Hamish McRae: Markets have faith in the European high command

Economic Life: If banks must raise more capital they will lend less and charge more. A safer banking system is a more expensive one

A strange inversion has occurred. Usually it is the financial markets that are twitchy, fretting about this and that, while the central bankers dollop out the calm. Now it is the other way around, with central bankers sounding off in increasingly alarmist tones, while the markets have managed a decent enough rally. Who is right?

Click HERE to view graphic (287k jpg)

Well, we cannot know, but it has at least become clearer why the central bankers are so worried: they think there may be a run on Italian sovereign debt, and if that were to happen they are concerned that they would not have the firepower to stop it. The markets, by contrast, have become increasingly confident that the European authorities will indeed be able to stitch together some sort of deal by the end of this month that will at least patch things for a bit. Bank shares came off yesterday in response to downgrades, but European equities are still close to a two-month high.

Central bankers have lined up over the past week to get on the record how dangerous the present situation is: Mervyn King, Jean-Claude Trichet and Mario Draghi have all made similarly dire statements. Of these, the views of Dr Draghi carry the greatest significance as he steps over as governor of the Bank of Italy to become president of the European Central Bank next month. "We must," he said, "act fast. The sorts of interest rate rises seen over the last three months, if protracted, could lead to an uncontrollable spiral."

The potential domino sequence of just such a spiral is caught in the first graph. The figures, from an analysis by Fathom Consulting, have been derived from CDS spreads that show how the markets are calculating the risks of default. The chances of Greece defaulting are now close to 100 per cent. If that were to happen there would be a 60 per cent chance that Portugal would follow; then if that were to happen, a 70 per cent chance that Ireland would follow, and sequentially on through Spain, Italy and France.

My own feeling remains that Ireland is less likely to default than these numbers would suggest. But the mood running against Italy is strong, as you can see from the next graph, which shows the premium on Italian 10-year debt over German debt. The spread is now more than 4 per cent, whereas it was less than 1 per cent even 18 months ago. Again, you can question this and argue that in reality the chances of an Italian default are being overstated. But whether or not that is true, the plain fact remains that the Italian bond market is the third largest in the world after the US and Japan. It would be beyond the ability of Germany to rescue Italy by underwriting its debt, even in the unlikely event that it were prepared to do so. You can understand Dr Draghi's concern.

The more immediate issue is what will happen to the banks. There is a medium-term capital problem. When Greece defaults some will need to raise more funds to bring their ratios back to an acceptable level. If other countries follow, that would mean more capital still, and there is a legitimate debate as to whether they should mark all their sovereign debt to market. Should they adjust their books to fit every short-term panic that washes over the markets, or should they be allowed to take a longer-term perspective? There ought in common sense to be a middle way between making the banks hostage to short-term market fluctuations and allowing them to pretend that borrowers (including countries) can repay their debts when clearly they can't.

You can see the reasons why a number of bank ratings have been downgraded in recent days, including the two part-nationalised British banks, Royal Bank of Scotland and Lloyds. But this seems to me to be a rather mechanical response because in practice both those banks carry a British sovereign guarantee. In theory at some future date they might be allowed to fail, but in practice that is not going to happen. In any case, regulators that demand that banks raise more capital have to acknowledge that this will mean that those banks will lend less than they otherwise would and have to charge more for their loans. A safer banking system is a more expensive banking system.

However, quite aside from the medium-term issue of raising new capital, there is the immediate one of funding day-to-day activities. The entire eurozone banking sector is being dragged down by the loan of sovereign debt, as you can see in the bottom graph. Ignore the technicalities, and just see the spread shown there as a measure of stress. For most of the past year the experience of euro and dollar markets has been similar. In the past month, however, the two deposit markets have diverged widely. Dollar deposit markets are still functioning reasonable smoothly. The euro market is not, as banks worry about lending to each other. We are not yet seeing the sort of meltdown that occurred in 2008, but some banks are struggling. In the short term they can go to the ECB for funding, but that is not sustainable in the long term. There was a note yesterday from the fund managers F&C suggesting that Dexia, the Franco-Belgian bank that has just required a rescue, might be "the canary in the mine". Other banks are teetering.

So why, you might reasonably ask, given the funding difficulties of European banks and these dire warnings from the central bankers, are share markets reasonably sanguine? The short answer is that the markets seem to have decided that when push comes to shove the European high command will sort it. They reckon that notwithstanding the vicissitudes of Mr Berlusconi, the turmoil in the Slovakian parliament, the limited room for manoeuvre for Angela Merkel, and all the rest, some sort of deal will be done. So Europe may well have some sort of mild recession through the winter, but core Europe at least will have a reasonable recovery thereafter.

The markets are also saying something else. This is only Europe and Europe was always going to be a slow growth zone. The latest data from the States, while not great, is not awful. The much-needed slowdown in China is happening, but need not turn into anything more sinister. And the rest of Asia continues to grow too. So Europe is a regional problem, not a global one. Unfortunately for the UK, we still depend on continental markets, and there is not much in the short term we can do about that. But those in Britain who would like to see a realignment of trade policy towards faster-growing regions will see this recent experience as strong support for their aims.

Start your day with The Independent, sign up for daily news emails
ebooksAn introduction to the ground rules of British democracy
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating

By clicking 'Search' you
are agreeing to our
Terms of Use.

iJobs Job Widget
iJobs Money & Business

Recruitment Genius: Customer Service Advisor

£15000 - £16000 per annum: Recruitment Genius: Customer Service Advisors are r...

SThree: Trainee Recruitment Consultant

£20000 - £25000 per annum + OTE £45K: SThree: SThree were established in 1986....

Recruitment Genius: Compliance Manager

£40000 - £60000 per annum: Recruitment Genius: A Compliance Manager is require...

SThree: Talent Acquisition Consultant

£22500 - £27000 per annum + OTE £45K: SThree: Since our inception in 1986, STh...

Day In a Page

John Palmer: 'Goldfinger' of British crime was murdered, say police

Murder of the Brink’s-MAT mastermind

'Goldfinger' of British crime's life ended in a blaze of bullets, say police
The Real Stories of Migrant Britain: An Algerian scientist adjusts to life working in a kebab shop

The Real Stories of Migrant Britain

An Algerian scientist struggles to adjust to her new life working in a Scottish kebab shop
Bodyworlds museum: Dr Gunther von Hagens has battled legal threats, Parkinson's disease, and the threat of bankruptcy

Dying dream of Doctor Death

Dr Gunther von Hagens has battled legal threats, Parkinson's disease, and the threat of bankruptcy
UK heatwave: Temperature reaches 39.8 degrees on Central Line - the sweatiest place in London

39.8 degrees recorded on Tube

There's hot (London) and too damn hot (the Underground). Simon Usborne braved the Central line to discover what its passengers suffer
Kitchens go hi-tech: From robot chefs to recipe-shopping apps, computerised cooking is coming

Computerised cooking is coming

From apps that automatically make shopping lists from your recipe books to smart ovens and robot chefs, Kevin Maney rounds up innovations to make your mouth water
Jessie Cave interview: The Harry Potter star has published a feminist collection of cartoons

Jessie Cave's feminist cartoons

The Harry Potter star tells Alice Jones how a one-night stand changed her life
Football Beyond Borders: Even the most distruptive pupils score at homework club

Education: Football Beyond Borders

Add football to an after-school homework club, and even the naughtiest boys can score
10 best barbecue books

Fire up the barbie: 10 best barbecue books

We've got Bibles to get you grilling and smoking like a true south American pro
Wimbledon 2015: Nick Bollettieri - Junk balls and chop and slice are only way 5ft 1in Kurumi Nara can live with Petra Kvitova’s power

Nick Bollettieri's Wimbledon Files

Junk balls and chop and slice are only way 5ft 1in Kurumi Nara can live with Petra Kvitova’s power
Ron Dennis exclusive: ‘This is one of the best McLaren teams ever – we are going to do it’

‘This is one of the best McLaren teams ever – we are going to do it’

Ron Dennis shrugs off a poor start to the season in an exclusive interview, and says the glory days will come back
Seifeddine Rezgui: What motivated a shy student to kill 38 holidaymakers in Tunisia?

Making of a killer

What motivated a shy student to kill 38 holidaymakers in Tunisia?
UK Heatwave: Temperatures on the tube are going to exceed the legal limit for transporting cattle

Just when you thought your commute couldn't get any worse...

Heatwave will see temperatures on the Tube exceed legal limit for transporting cattle
Exclusive - The Real Stories of Migrant Britain: Swapping Bucharest for London

The Real Stories of Migrant Britain

Meet the man who swapped Romania for the UK in a bid to provide for his family, only to discover that the home he left behind wasn't quite what it seemed
Cheaper energy on the way, but it's not all sunshine and rainbows

Cheaper energy on the way, but it's not all sunshine and rainbows

Solar power will help bring down electricity prices over the next five years, according to a new report. But it’s cheap imports of ‘dirty power’ that will lower them the most
Katy Perry prevented from buying California convent for $14.5m after nuns sell to local businesswoman instead

No grace of God for Katy Perry as sisters act to stop her buying convent

Archdiocese sues nuns who turned down star’s $14.5m because they don’t approve of her