Portugal's bank rescue throws euro zone woes into sharp relief
Beneath the favourable sentiment towards the euro zone, investors still harbour big concerns about governance of the single currency area
Over the past two years, market sentiment towards Europe's single currency area has proved resilient to all sorts of risks and vulnerabilities.
For those who believe the bond market routs and financial contagion that were the hallmark of the euro-zone crisis are things of the past, the muted reaction to last weekend's €4.9 billion (HK$50.7 billion) bailout of Banco Espirito Santo (BES), Portugal's largest listed bank, attests to investors' underlying confidence in Europe.
That the government of Portugal - which exited a three-year bailout programme in May without the safety net of a precautionary credit line - was able to mount a rescue of BES, which imposed losses on the bank's shareholders and junior creditors without triggering panic in markets, shows the extent to which sentiment has improved.
Although the bank's spectacular collapse raises troubling questions about the competence of Portuguese and euro-zone financial regulators, bond markets appear unruffled.
The yield on Portugal's closely watched two-year bonds currently stands at just 0.8 per cent, a near-record euro-era low. Benchmark Spanish and Italian 10-year bond yields, meanwhile, have barely budged and are also trading at near-record lows despite the release of Italy's second-quarter GDP data on Wednesday which showed the economy is back in recession.
Sentiment-wise, one would never think that Portugal's biggest listed bank has just collapsed.
The insouciance of markets is all the more remarkable given that the rescue of BES - which adheres to a controversial new resolution regime for Europe's failing banks requiring that at least some of the losses fall on private creditors in order to help shield taxpayers - is a foretaste of things to come.
The eagerly awaited results of the European Central Bank's asset quality review, which are due to be published in of October, are almost certain to reveal more capital shortfalls in the euro zone's vulnerable banking sector.
While Portugal was fortunate in that it was able to draw on funds left over from the country's bailout programme to rescue and restructure BES, other euro-zone countries with vulnerable banking sectors are likely to find it much more difficult to shore up their ailing banks.
Indeed, the rescue of BES has shone a spotlight on the political and economic governance failings which continue to bedevil the euro zone.
While the resolution imposes losses on some of BES's private creditors, the bank's senior bondholders and unsecured depositors have been spared a haircut for fear that imposing losses on them would spook markets and increase euro-zone banks' funding costs.
This means that Portuguese taxpayers are providing the main backstop for the rescue of BES - precisely what euro-zone leaders wanted to avoid when they pledged in June 2012 to sever the pernicious links between the euro zone's vulnerable banks and sovereigns, often referred to as the "doom loop".
While the shift from a "bail-out" to a "bail-in" regime for Europe's failing banks has begun, the cautious approach to bailing in private creditors to BES shows how perilous this transition is likely to be.
The big question now is what happens if a hefty capital shortfall at a vulnerable bank in a large euro-zone economy is revealed when the results of the ECB's vetting and stress-testing of banks' balance sheets are published.
The country to watch is Italy, which accounts for about 17 per cent of the euro zone's GDP (compared with Portugal's 2 per cent) and, unlike Spain, whose economy is growing and whose banking sector has been aggressively restructured, is back in recession.
Italy's medium-sized regional banks are particularly vulnerable, weighed down by bad loans, weak profitability and poor corporate governance.
Shoring up Italy's banking sector could be the trigger for a much sharper sell-off.
Indeed, there is an inescapable feeling that beneath the favourable sentiment towards the euro zone, investors still harbour serious concerns about the governance of Europe's ill-managed single currency area. The euro-zone crisis has been kept at bay for the past two years - but it could yet return with a vengeance.
Nicholas Spiro is the managing director of Spiro Sovereign Strategy