At a media briefing in Sydney, Dr El-Erian pointed out that it was in the interests of all of Europe to resolve Greece's financial problems.
He said sovereign debt contagion had already spread from Greece, and had impacted other so-called PIGS (Portugal, Ireland and Spain). On the weekend, we saw the contagion spread to Austria and Belgium.
Left unchecked, the core of Europe would be "contaminated". He emphasised that when sovereign balance sheets were in play, no market was immune to contagion.
Dr El-Erian argued that resolving the Greek situation required a co-ordinated approach.
In the first place, Greece would itself have to make an adjustment. As a member of the eurozone, Greece lacks exchange rate and interest rate flexibility, so it would have to adjust its fiscal policy.
But, Dr El-Erian said this fiscal adjustment, while necessary, was not sufficient, because the scale of the fiscal adjustment required was so great that it would plunge the economy into a deep recession. Such deep budget cuts would prove socially unacceptable.
So the Greek fiscal adjustment would have to be co-ordinated with financing from external sources, such as other European countries or the IMF.
As he pointed out, solving Greece's problems would be a multi-round process and there would be no immediate solution.
Meanwhile, uncertainty over how European sovereign debt issues will play out is continuing to sap confidence in global markets.
The Financial Times reports that traders and hedge funds have bet a record $US8 billion against the euro, building up the biggest short position in the currency since its launch.
Traders and hedge funds are betting that the euro will be hurt as fears over Greece's budget problems infect its European neighbours. And as markets wait nervously for the outcome of a European Union summit on Thursday, Greek shares continued to slide.
The Greek share market dropped by almost 4 per cent yesterday, bringing its total losses for the year to almost 18 per cent.
Greek bank shares are bearing the brunt of the selling. They plunged by almost 7 per cent on Monday, on rumours that they are having financing difficulties, and could face further downgrades.
Meanwhile, there is mounting concern over the exposure of German and French banks to countries politely referred to in European newspapers as the 'Club Med' members of Europe.
It is difficult to get a precise measure of individual bank's exposure to the sovereign debt of the 'Club Meds', although the Bank for International Settlements works out overall lending exposures of each country's banks.
According to these figures, French banks had $US75.5 billion ($87 billion) exposure to Greece, while Swiss banks had lent $US64 billion.
German banks, meanwhile, have a more modest exposure to Greece of $US43 billion. But they have a huge US$240 billion exposure to Spain. These exposures present two main risks for the French and German banks.
The first concerns their holdings of 'Club Med' government bonds. As the perceived risk of these bonds increases, their prices fall (and yields spike). As a result, French and German banks could face billions of dollars of write-offs on the value of their sovereign debt holdings.
The other risk is that when these 'Club Med' countries introduce tough austerity measures, their economies will sink into deep recessions. High unemployment and rising business failures will inevitably translate into rising bad debts for the French and German bankers.
As Dr El-Erian noted yesterday, sovereign risk issues will remain centre stage for some time ahead.
This article first appeared on Business Spectator.
