Merkel delayed her departure to a summit of the Group of 20 that starts Monday in Mexico, a possible indication of nervousness over the outcome of the elections. Germany, the EU’s most powerful economy, continued to signal it isn’t inclined toward leniency with Greece.

The Federal Reserve has prepared contingencies while the Bank of England announced plans Thursday to insulate the U.K. if the euro crisis deepens.

“Europe will not survive if we do not show enough solidarity, but it won’t survive either if too much solidarity is shown,” Foreign Minister Guido Westerwelle said Friday.

Mr. Westerwelle also made a distinction between Greece and other struggling euro-zone members such as Portugal and Spain. “We have to recognize that the situation is very different across Europe,” he told journalists in Berlin.

Any effort to overhaul the March bailout with Greece would severely test the willingness of euro-zone paymaster Germany to provide more finance—increasing the risks of Greece departing the currency bloc.

While some officials, notably at the German Bundesbank, have said a Greek exit would be manageable, many analysts have said it could generate panic similar to the decision to allow the U.S. brokerage house, Lehman Brothers, to fail in 2008. If one country can exit the euro zone, it will be clearer that other weak economies can also. Citigroup says it rates the probability of Greece’s exit from the euro at 50-75%.

If an exit is averted, Greece still will likely need more bailout aid in coming months to keep its economy limping along, and tensions between Athens and its official lenders are likely to return whoever runs the government.

“Whatever the outcome of these elections, it will be very difficult for Greece to fulfill the requirements of its [bailout] program,” Mr. Michels said.

Even if Greece stays in the euro, pressure on Spain and Italy is unlikely to lift. The governments of both countries have relied heavily on foreign investors—and are now vulnerable because foreigners have retreated.

The failure of last weekend’s announcement of the preparation of a bailout plan for Spanish banks also exposed serious weaknesses in the region’s rescue measures. The bailout funds can’t directly provide capital to banks—they can only lend to national governments in order to give them the resources to bailout banks, swelling the debt burden of struggling governments.

The International Monetary Fund said Friday that Spain must redouble its efforts to stop its debt from rising further. Spain’s public debt rose to 72.1% of gross domestic product, government figures released Friday showed. That is 30 percentage points higher than in 2008.

In another weakness of the bailout arrangements, the bailout loans will have a senior status—meaning that buyers of government bonds will move a notch lower in the pecking order in case Spain needs to restructure its debt. More than that, the funds aren’t large enough to take over responsibility for the borrowing needs of Spain and Italy.

Flaws have also been exposed in the euro zone’s other rescue plans. The ECB took no losses on its holdings of Greek government bonds when Greece restructured its debt earlier this year—subordinating government bondholders. A big ECB move to prop up Spanish or Italian bond prices would likely heighten worries of private bond investors that their interests will be muscled aside by powerful official creditors.

Beyond that, ECB moves to flood banks with long-term funding in December and February helped banks—but offered only short-lived support to government bond markets. That suggests another dose wouldn’t resolve the fundamental underlying problems.

Bank of England Governor Mervyn King said Thursday that the fact the boost from the ECB’s long-term refinancing operations was so short-lived shows that a shortage of short-term liquidity isn’t the euro zone’s problem. “The problem is one of solvency,” he said.

Given these weaknesses, financial markets appear to be seeking evidence that more decisive steps are being considered. These would entail the stronger governments taking some responsibility for the obligations of weaker governments and of troubled national banking systems. “The traditional instruments have reached their limit,” said Mr. Pisani-Ferry. “That’s why people are starting to consider debt mutualization and the issue of a banking union.”

There is strong resistance to these concepts from the countries that are members of what some analysts have described as the “Club of No”: Germany, the largest European economy, backed by Finland, the Netherlands and Austria.

The latest setbacks have further increased the pressure on Germany, whose chancellor, Ms. Merkel, is likely to be pushed by other leaders at the G-20 summit to take further steps to boost confidence.

Investors increasingly see two opposing outcomes from the crisis: an unraveling of the euro zone or decisive action from Berlin. If the euro is to be saved, many say, Germany or the ECB, and probably both, will have to put their resources on the line in a decisive way.

That decision will likely be brought forward if an antiausterity government takes power in Greece. In coming days, Berlin will have another decision to make, say European officials: to decide whether a new government in Greece is a partner that deserves further help or an obstructionist administration that should be left to go its own way.

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