The euro’s biggest crisis yet

Members of the EU, ECB, IMF troika descending upon the Department of Finance. According to Dan White, ECB president Mario Draghi has failed to deliver on his promise to "do whatever it takes" to save the euro
Members of the EU, ECB, IMF troika descending upon the Department of Finance. According to Dan White, ECB president Mario Draghi has failed to deliver on his promise to "do whatever it takes" to save the euro

With Spain seemingly headed inexorably for a bailout and the ECB deadlocked the future of the euro is now in greater doubt than ever. Dan White reports



8 August 2012

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Since May 2010 four members of the single currency, Greece (twice), Ireland, Portugal and Cyprus have had to be bailed out. Will Spain increase the number of bailout countries to five? The comparisons between Spain and Ireland are eerie. Like Ireland its public finances were apparently robust with Spain’s government debt being just 43% of GDP as recently as 2007 while it ran a budget surplus of 2.2% of GDP in the same year.

Like Ireland, what did for Spain was a property bubble and its knock-on effect on the Spanish banks. Spain was second only to Ireland in its property mania, with construction climbing to 16% of GDP in 2006 – the comparable figure for Ireland in the same year was 20% of GDP and a truly massive 23% of GNP.

As in Ireland the bursting of the property bubble ravaged Spanish government revenues, which were heavily reliant on construction, and devastated its banks which were up to their gills in bad property loans.

It is only now, five years after the bubble burst that the full extent of the carnage is becoming apparent. While the two main Spanish banks, Santander and BBVA, have so far managed to avoid the worst of the carnage, the regional savings banks or cajas have been all but wiped out.

The Bankia debacle

Indeed it was the problems of Spain’s fourth-largest bank Bankia, the product of the December 2010 merger of seven cajas, that triggered the current crisis. When Bankia first got into bother in early May the Spanish government assured its citizens that fixing the problem would cost “only” €4.5bn. Within three weeks this had risen more than five-fold to €23.5bn. What’s the Spanish for Anglo?

The Bankia debacle crystallised fears about the health of the Spanish banking system and led to a massive sell-off of Spanish bonds, with yields rising to a euro-era high of over 7.5%.

This forced the Spanish government, after a bad-tempered stand-off with Germany, to seek a €100bn package from the EU to rescue its banks. When the Spanish bank rescue deal was agreed on 21 June it appeared that the country’s prime minister Mariano Rajoy, who had insisted that the EFSF invest directly in the stricken Spanish bank rather than lend to the Spanish sovereign, had scored a notable truimph. Just over a month later, with Germany furiously rowing back, the situation is considerably less clear.

In any event it is becoming increasingly obvious that the Spanish bank rescue package is being rapidly overtaken by events. While €100bn might seem like a large amount in absolute terms, it comes nowhere close to meeting Spain’s needs if, as seems likely, a bank rescue morphs into a full-blown bailout.

A numbers game

Consider the numbers: This year’s Spanish GDP will be just under EUR*1.1 trillion. Compare this to Ireland whose 2012 GDP will be just under €160bn and whose GNP, by far the more realistic indicator of the overall size of the Irish economy as it excludes repatriated multinational profits, will be €125bn. In other words, depending on which yardstick you use, the Spanish economy is between seven and nine times larger than the Irish economy. We required an EU/IMF bailout of €85bn and spent €63bn recapitalising our banks.

If Spain’s problems are of a similar order of magnitude to our own then the country is likely to require a bailout of between €595bn and €765bn and a bank rescue package of somewhere between €441bn and €567bn – in practice if the Irish experience is any guide there will be a large overlap between the sovereign bailout and the bank rescue package.

A bailout/bank rescue of that scale would completely overwhelm the EFSF, the existing EU bailout fund, and the ESM, the permanent new EU bailout fund which is supposed to take over the role of the existing EFSF as soon as last December’s eurozone treaty is ratified. Between them these funds have total funds of €440bn of which over €300bn have already been committed to the Greek, Irish, Portuguese and Cypriot bailouts.

Reluctance to lend to EFSF

With investors already displaying a marked reluctance to lend to the EFSF any Spanish bailout, which would probably be larger than the five previous bailouts combined, would almost certainly prove impossible to finance using the current method favoured by the EU and the ECB.

And that’s before any possible Italian bailout. After falling sharply following the financial coup d’etat which ousted democratically-elected prime minister Silvio Berlusconi last November, Italian bond yields have started to creep up once again. If a Spanish bailout threatens to overwhelm the EFSF/ESM then an Italian bailout would drown them without leaving so much as a trace of their previous existence.

Is the euro doomed?

So is the euro doomed, unable to afford the cost of bailing out its fourth and possibly third-largest economies? Not necessarily. While there is no way that the EFSF/ESM could afford to borrow from the markets the trillions of euro which would be needed to ensure that any Italian or Spanish bailouts were credible, there is another way. That is to grant the ESM a banking licence.

This would allow the ESM to borrow unlimited amounts from the ECB and use that money to buy the bonds of eurozone member countries and to directly recapitalise distressed eurozone banks. Allowing the ESM access to the ECB’s virtually unlimited balance sheet is the one course of action virtually guaranteed to bring down Spanish and Italian bond yields thus eliminating the need for bailouts for those two countries.

Expectations were high that ECB president Mario Draghi would announce such a move at the ECB council meeting held at the beginning of this month. After promising the previous week to “do whatever it takes” to save the euro, Draghi failed to deliver, ruling out a banking licence for the ESM.

While Draghi did pledge ECB purchases of Spanish and Italian bonds in the autumn, denying the ESM a banking licence means that any such bond purchases will be half-hearted at best. Even worse, the ECB seems to envisage such bond purchases only taking place in conjunction with the ESM, which would presumably have to borrow the money on the markets.

Given the reluctance of the markets to lend to the EFSF why should they look any more favourably on the ESM? They won’t. With the ECB having apparently bowed to German opposition to granting the ESM a banking licence and unlimited bond purchases, Draghi’s promise to “save” the euro is already looking threadbare. 



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