Many observers have suggested that a break-up of the euro zone would be near-impossible. But strategists at UBS AG don't think it's all that far-fetched as Europe's debt crisis moves into "a worrisome new phase."
Greece is still "a clear candidate" for a debt restructuring, Portugal and Spain are potential candidates for trouble, and the contagion could spread to Belgium, Italy and France, analyst Thomas Wacker and Dirk Faltin write in a lengthy report on the dysfunction that is the 17-member monetary union.
"There does seem to be a credible risk that the euro zone could break up if faced with certain adverse circumstances, and we think this risk should not be neglected just because it appears unthinkable right now," they added.
The UBS strategists warned the crisis will probably flare up again - not that it ever really went away - as markets no longer focus on single countries but question the "very ability to deliver an effective solution" among policy makers. They believe the European Central Bank will intervene further, and may even bring in new measures, while the countries that share the currency probably move closer toward more fiscal integration.
"Yet, we don't think there is sufficient political will to move to a full-scale fiscal union - especially not over the next two to three years."
The European crisis is more complex than others of the past, they wrote, because its roots are in the common currency itself, which came into being with the European Economic and Monetary Union, or EMU.
"The founders of the EMU had hoped - erroneously as it turns out - that once the union was established, the economic conditions necessary for it function properly would evolve over time," the strategists said, citing the fact that for such a union to work, its members must share "broad policy preferences" on exchange rates and interest rates, which implies economic and structural similarities among the countries.
That hasn't happened.
While monetary unions can work, the euro zone's mechanisms for success - free movement of labour and a flexibile price and wage system - aren't up to snuff.
"Structural reforms to improve competitiveness, increase labour mobility and price flexibility would certainly hellp strengthen the eurozone," they said. "Given the region's diversity, however, problems could quickly arise due to ethnic, cultural and linguistic boundaries. We think European leaders will make serious efforts to form a more closely integrated union, but political support may weaken if leaders fail to achieve a consensus on crucial questions, including limitations on national sovereignty. There will most likely be a limited fiscal union at first, with many exceptions and imperfections."
Key reforms, notably co-ordination of fiscal policy and transfer payments from the haves to the have-nots, are crucial.
"Beyond its economic benefits, the euro was introduced to foster peace and understanding in Europe. If the EMU starts looking like it generates the exact opposite effect, this would clearly compromise its raison-d'etre.
In the markets, the crisis shows no signs of ending. Indeed, the yield on Portugal 10-year bonds climbed Friday to 7.1 per cent, a record for the euro zone, and the common currency slipped to a four-month low against the U.S. dollar.
Economists at BMO Nesbitt Burns believe the debt concerns will continue to dog Europe in the next several months, which will see continued volatility in the currency. But if the union pulls through the first half with a major bailout - beyond Portugal, that is - further stability and a better economic picture could stabilize the euro, said Michael Gregory and Benjamin Reitzes.
"If 2010 was a year of crisis for the euro area, 2011 will need to be a year of progress toward a lasting and tenable economic framework for the region," Mr. Gregory and Mr. Reitzes said. "The first big test will come early in the year with Portugal and Spain facing €4.5-billion and €15.5-billion in debt rollovers in April."