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EU policymakers need to think big

Wednesday, June 13, 2012
By Steven C. Johnson and Angela Moon, Reuters


NEW YORK -- So much for the relief rally.

After bouncing overnight on news that Europe had stitched together a US$125 billion rescue for Spain's banks, gains for global stocks and the euro fizzled.

Bailouts for debt-strapped countries have provided a short period of comfort for investors, one that quickly gets eroded by fear about Europe's vicious circle of slow or no growth and growing debt burdens. On Monday, the speed of that reversal was quicker than ever.

Greece's first bailout in 2010 sparked a healthy 1.3-percent rally in the benchmark Standard & Poor's 500 stock index on the following day, but subsequent rescues fostered more muted responses.

The reaction after Spain's bank bailout has been the most downbeat of the lot, particularly given the size of the package and the speed with which gains were wiped out. U.S. stocks fell into negative territory within an hour of Monday's opening bell and then continued dropping.

“Even the most inconsolable and bearish analysts were taken aback at how decisively markets rejected this bailout,” said Richard Franulovich, currency strategist at Westpac Securities.

U.S. stocks fell 1.3 percent, and the euro shed 0.2 percent, while Europe's leading index of blue-chip shares and Spain's IBE-- 35 declined.

The four prior bailouts — for Greece and Ireland in 2010, Portugal in 2011 and Greece again in 2012 — showed the euro's rallies fade within a month, while stocks were mixed, based on various factors.

In the credit default swaps market, where investors take out insurance against the risk of sovereign default, the pattern has been similar. The cost of buying insurance against Greek, Irish or Portuguese default tended to drop after the first two weeks as investors took the bailout news as a sign of relief, only to rise back to pre-bailout levels or higher within a month.

After initially falling, the cost of insuring US$10 million of Spanish government debt against default rose to 595 basis points, or US$595,000 per year for five years, financial information firm Markit said. That is just off a record high.

Investors eager for a fix that involves more European Central Bank support and a common European bond market say Europe's piecemeal approach to the crisis is scaring markets.

“We've been getting what I call 'bread crumbs,'” said James Dailey, portfolio manager of TEAM Financial Asset Management. “What we need is a comprehensive European solution. Until we see something massive from the ECB, it's not addressing the issue. The problem is not liquidity, it's solvency.”

Investors worry that higher borrowing costs for Spain, Italy and others will shut these governments out of international capital markets entirely.

Yields could rise further if a Greek election next weekend produces a government that opts to abandon the euro rather than stick to fiscal austerity, or if Spain suffers another downgrade.

Markets also fear that the bank rescue will add some 10 percent to Spain's debt-to-output ratio, which is expected to near 80 percent by the end of the year.

The end result could be one in which European Union leaders are forced to follow the bailout of Spanish banks with one for the Spanish government.

“For the Spanish economy as a whole, there has been no debt relief,” Franulovich said. “This is what happened to Ireland. The banks are in healthier shape today, but the sovereign is in real trouble.”

In fact, a report by Spain's central bank showed Spanish banks were the main buyers of Spanish sovereign debt last year, essentially making the government dependent on the banks it is now trying to help.

Spanish 10-year government bonds had one of their worst days in two months on Monday. The yield rose to 6.51 percent, a clear sign that the market lacks confidence in the measures taken.

Of most consequence is No. 3 eurozone economy Italy, which has the world's third-largest sovereign debt market. Italy's CDS widened to 550 basis points on Monday.

Jack Ablin, chief investment officer at Harris Private Bank in Chicago, said the ever-growing crisis should convince policymakers to think bigger in addressing the crisis.

“Investors are getting tired,” he said. “There's only so much plaster you can put on a crumbling wall.”

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