Countdown to an EU implosion?

As European leaders again prepare to gather in Brussels to discuss the latest plan for quelling the raging European debt crisis, investors are growing increasingly pessimistic that the eurozone can be saved.

Overnight, German Chancellor Angela Merkel and French President Nicolas Sarkozy released the outline of their plan, which aims to enforce serious fiscal discipline in eurozone countries, along with tough penalties for countries that fail to reduce their deficits, or debts. In Paris, Sarkozy left little doubt that the future of the eurozone was now at stake. "The risk of explosion is looming if the decisions taken with Angela Merkel are not put into effect,” he warned members of his ruling UMP party.

But some believe that it could be too late. Investors are losing faith in the ability of politicians to find a solution to the eurozone's woes. Increasingly, financial institutions around the world are trying to model what will happen if some debt-laden southern countries are either expelled from the eurozone, or decide to quit.

Most forecasters predict that the break-up of the eurozone will trigger a deep recession through the region, lasting several years. We could see a string of bank failures, and scenes of panic as nervous investors rush to pull their money out of risky financial institutions.

Countries that leave the eurozone will reintroduce their own currency, and will immediately slash their exchange rates by around 40 to 50 per cent against the euro in order to regain their competitiveness. This will trigger a spate of bankruptcies for borrowers – industrial, financial and personal – that have their borrowings denominated in euros.

Countries that remain in the eurozone will be forced to stage massive bank bailouts, because their banks will likely suffer huge losses from their loans to the weaker eurozone countries.

Some forecasters believe that the growing pessimism means that we may have already passed the point where the European Central Bank is able to restore market confidence by buying up massive quantities of debts issued by countries such as Spain and Italy.

They argue that the typical buyers of European sovereign debt have been banks, superannuation funds and insurance companies that want an ultra-safe investment, where they are guaranteed to get their money back. But they're now being forced to contemplate a range of different, and unpalatable, outcomes on their investments – such as defaults, debt restructurings and possible currency changes. As a result of this surge in uncertainty, traditional investors are deserting the European bond markets.

At this point, even if the ECB started buying huge amounts of Spanish and Italian bonds, these traditional investors would remain wary. After all, they know that in the Greek debt restructuring, banks and insurance companies were forced to take hefty writedowns on their Greek bonds, but the ECB refused to take any losses on its Greek bonds. As a result, the ECB clearly signalled that it regarded itself as a 'senior' lender, and that private sector investors were in a subordinate position.

But typical bond holders have no interest in being in a 'junior' position. They buy bonds because they want an absolutely safe investment. Ironically, for these investors, increased ECB buying could simply highlight the riskiness of their investments, and make them even more inclined to dump the bonds of weaker eurozone countries.

As a result, investors are losing hope that politicians will be able to cobble together an agreement that will keep the eurozone intact.