SERIOUS MONEY:FEAR HAS returned to the world's financial markets as the euro zone's travails along with fears of a double-dip recession have unnerved investors and contributed to a reassessment of risk positions.
Plans for fiscal austerity in the euro zone suggest the fledgling economic recovery is likely to stall. Coupled with a fragile sector, a further downturn in business activity cannot be dismissed out of hand. Indeed, the recent trend in the price of German Bunds and US Treasuries implies that the risk of a full-blown crisis is growing by the day.
Investors are focused on financial institutions in periphery states following yesterday’s expiration of the European Central Bank’s key refinancing programme implemented a year ago to provide liquidity for ailing banks. How banks from the so-called PIGS of Portugal, Ireland, Greece and Spain cope with the taps turned off is a genuine cause for concern. However, it is important to appreciate that the banking sector’s woes are not confined to these nations.
Several lending institutions in core states, including France and Germany, remain in a perilous state. The clean-up to date has been less than impressive. The fragile balance sheets among financial institutions from the euro zone’s core states are a byproduct of the large internal imbalances that developed since the introduction of the single currency.
Relatively low inflation in the core resulted in negative real interest rates on the periphery. This contributed to unsustainable economic booms in the PIGS counties accompanied by the emergence of persistent current account deficits.
The Greeks’ cumulative current account deficit was equivalent to 67 per cent of its GDP from 2000 to 2007. Portugal’s was more than 70 per cent of GDP over the same period, Spain’s more than 45 per cent and Ireland’s roughly 12 per cent. The current account deficits required financing and this was satisfied via the recycling of the surpluses in the core. This meant that lenders from Germany, France, Austria, Belgium and the Netherlands became increasingly exposed to public and private debt in the Pigs. The numbers involved are astounding.
Data compiled by VoxEu.org shows that holdings of Spanish debt by euro zone core banks grew from less than €100 billion a decade ago to more than €600 billion at the end of last year. The banks’ holdings of Irish debt increased from €60 billion to almost €350 billion over the same period, Greek debt holdings climbed almost six-fold to more than €140 billion, and exposure to Portuguese debt jumped more than four-fold to €110 billion.
The large holdings of PIGS debt by banks in the core nations means that difficulties in the periphery create problems in the core. Until this is resolved, even the slightest increase in financial stress across the periphery has the potential to morph into a systemic crisis, leaving the core nations vulnerable to “bailout blackmail”.
It is clear that a clean-up of bank balance sheets is a matter of some urgency.
Stress tests are under way across the EU’s large cross-border banks and the process is to be extended to include a further 60 to 120 lenders. It is not clear whether the results, due to be released in the second half of next month, will assuage investors’ concerns. If the tests do not include scenarios that involve the restructuring of Greek or other Pigs debt, the results will not be taken seriously and financial turmoil will persist.
The stress tests must acknowledge potential losses hiding in the balance sheets of banks in the euro zone’s core states if the results are to be deemed credible, but the results must also be accompanied by a sound resolution strategy that recapitalises those lending institutions which cannot bear the losses.
Doing nothing is no longer an option. Shoring up the banking systems of the core, notably of France and Germany, via a transfer of public funds would help build confidence and reduce systemic risk. In the absence of effective measures, a full-blown crisis is virtually inevitable, as a run on wholesale funding would likely ensue.
Financial markets stand on the precipice yet again as investors begin to appreciate that the crisis in the euro zone has reached a critical phase.
The banking sector is in disarray, and not only in the peripheral states. The stress tests must be realistic if they are not to prove self-defeating, and must be accompanied by appropriate recapitalisation measures if a renewed crisis is to be avoided. The omens so far are hardly encouraging; caution is warranted.
charliefell.com
