What Can We Learn From the Cypriot and Spanish Bailouts?

29/06/2012 09:18 BST | Updated 28/08/2012 10:12 BST

In the past two weeks, Spain and Cyprus have formally applied for eurozone rescue packages. Each case is a lesson for the eurozone and offers some indications of what the outcomes of the EU summit on June 28-29 should be.

The first lesson, which can be learned from the Cypriot experience, is that contagion from troubled economies threatens to spread to the entire eurozone through its financial sector.

The Cypriot economy has an oversized financial sector, with financial assets equalling several times the island's GDP. Supporting growth in this sector worked well in the past decade, acting as a gateway for foreign investors attracted by Cyprus' advantageous taxation.

Things began to turn sour when the crisis in Greece started. The Cypriot banking sector was, and still is, heavily exposed to the Greek economy. Back in 2011, nearly 50% of the three main banks' loans were to Greece. The debt write offs in Greece caused a severe deterioration in Cypriot banks' capital ratios, thereby threatening their very solvency. Given the size of the banking sector, the government was unable to provide sufficient support, and was forced to ask for external help. Cyprus became the first country in the eurozone to request a bail out as a consequence of developments outside its territory.

Although this situation can be seen to be the result of Greek and Cypriot historical and economic ties, the same phenomenon of contagion could well take place in other parts of the euro zone. French and German banks are indeed heavily exposed to the Spanish and Italian banking sectors. The first casualty of the domino effect was Cyprus, an economy small enough to be bailed out without triggering market reactions.

The lesson here is that direct contagion has started. It is likely to continue, and will often take place through financial institutions and have dramatic consequences.

The second lesson taught by the markets' reaction to the Spanish bailout is that shifting debt from banks to the sovereign does not address a solvency crisis. Transfers among euro zone members are necessary.

Spain enjoyed a strong boom in the decades prior to 2007, mainly on the back of one of the largest housing bubbles ever. The bursting of this bubble left the Spanish banks in a very dire situation, and again government support was needed. Spain faced a situation where its economy was in the doldrums, its financial sector was partly insolvent and its own finances already under serious pressure. The government struggled to find the resources to help its financial sector and, as a consequence, got virtually shut out of the markets with bond yields at punitive rates.

Support from EU institutions was thus inevitable, and the government and the eurozone agreed that the euro zone would lend up to €100bn to the Spanish government to shore up its banking sector. Far from the positive reaction expected by some officials, it took financial markets less than 2 hours to push Spanish bond yields back to their highest levels in years. This is because this loan, in essence, represents only a debt reshuffling inside Spain: the government borrows money to invest in its banks which then, in turn, buy the governments bonds.

As a result, although it could solve the liquidity crisis in the short term, it fails to provide a viable answer to the acute solvency crisis in Spain. The message was therefore that private losses will continue ending up on already heavily burdened public accounts. Knowing this, and given the continuing uncertainty over the size of the losses in the private sector, investors rightfully fled the Spanish bond market. To survive, Spain needs some form of direct external injection into its banks, rather than additional debt to the sovereign.

The lesson here is that debt reshuffling is not enough. Whatever the form adopted, be it a fiscal union, a banking union, or anything else, transfers inside the eurozone are the only way for it to survive.

The current summit will again be a test game for the eurozone. Contagion has started through the financial system, and some form of transfers between the core and the periphery is the only way to stop it. If the summit does not acknowledge this, it will only accelerate the crisis further.