Is a Liquidity Crisis Brewing in Europe?

The problem facing euro zone policy makers as we head into what could be another eventful summer for the global markets is surprisingly simple, yet very unpalatable.

Euros at an angle
Thomas Northcut | Photodisc | Getty Images
Euros at an angle

Angela Merkel, Jean-Claude Trichet and to a lesser extent Nicolas Sarkozy have to answer the following question: do we bailout the banks or do we throw more money at highly-indebted nations like Ireland, Portugal and more urgently, Greece?

Since January the euro zone debt crisis has been overshadowed by events in the Middle East, Japan and fears over the health of US finances but over the coming months the problems facing the euro zone will have to be addressed, or - if history teaches us anything - at least fudged.

With talk of Greek debt restructuring rife, the fact that Portugal has finally agreed the terms of its 78 billion euro ($115 billion) bailoutby the European Union and the International Monetary Fund is likely to be pass relatively unnoticed on global markets ahead of Thursday’s ECB meeting.

In the not too distant future the global market will not be able to ignore the state of Europe’s banking system as the implications of a Greek restructuring become clear.

“Last week, 241 banks bid for money at the ECB repo window. Why are so many banks retracting from the business of lending unsecured funds to each other at 40 percent of the banks in the euro zone need to come to the ECB repo window?” asked Carl Weinberg, the chief economist at High Frequency Economics in a research note on Wednesday. These funds are not attractively priced. We can only assume that banks with excess reserves see an increasing number of counterparty institutions as too risky in the face of an exploding sovereign debt crisis,” Weinberg added. The problem is that Europe’s banks hold an awful lot of Greek government debt, and the debt of others like Ireland and Portugal, on their books.

As investors and bankers await the compromise deal that will ultimately put Greece’s finances on a sustainable path at the expense of bond holders anyone who has watched the euro zone debt crisis unfold knows what happens in Greece today is likely to happen elsewhere tomorrow.

Amid widespread opposition in Germany to the bailout of Greeceand its troubled peers in the euro zone, Angela Merkel could not attempt another national bailout even if she wanted too.

So hence the bond holders will have to take the hit on either the time it will take to reclaim their money or the principal.

As we wait for the final decision on what the Greek restructuring will look like, the banks look on nervously, knowing that unless a classic EU compromise deal can be agreed they face losses on their bond holdings. “This week’s repo result is a bad signal that banks doubt each other's creditworthiness. The banking sector is seizing up in response to a deepening and broadening sovereign debt crisis in the euro zone. Interbank lines are being shutdown. This ain’t good,” Weinberg said.

Investors hoping for some sun in Greece or Portugal over the summer might end up stuck at their desks wondering why they ignored the crisis for so long unless someone can find a smooth exit strategy from the euro zone debt crisis.

History would suggest you should not book your flights just yet.