Euro Tremors Risk Market Respite on Spain-Italy, Banks

Europe’s political tremors risk spoiling the region’s market calm, with corruption allegations buffeting Spanish Premier Mariano Rajoy and Italy’s Silvio Berlusconi narrowing the front-runner’s lead as elections loom.

Rajoy, facing opposition calls to resign amid contested reports about illegal payments, traveled to Berlin today as euro-area leaders schedule a flurry of meetings this week ahead of a Feb. 7-8 European Union summit. Last week’s nationalization of the Netherlands’ fourth-largest bank and a 2.17 billion-euro ($3 billion) loss at Deutsche Bank AG underscore the fragile economic health in the region.

“The euro crisis is not over,” German Finance Minister Wolfgang Schaeuble said Feb. 1 at the Munich Security Conference where fellow panelists included Deutsche Bank co-Chief Executive Officer Anshu Jain. Still, “we’re in a much better position than we were a year ago,” the minister said.

A sluggish economy, uncertainty over the outcome of this month’s Italian election and Rajoy’s new troubles threaten to curtail the time won by politicians with the central-bank bond buying. For now, European policy makers have room to maneuver as borrowing costs for indebted nations have fallen and investor confidence returns.

Bond Yields

Spanish bonds slumped today, sending the 10-year yield up 22 basis points to 5.43 percent, the highest in seven weeks, at 4:25 p.m. in Madrid. Italy’s 10-year bond yields climbed 13 basis points to 4.46 percent -- still almost 3 percentage points below its 2011 euro-era record. The euro fell 0.6 percent to $1.3559.

In Madrid, opposition leader Alfredo Perez Rubalcaba said Rajoy should resign after reports in El Pais newspaper that he or members of his People’s Party received illegal payments. Rajoy said Feb. 2 that the allegations are unfounded and stem from unknown people trying to damage his party.

“It’s false, I have never received or shared out illegal payments within the party or anywhere else,” Rajoy told reporters in the Spanish capital. El Pais had reproduced what it said were handwritten extracts from ledgers detailing payments to party officials, including the prime minister.

Rajoy has imposed the harshest austerity measures in Spain’s democratic history to curb the budget deficit and lower borrowing costs.

German Backing

In Berlin, German Chancellor Angela Merkel backed Rajoy, saying, “I’m convinced that the Spanish government and Mariano Rajoy as prime minister can resolve this task -- and Germany will assist him with all of our strength.”

In Italy, a Feb. 1 poll showed billionaire media magnate Berlusconi closing the gap with leader Pier Luigi Bersani to 5 percentage points, as he undertook a media blitz.

The surge by Italy’s former premier, who was pressured to resign in 2011 amid soaring bond yields, threatens Bersani’s ability to win a majority even if he remains ahead in the polls. Berlusconi has pledged to refund a tax on primary residences imposed by his successor, Prime Minister Mario Monti. Voting takes place on Feb. 24-25.

“Berlusconi wants to buy the votes of Italians with the money that Italians had to turn over to cover up the shortfall left in the public accounts by Berlusconi, who governed for eight of the past 10 years,” Monti said today on RTL radio.

Monti has won plaudits from his counterparts for imposing austerity measures that helped temper the crisis.

“The markets have saluted” developments in the euro area, French President Francois Hollande said upon meeting Monti in Paris yesterday.

Deutsche Bank’s Jain lauded Germany’s pro-austerity policies and the European Central Bank’s commitment to limitless bond purchases as catalysts for bringing the 17-member currency past the “acute” stage of the crisis.

Default Probabilities

“Thank God the acute phase of the crisis is over because we were flirting with the edge of the precipice for entirely too long,” Jain said at the Munich conference. Still, implied default probabilities in Italy and Spain that were at 50 percent last July are still as high as 20 percent, he said.

Those levels “on countries which owe the world 2 trillion euros is still very much a worry,” Jain said.

Frankfurt-based Deutsche Bank, Europe’s biggest lender by assets, reported a fourth-quarter loss on Jan. 31 that exceeded estimates after it eliminated more than 1,400 jobs and set aside 1 billion euros for legal expenses. The next day, Credit Agricole SA, France’s No. 3 bank by market value, said it’ll book 2.68 billion euros in goodwill writedowns to reflect stricter rules and a worsening economy in the region.

Dutch Takeover

The European banking landscape dimmed further when the Dutch government took control of SNS Reaal NV for 3.7 billion euros after real-estate losses brought the lender to the brink of collapse. The lender had been left struggling to repay a government bailout before next year’s deadline.

“Banks still are a very weak link in Europe’s recovery,” said Bas Jacobs, a professor of economics at the Erasmus University of Rotterdam. “Not enough losses have been written off. Eurobanks with impaired balance sheets become zombiebanks, which reduce lending to make up for those losses.”

Teetering banks are also the central issue in a bailout for Cyprus, which will be the euro-area’s fifth. As European leaders hold off on a rescue agreement for the Mediterranean island nation, a report cited by Nicosia-based broadcaster Sigma placed the worst-case scenario for recapitalizing Cyprus’s lenders at 9.2 billion euros.

That would make the country’s debt unsustainable, Sigma reported yesterday, citing a Pimco report.

Joachim Fels, chief economist at Morgan Stanley in London, cited concerns over a Cyprus bailout and possible debt writedowns that could again roil markets.

“I worry about a resurfacing of worries about bail-ins for bank creditors in Cyprus and even about euro exit, which could easily lead to another bout of the euro crisis,” Fels wrote in a note to clients yesterday.

Before it's here, it's on the Bloomberg Terminal.