Cyprus, Luxembourg, Italy or Malta: Which country will unravel the euro zone?

Cyprus’s president says that country’s economic crisis is now contained, and it won’t need to leave the euro. But even if you believe him, that hardly means Europe is out of the woods. Slovenia was prompting concern last week, and Luxembourg and Malta are also stoking worries. And that’s not to mention the biggies Italy and Spain, whose failure would probably spark a worldwide economic crisis.

So which of these countries is likeliest to doom us all? Let’s run through the possibilities.

So let’s say we don’t believe the Cypriot president. How could things still go wrong for the small island nation? Well, if the capital controls don’t work as planned and depositors start withdrawing money from Cyprus’s banks in reaction to the haircut, that could threaten the stability of those already fragile institutions. It would mean that they may not have enough in the way of deposits to cover a precipitous drop in loan repayment, as would occur if, say, more of Greece’s debt were to go bad. Basically, if either of the country’s two big banks fail despite the bailout, everything starts to fall apart again.

This tiny duchy, sandwiched between France, Belgium and Germany, is a historical center of the European project, having been a founding member of the European Coal and Steel Community, which evolved first into the European Economic Community and then into the European Union. Jean-Claude Juncker, who since 1995 has served as prime minister of the nation of half a million people (about the same population as the District of Columbia, or Vermont), has twice served as president of the European Council and until recently chaired the Euro Group, which has jurisdiction over policy involving the currency and which engineered the Cyprus bailout. His predecessor left the office to become president of the European Commission.

But it’s also a major banking center. According to Businessweek’s Peter Coy, its bank assets currently total about 23 times the country’s GDP. That’s down from about 29 times its GDP before the crisis. Those assets are generally safer bets than Cypriot debt, as the country is much less exposed to bad debt from Greece. But if a sizable chunk of it goes bad, there’s just no plausible scenario in which the country could pay to recapitalize the banks itself. As of late 2011, 29 percent of its assets came from Belgium, Germany and France, so those countries may be less likely to accept haircuts than they were with Cyprus, whose banking clients included many Russians. Any bailout would probably have to come from those countries’ treasuries.

The country is important enough to the continent’s finances that those countries would be inclined to agree to such a bailout, but if they don’t, or if the bailout fails to prevent significant institutions in Luxembourg from collapsing, then clients in Germany, France and elsewhere could lose a lot of money, battering the European economy.

Malta, best known until now for the Knights thereof and for Goosio, friend of Maltese children everywhere, is, like Cyprus, a tiny island nation with an outsize banking sector. As of December, its bank assets totaled 792 percent of GDP, an higher share even than seen in Cyprus. The country, as of mid-2012, was even more exposed to Greece, as well, with exposure totaling 4.3 percent of GDP.

But overall, international observers are less worried about Malta than they are about Cyprus. In May 2012, the International Monetary Fund (IMF) judged: “The sensitivity of the Maltese banking sector to sovereign risk events in Europe is low given very low direct exposures to vulnerable countries, as well as domestic banks’ reliance on a traditional retail deposit-based banking model.”

You know we love you, Slovenia. But the bond markets don’t love you, and the country needs to generate several billion euros in bond revenue by the end of the spring. If it can’t do that at a reasonable price, it could have to turn to the troika — the European Central Bank (ECB), the European Commission (EC) and the IMF — for a bailout. The country’s bank assets are much smaller than those of Luxembourg, Cyprus or Malta, but that may not stop bailout-weary European policymakers from demanding major sacrifices in the form of haircuts or, more plausibly, tax increases and spending cuts.

Italy, the third-largest economy in the euro zone after Germany and France, does not have a government. And even if it gets a government following further negotiations, or after another round of elections, that government is likely to include parties other than that of centrist Prime Minister Mario Monti and the Democratic Party run by Pier Luigi Bersani, both of which have been amenable to Europe’s policy demands.

Beppe Grillo, a comedian whose party finished in third in the latest elections, might play a role, and he is a strong euroskeptic who has called for a referendum on leaving the euro currency. All this might spiral out of control if bond buyers start demanding untenable interest rates. And given the size of Italy’s economy, it might be impossible for even France and Germany to bail it out. Direct bond purchases by the ECB — basically, monetizing the debt — are a possibility, but ECB President Mario Draghi, himself Italian, may demand reforms and concessions in exchange that a dysfunctional Italian government is unable to execute.

Spain is in the midst of an economic depression with mass unemployment, but it’s moving forward with last year’s bank bailout, having used European funds to recapitalize its banks. However, its attempt to sell one of those rescued banks floundered, which prompted concern that the financial system could need yet more time to recover. The odds of another bailout remain slim, but given how terrible the country’s economic situation is in general, it’d be foolish to rule out the possibility.

Oh, Greece. Your brand of doom is almost a comfort in this time of crises in countries we had barely heard of before March. But Greece isn’t out of the running yet. There’s still a chance that Syriza, the far-left party that’s currently leading the opposition, could end up running the show. That could spook bond-buyers, sending interest rates up and necessitating either a bailout (which would be likely to involve concessions on budget policy that Syriza would be loath to accept) or exit from the euro, with all the dangers that entails.

Despite having a huge banking sector almost on the scale of Luxembourg, Malta or Cyprus, Ireland doesn’t look likely to cause problems anytime soon. It’s been paying back the 2010 bailout from the E.U. faster than it had too, which has pushed bond rates way down. Its economy is still in the gutter but its financial sector doesn’t appear to need outside money in the near future.

Grand Fenwick
Grand Fenwick, having a strong economy based on wine exports, and possessing a sovereign currency, is doing just fine.

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