The euro crisis Is everything fixed?

AT THE European Central Bank's last meeting, Mario Draghi did not announce any plans to scale up purchases of sovereign debt and, indeed, he indicated that previous statements interpreted as a promise to do so were in fact no such thing. He did, on the other hand, announce new measures to boost liquidity across euro-zone banking systems, including a facility through which banks can borrow unlimited amounts from the ECB, very cheaply, for up to three years. It quickly dawned on observers that banks might just use this borrowing to fund purchases of government debt, thereby addressing the crunch in sovereign debt markets. And I see that some writers are now arguing that this step actually amounts to the critical turning point in the crisis. Is it?

The wheeze, however, seems to have been too clever by half. Hours after Mr Sarkozy was urging banks to bail out governments, the European Banking Authority (EBA) released the results of its updated stress tests showing that European banks need to raise €115 billion ($149 billion) in extra capital, mainly to offset a fall in the value of their existing holdings of government bonds issued by troubled peripheral European countries.
The banks with the biggest capital shortfalls are those from Spain, Greece and Italy. Several may have to tap government bail-out funds to raise the capital, creating the circular prospect of governments bailing out their banks that are in turn supposed to bail out the government. Italian banks, for instance, will need €15 billion in additional capital; among them is UniCredit, Italy’s biggest bank by assets, which holds some €40 billion in Italian government debt and needs to raise almost €8 billion in capital. Spanish banks need €26 billion. Europe’s core has not been spared either. Banks in Germany, the euro area’s biggest creditor country, need additional capital and Commerzbank, Germany’s second-largest bank, may also find itself asking for government help to fill a €5.3 billion hole in its balance-sheet.

Banks around the periphery are in a difficult situation. If the sovereign fails, they fail and vice-versa. Given this, there might be some logic to a move to go all-in on the sovereign's debt: hope that funneling ECB loans into sovereign debt will take some pressure off the government, and that over time confidence will return and everyone's bets will turn out all right. On the other hand, markets and regulators are pushing against such a move, demanding that such banks raise capital and reduce exposure to risky debt. How much room do troubled governments actually have to force banks into such purchases? Outside of the periphery, the incentives are clear: cut exposure to the south. Banks there will do their best to raise capital, and will take advantage of cheap financing to roll over existing debts. Meanwhile, none of these banks are in a position to scale up lending to private businesses. The impact of the credit crunch on the real economy will make it very difficult to escape the current, nasty equilibrium.

Why, then, are short-term yields falling? Well, one short-term liquidity freeze-up has been averted, and maybe something good will happen before more bad news strikes. There are surely some banks using some of the liquidity to buy government debt, for any number of possible reasons. It will be easy to overinterpret moves between now and January, however. Volume is likely to be low, as activity winds down for the holidays. And importantly, falling short-term yields are not translating into big declines in long-term yields, a big upward swing in equities (for banks or anyone else), or a recovery for the euro. Unfortunately, it does not appear that the euro-zone crisis has been brought to an end.