Spanish bailout blues

June 10, 2012

100 billion used to be a big number. These days, it barely buys you a little time.

Euro zone finance ministers agreed on Saturday to lend Spain up to 100 billion euros ($125 billion) to shore up its ailing banks and Madrid said it would specify precisely how much it needs once independent audits report in just over a week. 

A bailout for Spain’s banks, struggling with bad debts since a property bubble burst, would make it the fourth country to seek assistance since the region’s debt crisis began, after Greece, Ireland and Portugal.

According to Nicholas Spiro at Spiro Sovereign Strategy:

(The) decision by the Spanish government to announce its intention to formally request external financial assistance is the most significant and alarming development in the two-year-old euro zone crisis.

One of the two southern European economies that matter most to the future of the euro zone, and the bloc’s fourth-largest, is no longer capable of managing its own financial affairs.

Market reaction is unlikely to be favourable given that the bailout places even more strain on Spain’s creditworthiness, sets a precedent that the euro zone’s other bailed-out countries (in particular Ireland) are likely to object to and risks putting pressure on Italy.

Speculation that a European policy response for Spain’s banking problems would soon come and hopes for more central bank stimulus eased pressure on Spanish yields this week, after they rose near 7 percent danger levels the week prior.

Any market reaction could be complicated by concerns about Italy, the euro zone´s third largest economy. Will a rescue for Spanish banks be enough to contain market pressure on riskier debt or will it fuel this by depleting the funds available to deal with Italy should contagion spread?

According to Gary Jenkins, director of Swordfish Research:

If Italy was struggling to fund itself and required a bailout then European politicians would have to decide either to issue common euro bonds (and) move towards some kind of fiscal union or break up.

It may be that euro zone officials have finally grasped this.

German news magazine Der Spiegel reported on Saturday that leaders of European institutions are working on a comprehensive plan to rescue the euro that would include the issuance of joint euro bonds – a move Germany has repeatedly rejected.

The Economist also made a plea for German Chancellor Angela Merkel to act in a piece entitled  “Start the engines, Angela” in the latest edition of its magazine:

Once Germany’s commitment to greater integration is clear, the ECB would have the room to act more robustly — both to buy many more sovereign bonds and to provide a bigger backstop for banks. With the fear of calamity diminished, a vicious cycle would become virtuous as investors’ confidence recovered.

The world economy would still have to grapple with ineptitude elsewhere and with weak growth. But it would have taken a giant step back from disaster. Mrs Merkel, it’s up to you.

Others also see a need for the European Central Bank to play a more aggressive role. Kemal Derviş, a former minister of economics in Turkey, argues the ECB should continue to buy Spanish bonds until it is able to bring down yields to more sustainable levels.

These interest rates must be brought down through ECB purchases of government bonds on the secondary market until low-enough announced target levels for borrowing costs are reached, and/or by the use of European Stability Mechanism resources. The best solution would be to reinforce the effectiveness of both channels by using both – and by doing so immediately.

Such an approach would provide the breathing space needed to restore confidence and implement reforms in an atmosphere of moderate optimism rather than despair. The risk of inaction or inappropriate action has reached enormous proportions.

No catastrophic earthquake or tsunami has destroyed southern Europe’s productive capacity. What we are witnessing – and what is now affecting the whole world – is a man-made disaster that can be stopped and reversed by a coordinated policy response.

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