How can Spain avoid depression?

12th July 2012

Just over a month ago on June the 11th I analysed the implications of the bail out package that had been agreed for Spanish banks. Actually of course in usual Euro area practice it turned out that they had agreed to agree and little else! However at the time the Spanish Prime Minister Senor Rajoy called this a "victory" for Spain. As part of this claim the impression was spread that there would be no conditions on Spain herself but only on her banks. So as we have much more information now let us take a look at the form of this "victory"

What has happened since?

In true Euro area fashion the 100 billion Euros promised seems to have metamorphosed into 30 billion Euros by the end of July in a type of anti-inflation. As the 100 billion Euros already seemed a bit thin this does present a problem. After all Bankia on its own appears well on its way to swallowing up a similar sum. I will put to one side for the moment that the impression was given that the 100 billion Euros could be provided quickly.

But even if we assume that Spain does get the 30 billion Euros by the end of July -there are still some hurdles to be cleared- we can see that the "victory" seems much less now.

A swing of a scorpion's tail for Spain's small investors

Tucked away in the detail of the memorandum was this.

"After allocating losses to equity holders, the Spanish authorities will require burden sharing measures from hybrid capital holders and subordinated debt holders in banks receiving public capital, including by implementing both voluntary and, where necessary, mandatory Subordinated Liability Exercises (SLEs)."

If we translate the legal terms this means that bondholders will share the losses. As a concept this is an improvement on what we have seen before with Ireland often being the example of the reverse principle of privatised profits and socialised losses. However in the tangled web we now live in I see a principle of which I approve has in reality a much more difficult outcome.

Why? Well take a look at this from the Financial Times and the emphasis is mine.

"Spanish banks have €67bn of subordinated and hybrid debt outstanding, according to Bank of Spain, much of which was sold to retail investors as savings products."

I am no expert in Spanish law but that looks like a recipe for cases of miss-selling to proliferate. And yes we have one more banking scandal to add to the list. But returning to the theme of today's post this looks like a problem on many levels.

1. Pain for retail savers will be a drag on the economy.

2. The likelihood of more losses for Spain's banks as a result of miss-selling compensation and legal costs. They will be even less likely to lend normally going forwards.

So a bailout ends up creating costs for the banks bailed out! And will taxpayers in the Euro area find themselves in effect paying the compensation for the miss-selling?

And here is a darker thought for you. Have bondholders suffered this time because there are more retail investors and less institutional ones? This is very much what Yoda would call the dark side of the force.

Spain's new austerity package

Hot on the heels of reports that Spain will get an extra year (2014 now) to hit its fiscal deficit target of 3% of GDP came the news that to hit it she will need a further 65 billion Euros of austerity. News management? Perhaps. However this is a substantial move as it will represent -if it is ever implemented- some 6% of Spain's economic output.

Back on January 27th I argued that Spain was in danger of an economic depression:

Since then the extra evidence we have received has reinforced this view and if anything the downwards spiral has accelerated. On such a basis there is a clear case for arguing that taking the equivalent of 6% of the economy away -via higher taxes and lower public spending- from a weakening economy will guarantee that she falls into an economic depression. There is also the Greek experience to consider where exactly this outcome was achieved with the same measures.

We are back to the same vicious circle of a weak economy leading to a higher deficit leading to more austerity and a weaker economy and repeat.

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