If it explodes it could blow the European single currency apart and send shockwaves across the global economy.
Pressure is building in the European single currency, whose “fundamental flaw” is leading to profound and growing imbalances between its 19 member countries, which include Germany, France, Italy and Greece.
Jeremy Batstone-Carr, European strategist at Raymond James, has likened the threat to Vesuvius, which destroyed Pompeii almost 2,000 years ago and looms over the city of Naples today, “long dormant but certainly not deceased”.
Vesuvius is not expected to erupt any time soon but it is a different matter for the euro, Batstone-Carr warned. “Europe’s population and financial markets blithely go about their business seemingly unaware of the pressures building in the vast magma chamber that is the regional banking system.”
Under the single currency, fiscally sound Germany stands behind debt issued by poorer southern states.
This is an effective subsidy, allowing “the more vulnerable economies of Italy, Spain, Greece and others to piggyback on Germany’s debt rating”, he said.
Latest European Central Bank (ECB) data shows these subsidies are growing, with TARGET 2 cross-border eurozone transfers suffering huge imbalances that “are growing with every day that passes”, Batstone-Carr said.
Germany is by far the biggest creditor, owed a massive €1.23trillion, while Italy has a deficit of €670billion followed by Spain at €484billion.
“Were the system to collapse, the Bundesbank would lose billions of euros owed to it by other national central banks and the ECB itself, plus an additional near €400billion of net losses, based on prevailing imbalances.”
Batstone-Carr warned: “This would wipe out the Bundesbank’s own balance sheet many times over.”
Some countries’ central banks are now holding Germany hostage by using the system to fund their own insolvent commercial banks, he added.
We risk “an eruption at the core of the European project’s financial system”, that would trigger “a chain of events which could escalate swiftly into something severe”, Batstone-Carr said, calling the danger “spine-tingling”.
Julian Jessop, economics fellow at the Institute of Economic Affairs, said the financial imbalances at the heart of the euro area are likely to grow. “The single currency will only survive if the stronger members are willing to prop up the weaker ones, which requires large subsidies and debt sharing.”
He said this problem has been brewing for some time. “The end of the long period of very low interest rates is now coming to an end and this will worsen the problems faced by high debt countries like Italy and Greece.”
Jessop added: “Their borrowing costs have already shot up, after hawkish comments from the European Central Bank on Thursday.”
There was a warning sign on Thursday, as yields on Italian 10 year bonds jumped to 4.35 percent and to 4.38 percent in Greece, after the ECB threatened to be more aggressive about hiking interest rates.
By comparison, German 10-year bonds yield just 2.18 percent because investors consider them safer and are willing to accept a lower return.
Rising interest rates are piling the pressure on high-debt countries like Italy and Greece, Jessop added.
Martin Hartley, UK managing director of management consultant Emagine and a member of the Bank of England’s Decision Maker panel, said: “This is very dangerous indeed and could potentially ruin the south of Europe, which has relied on being propped up by richer EU nations for too long.”
He warned: “Spain, Greece and Italy need to make reforms proactively rather than wait for disaster to strike because their debt is simply not sustainable.”
Hartley said this is “a huge problem”, as German taxpayers may not tolerate paying higher taxes to cover the likes of Spain and Italy for much longer.
In return, Germany benefits from the weaker euro, which makes its exports cheaper and boosts its economy. “But other EU countries also do not want to see Germany becoming stronger and stronger. That is a political hot potato.”
He said he could definitely foresee a day when “we might be paying in Deutsche Marks in Berlin or Francs in Paris. That would have seemed unthinkable a few short years’ ago.”