Euro Zone Heading for Another Hot Summer

By SIMON NIXON

Welcome back, euro crisis. Euro-zone bond and equity markets enjoyed a remarkable rally after the European Central Bank agreed to flood the banking system with cheap three-year loans in December. But now that Spanish bond yields are back at levels last seen before the ECB's Long Term Refinancing Operations and with stock markets sliding, it is clear the mood has changed. Euro-zone leaders should brace themselves for another long, hot summer.

This renewed market pressure largely reflects three things. First, fears that euro-zone economic conditions are deteriorating as austerity policies bite. Recent data paint a bleak picture of a worsening recession in the periphery. Unemployment in the euro area is now 10.8%. March's Spanish manufacturing purchasing managers' index showed an accelerating decline in output. The slowdown may even be spreading to the core: The German composite PMI is at a three-month low while France's suggests renewed contraction.
Second, the market fears a lack of urgency on reform efforts. As market pressure eased, worrying signs of complacency emerged. Spain's bank reform fell short of expectations and doubts have now emerged over Madrid's commitment to its fiscal targets. Italy has been forced to make concessions on its vital labor reform; the increase in euro-zone bailout funds looked inadequate; and there has been limited progress on a pan-European growth agenda, including boosting structural funds and deepening the single market.
Third, the market is worried about Spanish banks. Last week Caixabank  wrote off the entire €2.8 billion ($3.68 billion) book value of Banca Civica as part of its agreed takeover, raising doubts about the adequacy of provisions on other bank balance sheets. Yet the government says it won't use public money to recapitalize the banks and the deposit guarantee fund is out of funds. Meanwhile, Spanish bank customers are now significant holders of bank shares, raising questions about how they will react to severe dilution and the extent to which the equity can be truly loss-absorbing.

The rally so far this year was not entirely misplaced. The euro zone made progress on a number of fronts in the last three months in tackling its problems. Contrary to many people's expectations, Greece did not leave the euro but received a comprehensive new bailout. The ECB's LTRO took the risk of a systemic banking crisis off the table while creating the conditions for substantial bond issuance, and Spain has already raised 47% of its target funding for the year. Many countries have introduced important structural reforms that should boost the euro zone's growth potential.

But the market is sending euro-zone policy makers a signal, as it has done many times over the past 2½ years, that their job is far from done. Further reforms are needed at the national and euro-zone level. Big losses still have to be taken and investors want to know where the burden will fall. Until they get answers, the crisis is back on.

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