“As the summer draws to a close, it is becoming increasingly clear that neither the European sovereign debt crisis nor the banking sector crisis has been resolved,” Morgan Stanley economist Joachim Fels writes.
So far, it seems the euro and the single currency’s frequent escort, US stocks, haven’t received that memo yet. They show no signs of the turbulence ignited by the last flare-up in May. But that probably won’t last.
“The sovereign and banking crises continue to mutually reinforce each other because governments need to backstop banks, while banks own large amounts of peripheral government bonds,” Fels writes. “So, not much has changed since we last described (in June) this vicious circle, called for a circuit-breaker, and concluded that the obstacles to a real solution of the banking and sovereign crisis were formidable,” he says.
For some time, it looked as if Europe’s bank stress tests might be the “circuit breaker” Fels called for, “by providing transparency on banks’ exposures and serving as a catalyst for consolidating and recapitalizing the banking system,” he says. But investors continue to have doubts about the “stringency and relevance” of the tests, and they haven’t sparked the hoped-for consolidation or recapitalization.
So the ECB continues to provide liquidity, but Fels says the solution is more equity capital, not liquidity. Unfortunately, more capital doesn’t appear to be forthcoming.
Fels says there’s “significant risk” that the sovereign debt crisis in the peripheral countries migrates to the core. “If so, it is not obvious that governments in the core countries would be willing or able to respond with massive fiscal belt-tightening,” he writes.
In such a case, “the burden would fall on the ECB to support sovereign debt,” Fels says. “As the bank had already decided to buy government bonds of then ‘dysfunctional’ peripheral markets, we believe that it would be difficult for the ECB to refuse extending its purchases to core euro area government bonds,” should the crisis migrate to the core.
“Autumn looks set to bring new challenges to Europe.”