The vigilantes in Europe's debt and share markets have turned their attention to new victims and lit upon a weak link - banks in the troubled euro zone states. Bank shares tumbled in Ireland, Portugal and Spain as investors doubted the ability of lenders to finance their operations.
As the Irish government prepared for a new and more gruelling round of spending cuts to satisfy EU and IMF lenders, the governor of the Irish Central Bank, Patrick Honohan, conceded that the country's banks are for sale, adding: "I've been an advocate for a number of years for small countries to have foreign owners for their banks."
Mr. Honohan's comments, and worries that Ireland's hugely overextended lenders face nationalization or the butcher's block, sent shares in Bank of Ireland and Allied Irish tumbling by 20 per cent on Tuesday. Depositors have been fleeing Irish banks since the beginning of the year, with Allied Irish losing €13-billion ($21-billion). The rout prompted an executive at a leading bond investment manager, Mohammed El-Erian of Pimco, to warn that Irish lenders are at risk of a bank run.
But the focus of market anxiety is moving from Dublin to other European capitals, especially Lisbon and Madrid, where banks shares were under pressure Tuesday amid refinancing fears. Portugal's banks are heavily reliant on the European Central Bank, having borrowed €40-billion ($55-billion) in October as liquidity dried up in interbank lending markets.
Instead of sparking a relief rally in the euro zone bond markets, the €80-billion to €90-billion rescue package for Ireland triggered alarm bells - and a jump in the risk premium that a bondholder pays for insuring Irish, Greek, Portuguese and Spanish bonds. The yields on these bonds continued to rise on Tuesday, exacerbating the feverish market mood.
Spain attempted to reassure the markets with news that its deficit figures were better than expected in October, putting the government on track to achieve its onerous deficit reduction targets. But the bond vigilantes were having none of it, and Spain's borrowing costs soared to the highest level since the country joined the euro. As the Spanish government tapped the market for €3.3-billion in short-term bills, the spread between Spain's 10-year bond and the equivalent German bund reached 2.3 percentage points.
More than €50-billion in Spanish government and bank loans will mature and require refinancing next March and April, and the question is whether Spain's debt markets can cope. Spain's banks are under huge pressure because of financing difficulties, bad loan provisions from the property bust, and a domestic price war. To help finance their operations, the banks have been forced to raise savings rates to levels that are almost uneconomic.
The appalling prospect that lies before us is that the bond vigilantes might attack Spain. At that point, all bets must be off for the future of the euro zone because the German taxpayer cannot be expected to underwrite the financial future of every troubled EU state.
It makes no difference to investors that their judgments are unfair. The Irish government didn't borrow recklessly; it was the banks that led the country to ruin, pandering to people with absurdly cheap loans.
Portugal didn't binge on real estate and the Portuguese government took early steps to rein in spending, but Portugal is going backward rather than forward. It is not making convincing progress in cutting its deficit and the economy is slowing. There must now be little doubt that Portugal, too, will require assistance from the European Financial Stability Facility.
The problem is a rolling tide of debt maturities on the horizon. Each wave is bigger than the last and the European Union's ability to surf this breaker is looking doubtful.
Consider Greece. According to London brokerage Evolution Securities, Greece needs to repay €28-billion in rescue loans in 2014. But under the new German-inspired rules, any new bond Greece issues must contain a clause about debt restructuring, implying that bondholders will take a haircut in the event of default. As Evolution's Gary Jenkins put it: "Who will lend to Greece €28-billion in 2014 on subordinated terms?"
That question could also apply to Ireland when its rescue loan matures, and possibly to Portugal and to Spain. Investors now believe defaults are almost certain, but what is unknown is precisely when the wave breaks and the surfers crash.
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