Washington Matters


Europe's Debt Still Cause for Worry

Stress tests on European banks were designed to calm the markets, but don’t count on it.



A trillion dollars can buy a lot of peace of mind. That’s roughly what the European Union and the International Monetary Fund pledged on May 9 as a backstop against a Greek sovereign default. At the time, Europe watchers were in a panic that a default this would set off a chain reaction across the region, tipping the world back into recession. But since then, investors have taken questionable news about Europe in stride.

That’s likely to change soon.

The markets have been waiting for weeks as the Committee of European Banking Supervisors conducted stress tests on EU banks. One of the main reasons investors feared a Greek collapse is because they had no idea whether these banks, which own the vast majority of Greek government debt, could withstand a massive hit to their balance sheets from a write-down of those bonds. If they could not, the result would be a replay of the 2008 financial crisis, with EU sovereign debt in the place of U.S. subprime loans.

Now the results are out, and they’re not reassuring. That’s not because they predict doomsday -- they don’t -- but because they leave too many questions unanswered.

Advertisement

Of the 91 banks given the stress tests, 84 passed, including all but one of Germany’s notoriously troubled, publicly owned Landesbanken, and all but five of Spain’s equally worrisome cajas, or savings and loan institutions. Combined potential shortfall for the seven that failed: $4.5 billion. Not exactly chump change, but not a rerun of 2008 either.

But here’s the problem: The tests considered the risk on the bonds banks traded but not on those they are holding to maturity. That’s a lot of potentially bad debt to overlook.

If investors decide they’re not being told the whole truth, they’re likely to get nervous again very quickly. Their jitters will push up interest rates on euro-denominated bonds from shaky economies, notably Greece and Spain, and drive the euro itself down. Odds are China will cushion the blow to the EU by upping its purchases of euro-denominated bonds. It has already provided a lot of help in recent weeks, not out of altruism but because the euro zone is now China’s largest export market. A new European recession would hurt sales.

Senior policymakers -- notably European Central Bank President Jean-Claude Trichet, who wrote in today’s Financial Times -- are arguing that debt poses the greatest economic threat to the EU and that the only sensible thing to do is to slash government spending.

Austerity measures rein in fiscal deficits, but they can also cramp capacity for economic growth. That further starves governments of potential revenue and prompts investors to demand ever higher interest rates as the price of providing still more capital.

We’ve already seen the results in Ireland. Of all the region’s sick economies, Ireland has swallowed the bitterest fiscal medicine, with Dublin cutting government spending drastically to avert a debt crisis, even at the cost of years of slow growth. Its reward came last Monday when Moody’s cut Ireland’s debt rating, citing a poor growth outlook as one reason.

The best-case scenario is that Greece, and only Greece, has to restructure, probably by 2011. Athens is taking heroic steps to cut its own deficits, but the principal it owes on existing debt is so large that a write-down is inescapable. When that happens, we’ll find out just how much stress European banks can really take.

As Bette Davis put it, “Fasten your seatbelts. It’s going to be a bumpy night.”




You can get valuable updates like Washington Matters from Kiplinger sent directly to your e-mail. Simply enter your e-mail address and click "sign up."

More Sponsored Links


DISCUSS

Permission to post your comment is assumed when you submit it. The name you provide will be used to identify your post, and NOT your e-mail address. We reserve the right to excerpt or edit any posted comments for clarity, appropriateness, civility, and relevance to the topic.
View our full privacy policy


Advertisement

Market Update

Advertisement

Featured Videos From Kiplinger