The weekend just gone has seen the Kingdom of Spain join the countries in the Euro area which have called for international help to deal with debt problems. As ever the first casualty of such an operation was the truth as we saw the Spanish Prime Minister Mariano Rajoy call it a “victory”. Perhaps he just said the word pyrrhic so silently that the microphones did not pick it up. Of course he also contradicted many of his most recent statements because in claiming that Spain did not need and would not take a bailout he was in his own words denying her a “victory”. Let us remind ourselves of what he said as recently as May 28th.
There will be no rescue of the Spanish banking sector
What was actually agreed
The Eurogroup agreed in a telephone conference on Saturday afternoon/evening on these main points.
The financial assistance would be provided by the EFSF/ESM for recapitalisation of financial institutions.
The loan amount must cover estimated capital requirements with an additional safety margin, estimated as summing up to EUR 100 billion in total.
the Eurogroup considers that the policy conditionality of the financial assistance should be focused on specific reforms targeting the financial sector,
So to sum up Spain will receive up to 100 billion Euros from her Euro zone partners to help recapitalise her troubled banking sector. But there are problems with this before it even starts.
The (so-called) rescue vehicles are fatally flawed
You may have already spotted that the Eurogroup was unable to decide whether the European Financial Stability Facility (EFSF) or the European Stability Mechanism (ESM) would make the loans. This means that markets will eventually get around to focusing on the weaknesses of both! You would also think that if you were going to lend 100 billion Euros to someone you might have thought it through properly.
For the moment it is only the EFSF that is relevant because the ESM does not actually exist and even the Euro area is unlikely to be silly enough to make loans from a non-existent vehicle.
Isn’t the EFSF your unstable lifeboat Shaun?
Yes it is and a myriad of problems are created by using it. We start with the fact that it has already used some 192 billion Euros of its expected 440 billion Euro capacity for Portugal,Ireland and Greece. If add in the fact that Portugal is likely to need more we see that adding another 100 billion Euros means that we are looking at somewhat over 300 billion Euros now likely to have to be used. It is starting to look rather full!
How can Spain now back it?
Before this weekend Spain was responsible for 12.75% of the backing of the EFSF. At the point of receiving funds from it previous guarantors (Greece,Ireland and Portugal) became what are called “stepped-out” guarantors. This meant for example that Spain’s share rose from 11.87% to 12.75%.
The catch here is that Spain “stepping-out” is a much bigger problem as she is the fourth biggest economy in the Euro zone. And as this is the Euro zone where confusion reigns over most of its activities there is a debate over whether a bank bailout means that it will now step out. Frankly this really sums up the mess as the bailout of Ireland was in effect for her banks and she stepped out.
So either she steps out and the EFSF is weakened. Or she does not and the EFSF goes ahead with guarantees provided by a country that plainly cannot afford to make them. Otherwise Spain would have bailed out her own banks! Put another way Spain has to borrow at 6% for her ten year bonds (even after this morning’s bond market rally) but apparently can still guarantee loans at just over 3% to Greece,Ireland,Portugal and oh yes Spain herself!
There is also the issue of how the EFSF raises its money in so-called “cashless operations” as I discussed on the 29th of March.It is going to need up to an extra 100 billion Euros of them. Rather than go into the detail let me give you one issue/problem. Why is an organisation which is now lending for the long-term and probably the very long-term raising 3 and 6 month funding?
The ESM rides to the rescue?
The ESM does have advantages to the EFSF in that it has some capital and that backers cannot “step-out” (although some backers e.g Italy may not be so sure that this point is an advantage……..). But its lending outright calls for subordination with its bonds being senior. To put it simply everything else including Spanish government bonds takes a step further down the queue.
Why will this be an issue?
Already it is quite plainly that the probability of their being a debt haircut on Spanish banks is fairly high. So in any private sector involvement as it was called much official lending would be excluded from the haircut and so the amount of any haircut would move a notch higher. Indeed in the case of Greece the way that official lending avoided a haircut also meant that the haircut turned out to be virtually pointless.
Has Spain escaped scot-free from any conditions of the loans?
On an initial glance this may look true. But as ever this is far from the full story. Spain is already in the middle of a severe austerity programme. This means that her budget deficit is supposed to reduce from the 8.9% of her Gross Domestic Product last year to 5.3% this and 3% in 2013. So you could easily argue that quite a lot of conditionality is already in place. The Euro zone had in effect if I may use a football metaphor got its retaliation in first.
The Extra Borrowing is a burden for Spain
If we assume that Spain borrows the full 100 billion Euros then this repesents some 9.3% of her GDP in 2011 according to Eurostat. If we add this to Eurostat’s estimate of her national debt of 68.5% at the end of 2011 we get to a relatively low for these times 77.7%. The catch is that this is Spain’s central goverment and if we add in the regional governments and unpaid bills we find ourselves adding an extra 20% or so. Suddenly it is heading for the 100% barrier.
Why are Spanish financial markets rallying?
The knee-jerk response to this is to see this as unadulterated good news for Spain. Firstly her Euro zone colleagues have stepped in to help her. Secondly her banks will receive extra funding. Some will even believe that 100 billion Euros is enough. If we progress down this road we see that Spain will pay just over 3% as an interest-rate on the borrowing as opposed to much higher rates if she had to finance it herself. Indeed her ministers had begun to express doubts if she could raise the necessary funding at any price.
So we can see how bank shares are rallying today with Bankia up 13% as I type this and Santander up 5%. We can see how a wider equity market rally can take place with hopes that the banks might lend again. We can also see how Spain’s ten-year government bond yield has dropped back to 6% as she no longer faces the prospect of having to borrow on the markets to pay for a bank refinancing.
The problem is that we have seen this all before. For example the bailout of Greece led to a two week rally before the consequences of the bailout began to be factored in but successive bailouts have led to shorter and shorter rallies. The half-life of such moves has sometimes shrunk to a day or so.
Problems for Spain going forwards
Her Banking Sector is not fixed
Whilst her banking sector will now receive funds from the EFSF/ESM they are very unlikely to be enough. So as the phrase “up to” makes an entry in my financial lexicon we face a future where is we look at the scale of the collapse in Spain’s property sector that 100 billion Euros will prove insufficient. If we recall that Spanish banks have plenty of loans (mostly property loans) that they have not officially acknowledged as sour we can expect that just like what happened in Ireland the bill will rise and rise. Accordingly “up to” is likely to mean above and quite possibly considerably above.
Spain’s own debt problem is made worse
The extra borrowing will lead to more of a focus on the level of Spanish state borrowing as well as increasing the absolute levels as I have described above. Not only will the total number (including her regional governments and unpaid bills) head towards 100% of her economic output but more focus will go on the regional governments.
I have written quite a few articles now on the obvious contraction that is taking place in spain’s economy and have labelled it a depression. If we add an economy that is shrinking to higher debt levels we see the scale of the problem which Spain now faces.
What about those lending the money?
One of the problems of insurance is the credit rating and credibility of the insurer. Up until the end of 2011 Spain herself had provided just under 9 billion Euros of loans for other Euro area countries. This was money she could not afford. Well if we look ahead to future problems we see that Italy will be guaranteeing “up to” 19.18 billion Euros of lending to Spain’s banks which adds to the 13.2 billion Euros of loans she had given to other Euro nations at the end of 2011 plus of course we will see extra help for Greece and probably Portugal. Can anybody spot a flaw in a country with a high public-sector debt doing that?