If Spain falters ...

Even after finalisation of the US$113-billion EU-IMF bailout package to Ireland earlier this week, European financial markets were still nervous that the debt crisis could spread to other vulnerable countries on the continent - Italy, Portugal, Spain.

Investors' anxieties were reflected in widening spreads or higher-risk premiums between the 10-year sovereign bonds of these countries and the benchmark 10-year German bond.

Indications that the European Central Bank (ECB) is prepared to take further action have, however, had a moderating effect.

After the bailout of Greece, and now Ireland, it has become clearer that the health of the Eurozone financial system is deteriorating.

First, the slide in the economies of the region culminated in the bursting of asset bubbles, exposure of overleveraging by consumers and debilitating increases in fiscal deficits and public debt in the so-called PIIGS group of countries - Portugal, Ireland, Italy, Greece and Spain.

To pay for the sharply rising fiscal deficits, these countries have been borrowing heavily, triggering hikes in interest rates and raising debt-servicing costs to worrying levels.

Second, with the economies stagnating and borrowers being unable to service massive unsecured loans, the banks are imperilled by enormous bad loans.

The extent of these problems was not contemplated in stress tests conducted by Europe's bank regulators only four months ago. In the case of Ireland, the big banks - Allied Irish and Bank of Ireland - were given a clean bill of health, only to plunge the country into deep crisis last month, when the flight of depositors and investors triggered costly rescue efforts.

This pushed the government to pump huge sums into these same banks, thereby socialising the losses and necessitating the large bailout from the European Union (EU) and International Monetary Fund (IMF).

With Ireland's public finances already devastated by the economic recession, the bank bailouts will impose heavy burdens, involving cuts in spending on social services, tax hikes and layoffs starting next year.

These measures have provoked strong public reaction, as they have come on top of the austerity measures imposed last year.

In a weak global environment, the Irish economy, which is heavily export-dependent, is likely to further contract in 2011.

Greece, which is also undergoing a debt crisis and carrying out austere fiscal measures in return for an EU-IMF bailout, is experiencing deepening contraction in output as well.

Under these conditions, the risks of financial turmoil spreading across the 'peripheral' European countries are regarded as high.

In this regard, the speculation is that Spain is likely to be the next country to seek assistance to manage its debts and to deal with likely problems in its banks.

The fact is that the real-estate bubble in Spain surpassed any other in Europe and the financial fallout should logically be the worst, especially considering the failure of regulation across the EU's financial system.

When the asset bubble burst, the economy plunged into a deeper hole than in other EU countries.

Unemployment reached the highest level, more than 20 per cent, in the region and recovery has been the most lethargic.

If Spain falters, this will be a major shake-up of Europe's economy and financial system. Wasn't there an early-warning system to alert the regulators of these risks?

A remarkable aspect of the current crisis, and the United States and United Kingdom financial meltdown, is how watchdog institutions such as the IMF misread the signs of trouble.

Starting from 2001, the fund has been publishing its Global Financial Stability Report that was supposed to call "attention to potential fault lines in the global financial system" and to "play a role in preventing crises before they erupt".

Yet, over the period, it constantly assured of the resilience of the system each year and only as late as April 2007 did it issue a serious warning of the subprime mortgage problem in the US and credit quality deterioration.

Not until September 2007 did it highlight the "threat to financial stability" posed by hard-to-value structured credit securities and the opaqueness of such exotic financial instruments.

Prior to this, the fund had lauded these instruments, and only when the crisis was under way was it telling us that "credit discipline has deteriorated in recent years" and "of disruptions in money markets and funding difficulties for a number of financial institutions."