A credible recapitalization of the Spanish banks is now a necessary, though not sufficient, condition to stabilize markets. But there is disagreement about how to achieve this—increasing the risk of a damaging standoff and further volatility in European sovereign-debt markets.Spain was always going to be a key battleground in the sovereign-debt crisis. At €1.1 trillion, Spain’s economy accounts for 11% of euro-area output. It is almost twice as big as the combined economies of Greece, Portugal and Ireland. More pertinently, it has total banking assets of €3.7 trillion.
The size of those assets is connected with the huge boom in money, credit and asset prices that Spain, along with Ireland, experienced in the early years of monetary union. Unfortunately, the subsequent bust has left much of Spain’s banking system in tatters. Unlike Ireland, Spain has been very slow to deal with this problem.
While investors may continue to fret about debt sustainability, a credible plan to recapitalize the banks should help to neutralize one source of market concern and volatility. The question is whether this recapitalization would be supplied directly or indirectly by the European bailout fund, the European Financial Stability Facility (EFSF), and its successor, the European Stability Mechanism (ESM). An attempt by Spain to recapitalize its banks would not be regarded as credible.
For markets, a direct recapitalization would clearly be the best outcome, as it would help sever the link between the sovereign and the banks, and represent an important step towards debt mutualization. But the likelihood of this in the near term is another question entirely. Pressure on Germany is rising (though it is not alone on this issue), and Chancellor Merkel has said that there should be no “taboos” in the debate about the euro area’s future. But the reality is that Germany shows few signs of budging, raising the risk of a second-best solution or a prolonged standoff.
As has been the case throughout the sovereign-debt crisis, policymakers probably possess the tools to stabilize markets, but are either unwilling or unable to act quickly enough to pacify investors. It could be that current tensions in Spain, the risk of a Greek euro-area exit and the ongoing threat of capital/deposit flight will prompt policies that might, ultimately, provide a path out of the current crisis. But the story of the last two and a half years is that the policy response only comes after periods of severe financial-market tension, which often reduces its effectiveness. This ultimately raises the costs to the real economy, making fiscal adjustment that much more difficult. However illogical this may seem, the Spanish impasse is unlikely to be resolved any differently.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.
Darren Williams is Senior European Economist at AllianceBernstein.