How Germany’s neighbours could spoil Angela Merkel’s election party

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The euro zone crisis and the predictions of doom that went with it have all but vanished from the news this summer. Nothing could please German Chancellor Angela Merkel more.

Ms. Merkel, leader of the Christian Democratic Union (CDU), is fighting her third national campaign, and Germans go to the polls on Sept. 22. In the election runup, Ms. Merkel wouldn't likely welcome a fresh crisis brewing on the euro zone's southern flank, one that would thrust back into the spotlight Germany's role as the region's reluctant saviour and champion of growth-killing austerity.

But assuming she wins – the CDU is comfortably ahead in the polls – her merry avoidance of crisis talk will have to end quickly. That's because the bailout programs of Greece, Portugal and Ireland are in dire need of attention. Something potentially expensive for the German taxpayer may be in store.

Ms. Merkel has given little indication about how she and her European Union partners will handle the bailout overhauls of the three countries, or how she might handle future rescue programs, leaving economists, strategists and politicians guessing about her game plan.

To be sure, she is unlikely to undergo a personality change and deliver the Frau Nice Guy treatment to countries she considers the authors of their own misfortune. That means she won't support any program that whacks German taxpayers, who are suffering from bailout fatigue. "She will certainly try to minimize the impact on the taxpayer," says Nomura International's chief European economist, Jacques Cailloux.

At the same time, economists say, she will have to show more flexibility and creativity, even if that means imposing losses on bondholders, creditors and bank depositors.

"There will be a willingness to contemplate more radical solutions, maybe like the one they imposed on Cyprus," says Jens Larsen, the chief European economist for Royal Bank of Canada's investment arm, referring to the "haircut" delivered to deposit accounts in Cyprus in exchange for the Cypriot bank rescue program earlier this year.

The euro zone crisis receded partly because EU and International Monetary Fund officials were weary of talking about it and because there is little doubt the worst of the crisis is over. On Wednesday, the 17-country euro zone returned to growth after 18 months of contraction even if some countries – notably Italy, Spain, Greece and the Netherlands – remain on the downswing.

The improved outlook is also because of a pledge made a year ago by European Central Bank boss Mario Draghi to do "whatever it takes" to keep the euro zone intact. That led to a program to backstop sovereign bonds in struggling countries, a move that sent yields plummeting. Spanish 10-year bond yields, for instance, are down more than two percentage points, to about 4.4 per cent.

Still, the crisis could erupt again. Growth isn't sufficient to lower the region's record-high unemployment. As German-inspired austerity grinds on, national debt loads are soaring; Greece's debt will soon hit an unsustainable 175 per cent of gross domestic product and Italy, with the mother of all European debt loads, must raise hundreds of billions of euros every to roll over its debt and fund its widening budget deficit. In a shrinking economy, that's unsustainable.

Greece already threatens to become a fresh nightmare.

In a report carried earlier this month by Germany's Der Spiegel magazine, the Bundesbank (German central bank) said EU governments will "certainly approve a new aid programme for Greece" by early 2014 even though the country is now reporting a small primary surplus, the measure that excludes interest payments on debt. The report triggered immediate denials from Ms. Merkel's coalition government amid accusations from opposition parties that the government is lying. "There will be a rude awakening after the election," said Carsten Schneider, finance spokesman for the Social Democratic Party.

Indeed, Greece will need debt relief it its debt-to-GDP ratio is to fall to the target 124 per cent by 2020. Debt reduction could come from so-called official sector involvement, which would see non-private owners of the Greek debt take haircuts (private holders of Greek debt, mostly banks, took a euros 100-billion haircut last year). Any bailout overhaul might include another reduction in interest rates and an extension of maturities. If Ms. Merkel gets her way, helicopter loads of cash will not be dropped onto Athens. "There is a reluctance to sign bank cheques," said Nomura's Mr. Cailloux.

For its part, Ireland will almost certainly need a "precautionary" line of credit from the IMF and Europe's new permanent rescue fund, the €500-billion European Stability Mechanism (ESM), to backstop its bonds when it returns to the capital markets next year. Because Ireland's budget deficit and debt load are painfully high, Germany and the EU will no doubt insist on tough conditions before releasing the credit line.

Portugal, meanwhile, may need a second bailout even though its economy returned to growth in the second quarter. Portugal's relative debt may soon exceed Italy's level and its sovereign borrowing costs, at 6.4 per cent, are the euro zone's second highest after Greece's. If Ms. Merkel does not want to expose German taxpayers to a costly bailout, an imaginative solution will have to be found for Portugal's problems.

One sovereign debt trader in London, who did not want to be identified, said Ms. Merkel may embrace far more radical bailout strategies than most economists contemplate. He thinks she is ready, in essence, to cast Greece, Portugal and Ireland adrift so she can muster enough resources to support France and Italy, the euro zone's second and third largest economies. "The bad PIGS, forget them," he said, referring to Portugal, Ireland and Greece.

Mr. Cailloux thinks that scenario is highly unlikely. Letting those three countries go would break up the euro zone and few economists think Ms. Merkel wants to go down as the leader who presided over a catastrophic bust-up. "The policy set-up of Germany versus the rest of Europe is unlikely to change in a dramatic way," he said.

Still, Ms. Merkel and the EU will have to swing into bailout overhaul mode as soon as the September election is over. The crisis lull was pleasant, but it's about to end.