From John Stepek, across the river from the City

Dear Money Morning reader,

Markets are back in 'risk on' mode. It's what you'd expect after the carnage of May.

It's also more evidence, if you need it, that investors can only really hold one crisis in their minds at a time. Fear of Europe has been replaced by panic over BP, or British Petroleum as it's now better known in the US.

(Tip to Barack Obama – if you go back even further in time, the company used to be called Anglo-Iranian Oil, which might get you an even better response from the nationalist vote – just a suggestion, you don't have to thank me).

BP's situation is a big deal, no doubt about it. Not least because of what it might mean for future oil production, a subject we'll soon be returning to in MoneyWeek Online.

But investors shouldn't take their eyes off Europe. Because if another crisis is going to erupt, then Europe is where it's coming from. Spain, to be precise...

Why Spain is a much bigger problem than Greece

On Monday, markets got a bit of a shock when credit ratings agency Moody's downgraded Greek national debt to junk status. It means that Greek sovereign debt now can't be held by a number of investment funds. And it means the European Central Bank charges more to accept Greek bonds as collateral in return for loans.

But the euro kept ticking up. And little wonder really. Anyone who didn't already see Greek debt as junk by now probably shouldn't be investing for a living. Greece is old news.

Trouble is, there's a new country to worry about – Spain. And it's a much bigger problem than Greece.

At the moment, international markets are "virtually closed" to Spanish banks and corporations, reports the FT this morning. That's because investors are nervous about their exposure both to potentially dodgy government debt, and also to bad domestic debts. Spain's banks are heavily exposed to the country's property sector, which has of course been hammered by the slump in the market.

So how are the banks funding themselves? Simple. They're getting the money from the European Central Bank. They borrowed €85.6bn from the ECB last month. Just to put that in perspective, that's "double the amount lent to them before the collapse of Lehman Brothers in September." Without that support, "many of the savings banks [cajas], which make up 50% of the country's financial sector, would have already collapsed or faced mergers".

So far, the Spanish government is still able to borrow in the markets. It raised €5.2bn from two short-dated auctions yesterday. However, it had to pay significantly more for the money. It had to pay 2.84% to borrow over 18 months. Last month it only had to promise investors 1.95%.

The big fear is that Spain may end up being forced to resort to the Europe-wide emergency fund set up in the wake of the Greek crisis. As the FT says, that "would undermine the already shattered confidence of investors in the market".

For now, that doesn't look imminent. But the present situation is hardly sustainable, as Neil Unmack argues on Breakingviews.com. While banks are dependent on a lifeline from the ECB, they'll be in no mood to lend to customers. "This will lead to rising borrowing costs and lower loan growth."

Public stress tests are needed to stop the panic about banks

The only way to get rid of the jitters is for "banks to undergo rigorous public stress tests, using conservative estimates for public and private sector loan losses if say, Greece and other countries restructured their debt. Governments would need to back up the stress tests with a clear plan to recapitalise banks that fall short."

But as Reuters notes this morning, Germany, France and the European Central Bank have so far been reluctant to publish the results of stress tests. Why? "Because they fear it could trigger more speculation against European banks."

It's things like this that lend so much ammunition to knee-jerk Europe-bashers. European politicians seem unable to shake off the belief that as long as they can keep everything behind closed doors, then the 'elites' can keep control of the 'masses', who don't know what's best for them.

We've seen it so often in the way that European expansion has been driven through, without any regard for the wishes of the populations of member countries. It's why the first instinct of every eurozone politician to the crisis was to blame speculators or the media. They're not used to being held accountable for their actions. Frankly, they find it an affront.

The eurozone could end up full of zombie banks

But a culture of secrecy doesn't work when it's up against a true democracy – the markets. You can't pretend that Greece isn't bust by refusing to hold a referendum on the subject. Investors get to vote with their money every day. If financial authorities don't reveal the stress test results, then investors will naturally assume the worst. The strong banks will be punished alongside the weak. And the end result will be a eurozone littered with Japan-style "zombie" banks – too weak to fulfil their ultimate function of lending sensibly, but sucking resources out of the wider economy as they are kept on life support. Dealing with the problem now won't be easy or pleasant, but it would be a lot better in the long run.

Sadly, politicians generally perceive the long run as someone else's problem. So however this crisis is handled, it's unlikely to be smooth. As my colleague Dominic Frisby suggested last week, the euro has hit a natural area for a rebound, and we'd be cautious about shorting it just now. But another leg down, when the next piece of bad news comes along, looks all but inevitable.

Until next week,

John Stepek

Editor, MoneyWeek UK
New Business Editor of the Year, BSME Awards 2009

And for Tuesday's market update, see below...

Market update

Click here for the latest stock market news and charts.

The JSE all share index advanced 0.86% on Tuesday. The gold mining index gained 0.62%. Resources added 0.86%. Banks and financials grew 0.91% and 1.04% respectively. Industrials bounced 0.77% and the platinum mining index jumped 1.85%.

London's FTSE100 climbed 0.39%. The Dow Jones traded flat, up 0.05% and the Nasdaq traded flat, down 0.01%.

Tokyo's Nikkei closed down 0.6%. Hong Kong's Hang Seng added 0.34%.

Brent crude is currently trading at $77.82 per barrel.

Spot gold's trading at $1,233.45 up 0.05% and platinum was last quoted at $1,571.00.

And here's how the rand is performing against the major currencies:
R/$ 7.61
R/₤ 11.20
R/€ 9.35