ECB's Bini Smaghi warns debt trouble looming-UPDATE 1

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Saturday September 11, 2010 11:34:11 PM GMT

* Some developed economies face sustainability issue on debt

* Loss of 'risk free' belief would hurt financial system

* Greece quitting euro would result in default

(adds quotes, detail, background)

By Marc Jones

FRANKFURT, Sept 10 (Reuters) - European Central Bank executive board member Lorenzo Bini Smaghi warned on Thursday of a looming debt crunch in several developed countries that could cripple economies if left unchecked.

Although deficits are expected to start narrowing gradually next year, some major economies were staring at a bleak picture, with the U.S. for example, looking at debt to gross domestic product of 110 percent by 2015, Bini Smaghi said.

"The issue of the sustainability of the debt in several industrial countries is looming," he said in a speech given at a conference and posted on the ECB's Web site on Friday.

"Owing to the role of advanced economies as lenders of last resort to their own financial system, as has been confirmed by this crisis, a debt problem at the level of the state would cripple the economy as a whole," he added.

Bini Smaghi was speaking after a renewal of concern over banks and growth prompted spreads on the debt of some weaker euro zone to return to close to record levels and in Ireland's case pass them.[ID:nLDE6860O9] ^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^ Euro zone crisis in graphics: http://r.reuters.com/fyw72j Full Bini Smaghi speech: http://www.ecb.int/press/key/date/2010/html/sp100910_1.en.html ^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^

The Italian also warned there could be wide-scale ramifications if investors began to take the view that long-trusted government debt was no longer a 'risk-free' purchase.

"What scenarios open up if advanced economies' sovereign debt assets are no longer perceived as risk-free assets? How would this affect the functioning of financial markets?" Bini Smaghi asked.

"The disappearance of "good" collateral would reduce credit supply and thus impair economic activity," while "in the case of reserve currencies, higher solvency risk would potentially hamper the stability of the international financial system," he said.

ATHENS WOE

Bini Smaghi, one of the ECB's six-strong Executive Board, said Greece would default on its debts if it abandoned the euro and even an 'orderly' debt restructuring could cripple an economy.

He said the idea of Greece leaving the euro was absurd, arguing that its debt problems gave it even more reason to stick with the single currency.

"If Greece were to exit the euro, a hypothesis ... I consider absurd, its debt burden would de facto worsen given that it is denominated in euro, and partial default or restructuring would in that case be unavoidable," he said.

"What many analysts -- or I should say doomsayers -- have not understood is that the debt problem is the biggest incentive for Greece to remain in the euro area."

Greece, whose debt problems ignited the euro zone debt crisis, admitted on Friday that its deficit cuts fell short of target in the first eight months of the year due to heavy debt payments and worse-than-expected revenues. [ID:nLDE6890K1]

Debt problems also continue to blight the region's other highly indebted perimeter countries.

Ireland on Thursday said it would announce the cost of winding down troubled lender Anglo Irish Bank within weeks, aiming to draw a line under an issue that has raised fears of a full-blown Irish debt crisis.

(Reporting by Marc Jones; editing by Patrick Graham)

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