Faith Fades in Euro Zone Firewall

Fears that the euro zone’s firewall will prove insufficient to shield Spain and other embattled countries against the effects of a possible disorderly Greek exit from the currency union hit European financial markets on Monday.

European Union Flag
Jonathan Kitchen | Image Bank | Getty Images
European Union Flag

Spanish and Italian 10-year borrowing costs shot up to their highest levels this year and European stock markets suffered their biggest one-day drop in three weeks. German 10-year bond yields fell to a record low, widening the premium Madrid pays to borrow compared to Berlin to a new euro-era high.

“It’s looking alarming right now,” said Luke Spajic, a senior fund manager at Pimco, one of the world’s largest bond investors. “The market is effectively trying to price in a disorderly exit for Greece.”

The chance of Greece falling out of the euro zone — previously seen as a cataclysmic event that many European policymakers had refused to discuss — has attracted renewed speculation following an election that resulted in strong gains for parties opposed to budget cuts imposed as a condition for Greece’s bailout.

European leaders have created a 500 billion euro ($643 billion) euro zone rescue system, the European Stability Mechanism (ESM), as a financial firewall. But many analysts and investors have questioned whether it is big enough to rescue the larger economies at risk, such as Spain and Italy.

“The firewall is big enough in theory for Spain,” said Justin Knight, a strategist at UBS, but added that the ESM would be likely to face practical difficulties raising large loans.

To add to the somber mood, Moody’s announced on Monday night it was downgrading 26 Italian financial institutions by between one and four notches.

Those affected included Banca Monte dei Paschi di Siena, Intesa Sanpaolo, and UniCredit, as well as a number of small banks and subsidiaries.

The rating agency cited increasingly adverse operating conditions in Italy, mounting asset-quality challenges, and weakened net profits as well as restricted access to market funding. The outlook on all were put at “negative.”

Although Spain has announced deep budget cuts and unveiled new plans to strengthen its banks, concerns over economic contraction and souring property loans have grown. The cost of insuring against a Spanish default hit a record on Monday.

Four small Spanish savings banks are working on a merger supervised by the ministry of economy that could create the country’s fifth largest lender with assets of 270 billion euros ($347 billion), raising concerns among analysts after last week’s 4.5 billion euro ($5.8 billion) state rescue of Bankia — itself the dysfunctional result of a seven-way merger of savings banks.

Luis de Guindos, the Spanish finance minister, insisted the market turbulence was due to political uncertainty in Greece and not a verdict on his government’s efforts to shore up the banking sector, arguing Madrid had “done what we had to do.”

“Spain has taken measures, implemented a very deep banking clean-up, to improve our fiscal situation,” Mr. de Guindos said. “What we need now is the co-operation of the euro zone.”

However, Jean-Pierre Jouyet, the head of France’s financial markets regulator and adviser to incoming president François Hollande, warned that “there is a risk of contagion.”

“If Greece left the euro, which is a hypothesis that today we cannot avoid, we have to look at the chain of consequences” for banks, he said in a television interview.

U.K. Chancellor George Osborne, arriving for a finance ministers’ meeting, said the British recovery has been damaged over the last two years not by Britain getting a grip on its public finances, but by uncertainty in the euro zone.

“It is that uncertainty, not austerity, that is doing the real damage to the European recovery, and indeed the British recovery,” he said.

European banks were hit particularly hard by the contagion concerns, shedding almost 4 percent of their stock market value, the most in more than a month. The euro fell against the dollar for the 10th day in the past 11 days.

Investors and analysts said that European policymakers would have to act decisively before larger, more systemically important countries were further dragged down by concerns over Greece.

“We need more drastic policy intervention to calm nerves,” Mr. Spajic said. “Whatever policy framework they have in place now is not enough to ringfence Spain and Italy.”