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Euro zone fragmenting faster than European Union can act

Signs are growing that Europe’s economic and monetary union may be fragmenting faster than policymakers can repair it

Written by Reuters | Paris |
July 10, 2012 1:35:27 am

Signs are growing that Europe’s economic and monetary union may be fragmenting faster than policymakers can repair it. Euro zone leaders agreed in principle on June 29 to establish a joint banking supervisor for the 17-nation single currency area,based on the European Central Bank,although most of the crucial details remain to be worked out.

The proposal was a tentative first step towards a European banking union that could eventually feature a joint deposit guarantee and a bank resolution fund,to prevent bank runs or collapses sending shock waves around the continent. The leaders agreed that the euro zone’s permanent bailout fund,the 500 billion euro ($620 billion) European Stability Mechanism,would be able to inject capital directly into banks on strict conditions once the joint supervisor is established.

But the rush to put first elements of such a system in place by next year may come too late.

Deposit flight from Spanish banks has been gaining pace and it is not clear a euro zone agreement to lend Madrid up to 100 billion euros in rescue funds will reverse the flows if investors fear Spain may face a full sovereign bailout.

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Many banks are reorganising,or being forced to reorganise,along national lines,accentuating a deepening north-south divide within the currency bloc.

An invisible financial wall,potentially as dangerous as the Iron Curtain that once divided eastern and western Europe,is slowly going up inside the euro area.

The interest rate gap between north European creditor countries such as Germany and the Netherlands,whose borrowing costs are at an all-time low,and southern debtor countries like Spain and Italy,where bond yields have risen to near pre-euro levels,threatens to entrench a lasting divergence. Since government credit ratings and bond yields effectively set a floor for the borrowing costs of banks and businesses in their jurisdiction,the best-managed Spanish or Italian banks or companies have to pay far more for loans,if they can get them,than their worst-managed German or Dutch peers.

The longer that situation goes on,the less chance there is of a recovery in southern Europe and the bigger will grow the wealth gap between north and south. With ever-higher unemployment and poverty levels in southern countries,a political backlash,already fierce in Greece and seething in Spain and Italy,seems inexorable.

European Central Bank President Mario Draghi acknowledged as he cut interest rates last week that the north-south disconnect was making it more difficult to run a single monetary policy.

Two huge injections of cheap three-year loans into the euro zone banking system this year,amounting to 1 trillion euros,bought only a few months’ respite.

“It is not clear that there are measures that can be effective in a highly fragmented area,” Draghi told journalists.

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