URGENT E.U. ACTION IS NEEDED TO STOP CONTAGION / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( VERY HIGHLY RECOMMENDED READING )

Urgent EU action needed to stop contagion

By Mohamed El-Erian

Published: November 24 2010 11:22

The run up to the recent turmoil in Ireland was marked by two oddities. It is extremely rare for creditors to push a struggling debtor to ask for more loans. It is also unusual to see creditors signal so loudly their willingness to provide additional funding, before the borrower is ready to detail what it intends to do to restore its solvency.


All of this shows the extent of Europe’s concerns about Ireland. And with Greece already on financial life support, the region now faces the risk of further, widening disruptions in its periphery.


To avoid a spreading disaster, the comforting statements issued by European ministers in recent days must be urgently translated into meaningful actions. Unfortunately, this is not an easy endeavour.


Contagion from the sell-off in Irish bonds has already driven risk spreads in Portugal and Spain to record euro-area levels. Like Greece and Ireland before them, neither of these countries is wired to operate well with such high real interest rates.


Having already experienced some outflow of deposits, Ireland itself is getting uncomfortably close to a devastating banking crisis that would derail growth, employment and wealth creation for a whole generation. Now that its sovereign balance sheet is so closely interlinked to those of its banks, a banking crisis can also no longer be differentiated from a sovereign debt crisis.


But Ireland’s problems are Europe’s problems. The European Central Bank and European banks in general are now on the hook for billions of euros on account of both their direct and indirect exposures to Ireland and its banks.


A tremendous amount of complicated technical work must be done collaboratively by several Irish and European agencies. Both solvency and liquidity challenges must be addressed.


Europe’s yet-to-be used financing facility must be made operational quickly, with little room for slippage. The International Monetary Fund must also demonstrate agility in its support. And individual European countries must resist the bickering that is almost unavoidable when such delicate burden sharing judgments are in play.


In Ireland difficult policy decisions and trade-offs must be made, executed and sustained by a government with a paper-thin parliamentary majority and low popularity ratings among its citizens.


Even then, the rescue financing available will be of little use if it ends up simply funding the large-scale exodus of existing depositors and creditors. Little comfort can be drawn in this regard from the disappointing reactions of market risk spreads and a Standard and Poor’s two-notch downgrade of Ireland’s credit rating.


All this suggests that the dramatic events in Ireland are just preambles for the many further chapters yet to be fully devised, let alone written, if crisis is to be averted. Let us hope that these chapters do not end up having to also cover Portugal and Spain.


The writer is chief executive and co-chief investment officer of Pimco


Copyright The Financial Times Limited 2010