“Regulators have taken to warning that investors may be underestimating the risks still lurking in the euro zone – perverse given that central-bank policies have been explicitly designed to encourage investors to take such risks.”, Simon Nixon, WSJ
Portugal Isn’t Euro Zone’s Biggest Problem
What should worry investors is how growth appears to be stalling in some of the euro zone’s biggest economies
By Simon Nixon
For a few days last week, it was déjà vu all over again.
Fears over the collapse of a Portuguese bank spooked the market. European stock markets fell; bond spreads for euro-zone peripheral countries widened, spreads for core countries tightened; a Spanish bank pulled its bond auction and a Greek government bond issue raised less than hoped.
Ghosts that investors had begun to assume had been finally banished appeared to be haunting the markets again: the fragility of the euro-zone banking system and the risks of contagion.
Some would argue that a market wobble was long overdue. The tide of money that has poured into southern Europe this year has been extraordinary. The markets have been wide open to every government and bank. Even Cyprus has issued bonds and its largest bank is on the road raising equity. The European high-yield bond market is on track for its best year by volume. Regulators have taken to warning that investors may be underestimating the risks still lurking in the euro zone—perverse given that central-bank policies have been explicitly designed to encourage investors to take such risks.
The travails of Banco Espirito Santo have struck many investors as an excuse to take money off the table. AFP/Getty Images
The travails of Banco Espírito Santo may have struck many investors as a good excuse to take money off the table. The Portuguese bank is controlled via a cascade of family-owned holding companies and came under pressure when financial irregularities were uncovered at its ultimate parent, Espírito Santo International SA, a conglomerate with diverse interests all over the world. Not only was the Portuguese bank a lender to these family interests, but it had allowed units higher up the shareholder structure to sell bonds directly to its own customers. The market feared a black hole.
But there are good reasons to believe that BES isn’t a serious threat to the financial stability of Portugal, let alone the euro zone. There are other risks that should worry investors more—and may have been a factor in last week’s selloff.
The situation at BES looks better contained than initially feared. Its exposure to companies higher up the shareholder structure turns out to be just €1.1 billion ($1.5 billion)—that is manageable in the context of a €100 billion balance sheet and its €7 billion of equity, €2.1 billion above the regulatory minimum. Even if, in a worst-case scenario, BES came under pressure to honor guarantees given by its controlling shareholder to buyers of its bonds, the total exposure would rise by €700 million to €1.8 billion.
The debacle at BES is sure to be painful for the bank’s shareholders, many of whom only recently subscribed to a €1 billion capital increase and are already nursing losses on their new shares. The shares have so far lost more than half their value since early June.
Now they face the prospect of not only filling the hole caused by any losses on exposures to the bank’s controlling shareholders, but also the prospect of a 25% stake in the bank coming onto the market should the family be forced to sell. If they refuse to put up money, the government still has €6 billion of its bailout money earmarked for bank recapitalizations available to fill any shortfall, threatening shareholders with even deeper dilution.
But there is no reason so far why BES’s problems should cause longer-term difficulties for Portugal beyond any short-term knock to confidence. The country is already seeing the benefits of a far-reaching reform program; growth this year is expected to be above the euro-zone average at 1.2%, rising to 1.5% next year. Unemployment has fallen for seven consecutive quarters to 14.3% from a peak of 17.5%, which has helped fuel a recovery in domestic demand.
Despite BES’s problems, growth should be supported by a healthier banking system. Portugal’s second-largest listed lender, Millennium BCP, is raising €2.25 billion of new equity via a fully underwritten rights issue. The Portuguese banking system should also be the beneficiary of a new European Central Bank long-term cheap-funding facility announced in June.
What should worry investors is less Portugal but the fact that growth appears to be stalling in some of the euro zone’s biggest economies.
The latest surveys point to manufacturing having contracted in June in Germany, France and Italy. Some of this may be explained by one-off factors, including weather disruptions and the timing of public holidays. The crisis in Ukraine also appears to have hit German exports.
The real disappointment has been in the weakness of the recovery in the new sick men of Europe: France and Italy, both of which have been slow to deliver the reforms that have been boosting productivity and competitiveness elsewhere in the euro zone. Whereas J.P. Morgan last week raised its growth forecast for Spain for this year to 1.5%, reflecting the success of its structural reforms, it downgraded its forecast for Italy to 0%.
Given the size of Italy’s economy and the scale of its public debt—at 133% of gross domestic product—its lack of growth remains the single biggest threat to the stability of the euro zone. Yet to the concern of many policy makers and investors, Prime Minister Matteo Renzi appears to be spending the most political capital seeking changes to euro-zone fiscal rules to allow Italy to borrow more, rather than pushing through reforms that might boost Italy’s growth prospects.
When Mr. Renzi took office in February, he announced an ambitious 100-day program to change Italy. Having failed so far to deliver on any of his goals, he has now given himself a new deadline of 1,000 days. Yet the only substantial reform that now looks likely to be achieved this year is an overhaul of the electoral rules and the Senate—reforms of totemic significance to the Italian political class but of zero economic consequence.
Far-reaching reforms of the public administration, judicial system, government spending and labor market have been promised but details remain scarce and timing unclear.
Until Mr. Renzi proves he can live up to his own domestic reforming rhetoric, investors should brace themselves for more wobbly weeks like the last one.