A Scary Warning From Portugal About Europe's Doom-Loop Risk

Pedestrians pass an Banco Espirito Santo branch in Lisbon on March 30, 2012 Photograph by Mario Proenca/Bloomberg

Why would financial problems at a little-known Portuguese bank send a shudder through markets worldwide? It happened today, as equity markets slumped sharply after the parent company of Lisbon-based Banco Espírito Santo missed payments on its short-term debt.

What’s spooking investors is the risk of a doom loop. That’s a vicious cycle in which weakened banks lean on governments for support, draining the public finances, which in turn drag the banks down with them. It was the fear that overshadowed all others during the worst days of Europe’s debt crisis. And despite the progress made in easing that crisis, ”policymakers have done little to weaken the doom loop between banks and sovereigns in the euro zone’s periphery,” says Jennifer McKeown, senior European economist at Capital Economics in London.

Investors are signaling that they understand the risk only too well: Yields on Portuguese sovereign debt have risen sharply in the past few days on concerns about the health of the country’s banking system. Yields on Greek, Italian, and Spanish debt are rising, too.

On firmer footing since the global financial crisis, Portugal recently became the second euro zone country to exit the 2011 bailout program created by the European Union and International Monetary Fund. But it faces a long road ahead to reduce its €214 billion debt, the euro zone’s third-highest as a percentage of gross domestic product. The last thing it needs is a costly bank rescue.

The country’s central bank says it has acted “to avoid risks of contagion” from Espírito Santo, but markets aren’t buying it. They’ve hammered stocks Europewide, sending banking shares overall to their lowest level this year. Espírito Santo’s shares were suspended today after losing almost 20 percent of their value. “Espírito’s stresses have brought questions over the underlying health of peripheral banks and the still-evolving mechanisms for dealing with struggling institutions back into the spotlight,” strategist Jim Reid of Deutsche Bank wrote in a client note.

The weakness on the periphery might not seem so scary if the rest of Europe were doing well—but it’s not. Disappointing economic numbers continue to trickle out of the region’s major economies, including reports today that French industrial production fell 1.7 percent in May, while Italian production fell 1.2 percent. Even Germany is showing signs of stress.

Euro area countries have created a new banking union that’s intended to spread the cost of bank rescues among them, but the measures in place so far fall short of that, leaving the burden on national governments—and setting the stage for the doom-loop scenario.

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