10 April 2012

FT: Spain's crisis exposes limits of ECB help

Contagion underlines a fundamental problem with the ECB’s great liquidity injection. It reinforced the incestuous relationship whereby undercapitalised eurozone banks propped up overstretched sovereign borrowers who stood behind those same fragile banks. In Spain’s case foreign investors have been deserting the bond market, and domestic banks are finding it harder over time to plug the gap.

Bank balance sheets across the eurozone have been further weakened because access to ECB liquidity requires banks to pledge assets just as collateral requirements are rising sharply in many markets, such as covered bonds and repos. This has led to increased balance sheet encumbrance – the pledging of collateral to one group of creditors at the expense of another. As Hung Tran, deputy managing director of the Institute of International Finance points out, a greater degree of encumbrance pushes senior unsecured bondholders down the list of those who are paid out when a bank fails.

Spain now finds itself at the centre of a great eurozone laboratory experiment designed to show that a pro-cyclical increase in fiscal austerity in a deep recession can lead on to growth and debt sustainability. Markets, which are wrongly assumed always to favour the fiscal hair shirt, are torn on the issue. They responded badly to the rise in Spain’s forecast 2012 budget deficit to 5.8 per cent of gross domestic product from the previously agreed 4.4 per cent, even though that still represents a reduction of 3.2 percentage points of GDP.

Inevitably there will now be talk of whether Spain can find a way through these problems without a bailout. This will no doubt reinforce the market perception that the existing bailout funds are inadequate to backstop Spain and Italy. And there is scepticism about whether another LTRO would be effective. So it is beginning to look as though the initial benign impact of the liquidity injection on government bond yields was a temporary phenomenon. Solvency is once again an issue in southern Europe. 

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