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Portugal banks are the least of euro zone’s problems

PEDRO NUNES | AFP | Getty Images

Financial markets' reaction to the recent troubles of Portugal's Banco Espírito Santo (BES) is revealing.

First, the good news.

After a fairly dramatic sell-off July 10, which revived fears about the vulnerability of banks and governments in the euro zone, markets settled down very quickly.

Although BES's woes are worrying and could yet lead to a "bail-in" – where losses will be imposed on some of the bank's private creditors -- it is an isolated affair and is perceived as such by markets.

Yields on Spanish and Italian government bonds - the most reliable gauge of sentiment towards the euro zone - have barely budged. Even Portugal enjoyed strong demand for a sale of six- and 12-month bills July 16, with a lower yield on the six-month note than at a previous sale in March.

Make no mistake about it, the resilience of the debt markets of the euro zone "periphery" – in particular Spain and Italy -- shows no signs of waning.

Now, the bad news.

That the problems of a relatively small bank sparked a major sell-off in global financial markets suggests that, beneath the favorable sentiment towards the euro zone, investors still harbor serious concerns about Europe's ill-managed single currency area - and rightly so.

Read More Draghi: Strong euro is a risk to recovery

The growing uncertainty surrounding BES's capital shortfall and the manner in which it will be plugged are symptomatic of broader investor concerns - dulled over the past two years or so by the soothing effects of central banks' ultra-accommodative monetary policies - about the financial and economic governance of the euro zone.

Not only have European leaders failed to honor their June 2012 pledge to sever the pernicious links between vulnerable banks and governments, the risk-strewn shift from a "bail-out" to a "bail-in" regime for the bloc's failing banks has barely begun.

Fears about a bail-in at BES are a foretaste of things to come once the European Central Bank (ECB) completes its vetting and stress-testing of euro zone banks' balance sheets this year and further capital shortfalls are revealed.

Indeed, the pressure to bail in private creditors to failing banks stems partly from the glaring lack of support among Europe's leaders for the fiscal and political integration required to buttress the euro zone's shaky monetary union.

Read More Euro zone stalling? Barclays downgrades growth

The governance of the euro zone remains a shambles because of an enduring standoff between a German-led group of member states wary of sharing more risks and a French-led one reluctant to cede more sovereignty.

ECB president Mario Draghi, in a speech in London on July 9, called for much closer economic integration in the euro zone in order to force the bloc's governments - in particular France's and Italy's - to implement meaningful structural reforms.

This is a worrying admission from Draghi that the ECB's policies can't fix the euro zone's underlying problems and that the single currency area, in its present form, is unsustainable.

If Europe's economic recovery was taking hold, these governance failures could be papered over to some extent.

Yet this is patently not the case.

Read MoreIMF's Lagarde warns on 'upbeat' Europe markets

The euro zone is flirting with deflation and public debt burdens are now above or close to 100 percent of gross domestic product in nearly half the bloc's members. Meanwhile in France - which accounts for over one-fifth of the bloc's economy - private sector output is still contracting.

When even the ECB, which has been responsible for the dramatic improvement in sentiment, tacitly concedes that its policies are failing to address the euro zone's underlying problems, markets should take note.

Last week's sharp, albeit brief, sell-off suggests this is simply a matter of time.

Nicholas Spiro is managing director of Spiro Sovereign Strategy, follow him on Twitter @NicholasSpiro

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