Eurozone strains intensify as 'massive shock' looms

(BRUSSELS) - Eurozone tensions have intensified after grim news on the economic outlook and as investors sought safety in Germany on growing doubts over Greece's future in the currency union.

Shortly after an EU summit failed to produce a remedy, a May survey of eurozone business confidence on Thursday showed the sharpest monthly fall for nearly three years while the data for Germany was the worst for six months and a survey in France, the poorest for 37 months.

European Central Bank President Mario Draghi said the EU was at "a crucial moment in its history" and that the debt crisis has demonstrated the EU's weaknesses.

"The process of European integration needs a courageous jump in political imagination to survive," he said, adding that while growth was a priority, "there is no sustainable growth without ordered public accounts."

ECB governing council member Ewald Nowotny warned of a "massive shock" of unknown consequences if Greece should stumble back to the drachma and cautioned against taking the possibility too lightly.

"I believe the fate of Europe is too important to now carry out thoughtless experiments," Nowotny, an Austrian, said in words aimed squarely at Germany's Bundesbank which claimed a Greek euro exit would be manageable.

Amid the strain, the euro slumped to a 22-month dollar low of $1.2516, but Europe's stock markets staged a technical bounce after heavy losses on Wednesday despite a slew of bad news on the economy.

Italian Premier Mario Monti, in televised comments Thursday, said Europe had been wrong in recent years to insist on "a too-rapid adjustment" from Athens.

The kind of profound cultural and political changes involved "require a generation" to carry out, he said.

Nevertheless Monti encouraged Greece to honour its agreements, while at the same time urging its partners to avoid "diktats", in a clear allusion to Germany.

If Greeks vote in new elections on June 17 for parties against the budget cuts and reforms tied to a second debt rescue, the EU, International Monetary Fund and ECB are expected to cut their financial lifeline.

That would in effect force Greece out of the eurozone and could cause incalculable risks for other weaker members, notably Spain.

With these unknowns, investors are putting their money into safe-haven German 10-year bonds, pushing the rate of return down to a record low 1.358 percent.

However, EU President Herman Van Rompuy, according to an EU source, is now "less pessimistic than a fortnight ago," sensing the Greek vote will produce a clear outcome as people come to terms with the likely disastrous consequences of leaving the eurozone.

But Citi analysts had a different view.

"We assume that Greece will leave European monetary union in early 2013," they said, adding that sizeable adverse contagion around the eurozone would force an ECB rate cut, more cheap financing for troubled banks and a bailout of sorts for Spain.

They tipped EU leaders to combine eurobonds in the long-term with jointly-funded bank deposit guarantees in the short-term, to offer an incentive for investors to stay in countries seen at risk of exiting the euro.

The use of eurobonds for joint borrowing intended to ease the cost of raising fresh funds for weaker member states was discussed at length at Wednesday's EU summit as part of a new focus on generating growth.

This push was headed by new French President Francois Hollande but German Chancellor Angela Merkel held firm to her line that structural reforms to improve competitiveness in countries with debt problems must come before eurobonds.

Italy's Monti voiced cautious optimism on the possibility of the introduction of eurobonds.

However London-based ETX Capital trader Markus Huber said investors would remain wary of eurobonds unless they were introduced as part of a wider-ranging economic and political union.

The risk, he said, was that distressed countries such as Spain or Italy would "start spending again (with the new funds raised), leading to a crisis much worse then the one we are seeing now."

But OECD head Angel Gurria said policymakers were getting "hung up on a word" and that EU nations already shared risks through a whole list of institutions and mechanisms.

The comments came after the Organisation for Economic Development and Cooperation on Tuesday warned the intensifying eurozone crisis posed the most serious risk to the global economy.

At Berenberg bank, analyst Christian Schulz said that the next EU summit on June 28-29 was likely to result in a "very modest" growth initiative.

European Council