Spanish officials have shut down or forced the merger of most of the country’s “cajas” — the savings banks that lent heavily for real estate projects. But the level of bad loans continues to grow, and is now a $185 billion burden weighing on the capacity of banks to make loans to households and businesses.
The ability of banks to absorb those losses on their own may be limited, the IMF said, and “greater reliance on public funding may be needed.”
“Dealing effectively and comprehensively with banks’ legacy problem assets should be the priority,” the IMF said. “Unless the weak institutions are quickly and adequately cleaned up, the sound banks will suffer unnecessarily by a continued loss of market confidence.”
With three smaller European countries already receiving international bailouts, the larger economies of Spain and Italy have become the critical test of whether the euro region can revive its economy and avoid dragging down global trade and economic growth.
The IMF assessment of Spain’s banking system is a narrow example of the larger problem the euro region is struggling to confront: how to both support economic growth during a developing recession and avoid increasing government deficits that pose economic risks of their own.
The unchallenged priority until recently has been reducing public debt. But the euro region’s slide into recession and rising unemployment have provoked a backlash.
The government in the Netherlands – a chief proponent of fiscal austerity – collapsed this week, and the nation’s 11 parliamentary political parties are struggling to put together a deficit-cutting plan due to be presented to European authorities on Monday. In France, the challenger in a closely contested presidential race has demanded that a proposed European treaty on fiscal issues be amended to focus more on economic growth.
Greek elections could unravel an agreement under which the government has promised to make economic policy changes in return for an international bailout. Greece’s central banker this week said this deal must move forward if the country is to remain in the euro zone.
There is no obvious way out of the dilemma. Investors worried about Spain’s indebtedness are pushing up the country’s borrowing costs and have raised the specter of another European country needing an international bailout. Yet the effort to trim debt is pulling billions of dollars out of the economy and undercutting growth.
In Spain’s case, the IMF has suggested that support for the banking sector or the economy may be more important than strict adherence to budget targets.
The fund is also pushing for a possible European solution to Spain’s banking problems. The trillion-dollar fund that euro zone nations have created to battle their financial crisis can provide loans to governments. That means a troubled nation such as Spain would have to take on more debt if it wanted, for example, to borrow from the crisis fund to pay for a banking sector rescue.
The IMF wants the rules of the fund changed so it can lend directly to banks — and underwrite a rescue of the Spanish financial system without increasing Spain’s government debt.
The suggestion is controversial, and it would amount to asking taxpayers in more financially stable nations such as Germany to bail out private companies elsewhere in Europe.
But that sort of integration, many analysts argue, is what the euro area needs if it is to survive.