Sunday, June 10, 2012

In spite of the bailout of Spain's banks, periphery redenomination risks loom

The media is putting a great deal of emphasis on the EU-arranged Spanish bank rescue (discussed here), which will clearly provide Spain some much needed relief. But it's important to step back and look at the larger problem the Eurozone will still have to confront going forward. Here is a sobering assessment from Antonio Garcia Pascual of Barclays Capital:
Overall, the financial assistance by the EFSF/ESM to recapitalise Spanish banks is likely to be a net positive for Spain: the strict conditionality to complete the bank clean-up, including restructuring plans in line with EU state-aid rules and horizontal structural reforms of the domestic financial sector, should help restore credibility and transparency; it should also help alleviate funding pressures. However, the problem confronting Spain, and the rest of the periphery, is bigger.
While the completion of bank recapitalisation processes is welcome, the solution to the crisis also requires the euro area/core to make explicit decisions and strong commitments to the periphery, especially after the PSI exercise and the open discussion of a Greek exit. In fact, should market events accelerate the ongoing capital reversal (and a Greek exit remains a material contagion risk), given the contagion to other weak economies (eg, Italy has been trading at a spread versus Spain of c.30-70bp for 10y bonds), it would be unlikely that the financial assistance could be circumscribed to the banks only or even to Spain alone. And for that, there are no sufficient rescue funds readily available (ie, for multi-year full-fledged programmes for Spain and, depending on contagion dynamics, for Italy as well).

So long as the euro area does not remove the tail risk of potential FX redenomination for periphery countries, medium- and long-term investment commitments by foreign capital (or even domestic) are unlikely and that creates a growth disadvantage in the periphery. And without growth prospects, there is little hope to emerge out of the crisis.
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