The austerity woes that felled Portugal's government had but a fleeting impact on the euro, but Spain could pose the toughest test yet to the integrity of the 17-nation currency bloc.
Spain, a Group of 20 nation and one of the euro zone's largest economies, has undertaken stringent reform efforts that have helped it regain market confidence.
However, recent banking sector downgrades underscore the looming risks, which could resurface when investors least expect.
Analysts say the euro's recent surge is a reflection of traders' desire for the higher-yields offered by the single currency, which has momentarily blinded them to Europe's economic and financial travails.
The European Central Bank has indicated it could raise interest rates as early as next month, at a time when other global central banks such as the Federal Reserve are still embracing loose monetary policy. This has underpinned the euro, which hit new 4 1/2 month highs against the US dollar this week at $US1.4249.
Early yesterday (AEDT), investors sent the euro reeling after the Portuguese parliament rejected a budget-cutting plan that prompted the resignation of Prime Minister Jose Socrates. The news provided a brief yet stark reminder to markets that Europe's sovereign debt crisis remains a significant risk.
Markets are now looking ahead to the outcome of tonight's European Union summit, where leaders will attempt to strike a deal on a 500 billion euros ($693.5bn) bailout mechanism for the euro zone's most troubled economies.
Analysts expect to get a firmer sense of the details, yet do not anticipate any grand pronouncements.
Analysts expect to get a firmer sense of the details, yet do not anticipate any grand pronouncements.
Despite yesterday's turmoil, traders have long suspected Portugal would require an international bailout.
However, eyes are shifting to Spain, the world's 12th largest economy. While Spanish stock and bond prices rose in the wake of Portugal's news, questions continue to shroud the euro zone's fourth largest economy.
By all accounts, the Iberian nation has staged an impressive recovery from a deep recession sparked by a collapse in its housing sector. However, its banking sector is under severe strain, a reality underscored by Moody's Investor Service's decision to downgrade 30 Spanish banks last night.
"Spain is a very big deal and it needs to be firewalled," said Kevin Hebner, currency strategist at JP Morgan Chase in New York. "It's one thing with smaller peripheral countries, but there's nothing peripheral about Spain."
According to estimates from the Bank of International Settlements, Spanish banks are the most exposed to possible losses in Portugal, as they account for $US109bn ($106.6bn) out of $US322bn in total exposure of foreign banks in the country.
Investors have recently begun to differentiate between Spain and its smaller, more distressed peripheral brethren. But a contagion-like effect that disrupts Spanish reform efforts could potentially undermine the euro.
"As we stand now, the weight of opinion is that Spain won't need a bailout," said Rabobank's Ms Foley. "If that perception were to change for whatever reason, that could be (a) trigger for a huge amount of downward pressure on the euro."
One near-term certainty appears unshakable, however. Virtually no market participants see the possibility that the uncertainty roiling Portugal will prevent the ECB from increasing interest rates within the next few months.
The central bank vowed to act decisively to quell rising price pressures across the euro zone.
"The ECB is inflation, inflation, and inflation again -- there is nothing else," said John Taylor, chief investment officer at FX Concepts, adding there was "no way" the ECB could be deterred from its tightening bias.
©theaustralian.com.au
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