Contagion, Exposure and the Policy Response

- Bottom line: "Developments in the periphery can affect the rest of the euro area through various channels, ranging from the bond market to exports, confidence and bank lending. Contagion risks can be considerable in some cases, especially when countries the size of
Spain and beyond enter the picture. We look at the theme of contagion from four different angles:"
1. Exposure to the peripheral bond markets – who owns what? "Euro area banks’ exposure to the EMU periphery could amount to about €140 billion. Germany’s banking sector seems most exposed to Spain, France’s to Greece and Spain’s to Portugal."
2. Exports to the EMU periphery – is there a material risk? "No, not really. But German and, to a lesser degree, Italian exports are likely to be less affected by poor
economic prospects at the periphery than France’s and Spain’s, given their geographical specialisation."
3. How about the ‘confidence factor’? "The mood in core EMU is more upbeat than in the periphery, where it has not yet reached its long-term average. Negative feedback effects, admittedly unquantifiable, are more likely in the latter group of countries than in the former."
4. What’s the impact of an impaired bank lending channel? "Potentially large, we think. The chances are that the robust credit expansion witnessed over the past decade will not be there to support the euro area economy as and when growth strengthens."
- The policy response: "Providing additional liquidity can only buy time. Given the size of the fiscal and banking sector problems, a quick solution is unlikely. But we think that the recapitalisation of the banking system, along with further fiscal restraint and structural reforms in many EMU peripheral and also some core countries, might help to address the underlying issues."
Morgan Stanley Euroland Economics 20100702