If ever there was an example of shortlived euphoria, the outperformance of Spain’s government debt and its bank shares on Monday morning was it. By the afternoon’s trading the uplifting effect of the weekend’s promised €100bn bailout had worn off leaving the market feeling as bearish as it was before.
Some of the reasons were obvious and probably inevitable. Continuing uncertainty over the terms of the hastily planned bailout, a looming Greek election at the weekend and general European gloom are all partly to blame. But the unacknowledged drag on Spanish sentiment is the continued refusal of policy makers to recognise the crucial link between the fortunes of the country and those of its banks.
In a normally functioning market, there is a benign mutual relationship between the sovereign debt of a developed nation and the natural demand for those bonds from that nation’s banks – lenders need safe, liquid stores for their funds; countries need ready buyers of their debt.
In times of crisis, though, serenity turns quickly to sin in the eyes of the markets – analysts and economists start talking about negative feedback loops and vicious circles, and the fortunes of government debt and bank share prices start to move in lock-step.
Yet if the latest plan for a €100bn hypothecated bailout for Spain’s banks is any guide, the pervading mood from Brussels to Berlin seems to be disinterest in that structural truth, let alone in doing something to break it.
There are, of course, things to praise in the Spanish bailout. The EU’s action over the weekend was swift, restoring faith that European leaders have the determination to co-operate decisively when necessary.
The amount they settled on is also right at the top end of analyst estimates of what Spain’s banks might need in terms of capital support to withstand latent property loan losses – this is clearly an attempt at the kind of “shock and awe” response that Anglo-American policy makers have urged on the eurozone for months.
There was a recognition, too, that the bailout financing needed to be clearly restricted to banking sector capital, with limited strings attached for the government’s fiscal policies, which many feared could have proved counterproductive had they been too severe.
But the inescapable error is in failing to inject the money directly into the banks as equity, routing the money instead through the Spanish government. By doing so, the European authorities are intensifying the “doom loop”, as one analyst puts it.
That link was already redoubled when the European Central Bank’s December and February longer-term refinancing operation led to Spanish banks, far more than most, recycling the cash into sovereign bonds – buying €83bn since December.
Spanish banks account for a more than a third of Spanish sovereign bond ownership, nearly double the tally five years ago.
The increase has helped offset international investors’ dimming faith in Madrid – making Spain’s banks a valuable stabilising force in the country’s economy. Without them, Madrid would have little hope of financing itself.
But it is a delicate and dangerous balancing act, for the banks and the country. And this bailout could be the tipping point. As well as cementing the government’s vulnerability to the banks as it transmits the bailout money to the weakest operators in the sector, there could be yet another layering of sovereign investment going the other way. The bailout injections may go beyond what the banks immediately need to offset soured loans. If so, any excess funds will need to be invested, most likely in sovereign bonds.
European policy makers, particularly those in northern Europe who have insisted on routing bailout funds through Madrid, would do well to heed the echoes of Greece – where the weak sovereign has dragged down the banks – and of Ireland – where weak banks dragged down the sovereign. Apart from the practical risk of banks losing money if Spanish sovereign debt ever had to be restructured, there is a damaging perception of contagion. Europe must help break Spain’s “doom loop” before it is too late.