Another quarter and another European bailout. Spain last week became the fourth euro zone economy after Greece, Ireland, and Portugal to accept emergency support from the Union. This takes the total price tag of rescuing the Euro above 500 billion euros. The Spanish package is particularly important in two ways: (i) it escalates the remit of bailouts from relatively small peripheral economies to the fourth-largest country in the Euro-zone and (ii) it specifically focuses on the banking sector and may provide the impetus for rethinking the way Euro-zone banks are regulated. Yet as another band-aid is applied to the increasingly battered euro zone, few believe that the crisis is now over. The relief at the Spanish deal proved ephemeral indeed and fears are rapidly mounting that the European crisis may have passed the point of no return as yet more clouds loom on the horizon, whether to do with Italy, Spanish government finances, or the Greek elections.
Why was the Spanish deal needed? The fundamental problem is in many ways analogous to Ireland's. Even though the Spanish central government ran its fiscal outs fairly prudently, a lengthy period of low interest rates over time generated a massive bubble in the property markets diverting more and more investment into property development. Once economic activity began to slow down, house prices corrected, delivering a devastating blow to real economic activity, household balance sheets, and the financial sector with heavy exposures to real estate. Spanish banks for a while managed to contain the impact by renegotiating many loans and mortgages. In the end, however, this merely bought them time as the fundamentals continued to deteriorate. Spain is now left in the unenviable situation of a shrinking economy, 24.4 percent unemployment (Q1), and very little new bank lending. And the risk of a downward spiral looms large as Spanish banks are downgraded and Fitch recently took down the Spanish sovereign three notches to BBB. The government's ability to intervene is limited as the budget deficit now stands at an estimated 8.9 percent of GDP and few credible alternatives exist to continued fiscal consolidation.
The Spanish bank bailout is massive and it highlights the dwindling range of options in Europe. At a time when this emergency measure became necessary, the Spanish authorities lacked both the necessary funds and the means to raise them in the open market at a reasonable cost. The government has indicated that it might require up to 100 billion euros to recapitalize troubled banks. Following an impending overview of the sector, this figure might increase to something more like 150 billion euros. So what will this money buy? Hopefully a near-term insurance policy against a full-blown banking crisis but probably not all that much more. This is not trivial accomplishment as some 97 billion euros of money left Spain in Q1, a tide that clearly needs to be stemmed. But the bailout will do little to counteract the deteriorating economic fundamentals. It will probably have limited effect on bank lending in an environment of uncertainty, unemployment, and falling asset prices. True to the pattern of European bailouts to date, it will in essence buy time. From the Spanish perspective, limiting the bailout to the banking sector will contain the external oversight on the Spanish economy, which is something of a double-edged sword.
Indeed, the bailout is unlikely to meaningfully improve Spain's ability to raise money in the capital markets. The bailout will increase central government debt from the neighborhood of 70 percent of GDP to some 80 percent. If the EU loans take priority over other bond-holders, Spanish sovereign risks will in fact increase as happened with Greece. Moreover, Spain has now gained itself a place in the spotlight. The intense scrutiny by market participants and the credit rating agencies will likely offer minimal respite.
From the European perspective, the Spanish bailout has further underscored an increasingly dichotomous choice. Either European policymakers and people accept that the only way to save the Euro comes from taking the necessary steps to complete its faulty architecture or the Euro as we know it is ultimately doomed. Completing the faulty architecture would mean recognizing that the monetary union is indeed set in stone and centralized solutions need to be found to ensure the stability of the European banking sector while putting in place a proper fiscal union. The rhetoric on this seems to be shifting.
ECB President Mario Draghi recently suggested that bank restructurings should happen in a centralized way. Ideally, for the sake of efficiency and transparency, this should involve a euro zone funded resolution trust company which can force the restructuring of banks. At the same time, a European guarantee of bank deposits is likely to become necessary to manage risks. Such a step would logically have to be accompanied by the centralization of banking supervision. As one step toward the fiscal union, which would necessarily involve a slow process of overhauling the EU's legal architecture, the new banking authority could issue own bonds sold to Euro-zone governments or the ECB.
The incentives to get it right are considerable. A disintegration of the euro zone would involve unimaginable disruptions and a massive economic crisis especially in the growing group of peripheral economies. For instance Spain's total debt - private and public - was estimated at more than 360 percent of GDP in the middle of last year. At the same time, the EU, and possibly, the IMF, would have to play a much more direct role in enabling the troubled EU members to regain their competitiveness. Only this can ultimately avoid a downward spiral. Reinventing the economic model of these economies, which were either addicted to oversized government sectors or unsustainable credit, will not be easy. But it is almost certainly the case that breaking up the euro zone and reintroducing national currencies would not make the process easier and would create a whole host of other problems. Moreover, Europe is in this crisis together as the various claims the euro-system of central banks on the peripheral countries are in excess of 1 trillion euros.
But will the European policymakers rise to the occasion and admit their mistakes after years of buying time? If not, both the political and economic fundamentals now seem to be turning against them. Elections increasingly involve an element of protest which will make it difficult to honor previous agreements and ensure technocratic solutions. Electorates in the south are fed up with austerity. In the north, they are tired of having to underwrite seemingly endless bail-outs. For instance if Italy were to succumb, it might need a facility of at least 2 trillion euros, far beyond the existing arrangements. At the same time, the crisis is hitting real economic activity which in turn is increasing the political price of bailout and limiting the room for maneuver even the hitherto more flexible northern European governments enjoy. Problematically, there is still no open discussion of what the endgame in Europe might look like. And as the crisis has been fought one emergency at a time, there does not seem to be much of a Plan B either.
— Jarmo T. Kotilaine is chief economist at the National Commercial Bank, Jeddah.
