The strain on Spain: are we heading for a Spanish bailout?

25 July 2012

The strain on Spain: are we heading for a
Spanish bailout?

Summary

 This week Spanish borrowing costs have reached new euro-era
  highs of over 7.5%. These costs are starting to look ruinous for an
  economy already struggling to emerge from a steep public deficit
  and sharp economic contraction. Madrid is painfully close to
  being priced out of debt markets altogether. Although it can bear
  this expense for a while, it could quickly become self-defeating.

 Mariano Rajoy’s Partido Popular government has played a
  comparatively strong hand with a surprising lack of confidence,
  but it has also been hobbled by a massive banking crisis and
  collapsing growth.

 The stark reality is that the only answer for Madrid is for yields to
  fall back relatively quickly to sustainable levels more like the 5%
  of early 2012 and to stay there. If this sounds unlikely, then the
  only conclusion can be that a Spanish bailout is probably just a
  question of time.

 If the contagion effect from a Spanish bailout was to force the
  same course on Italy, which is probable, then the resources of
  the current Eurozone bailout funds would be insufficient. A
  Spanish bailout, even if it did not trigger a crisis in Italian
  sovereign debt markets, would push the Eurozone into a new and
  critical phase.

Is Spain headed for a bailout? The numbers tell a fairly grim and
inflexible story. A poorly-covered bond auction on July 19 cost
Madrid 6.7% for seven year debt and sent implied yields for
outstanding debt over 7% again. This week they have breached new
euro-era highs of over 7.5%. The costs of liquidity are starting to
look ruinous for an economy already struggling to emerge from a
steep public deficit and sharp economic contraction. Madrid is
painfully close to being priced out of debt markets altogether.
Although it can bear this expense for a while, it could quickly
become self-defeating.
The six-month old government of Mariano Rajoy has played a
comparatively strong hand with a lack of confidence, but it has also

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been hobbled by a massive banking crisis and collapsing growth and
confidence both in Spain and the wider Eurozone. As belief in the
Eurozone’s ability to resolve its problems has dwindled, so has
confidence in Madrid’s bankability. This Global Counsel Insight asks
what – if anything – might reverse this slide.

The strain on Spain
Madrid needs to borrow something in the region of €250bn in 2012 to
cover maturing debt and its estimated 6% deficit. It took advantage
of the increased demand created by the ECB’s emergency liquidity
programme for Eurozone banks in February to issue more than €50bn
in long and medium term debt, but it needs to issue another €31bn
in bonds in the second half of the year and continue rolling over
substantial amounts of short term Treasury paper. A further funding
requirement of at least €450bn in 2013 and 2014 is surely not
sustainable at current costs. Moreover, these estimates probably
understate the potential problem, because they assume that Spain
will meet its deficit reduction targets, which it may well not.

   8

 7.5

   7

 6.5

   6

 5.5

   5

 4.5

   4
 02/01/2012   02/02/2012   02/03/2012    02/04/2012   02/05/2012   02/06/2012   02/07/2012

Fig 1 Spanish 10 year bond yields 2012
Source: Bank of Spain

To compound this problem, the two main markets for this debt are
both contracting. Non-resident holdings of Spanish government debt
have fallen from more than half at the end of 2011 to around a third
now and are likely to keep on falling. This leaves Spanish banks,
which bought much of the issuance in the first half of 2012 to use as
collateral against ECB lending, to take up the slack. The €100bn
recapitalisation programme provided by the European Financial
Stability Facility bailout fund will help them invest in some of the
remaining issuance this year. But there is a flipside to this. When
they buy government debt they draw credit away from the private
sector, and they reinforce the relationship between Spain’s weak
banks and Spain’s struggling government – the very problem that the
June 29 European Summit supposedly agreed to address.
Even with the recapitalisation funds the Spanish public debt ratio at
the start of 2013 would be around 80% - below the Eurozone average
and less than the public debt of Italy, Belgium and France. In a

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different context it would probably be regarded as ‘sustainable’. But
against a backdrop of stalling growth, regional bankruptcies, 25%
unemployment, a traumatised banking system and high levels of
private debt, markets are predictably sceptical. The negative
feedback loop from sovereign downgrades – all three ratings
agencies have Spain just above junk status and on negative watch -
could compound the problem.
At that point rising debt costs combined with falling revenues put
Spain on a debt dynamic that starts to look unsustainable. The IMF
now estimates that Spanish public debt, including the costs of the
€100bn bank recapitalisation from the European bailout fund will not
peak before 2016 and is likely to peak at significantly higher than
100% of GDP. Some of this could potentially be moved to the balance
sheet of the European Stability Mechanism once a European banking
supervisor has been established in the ECB, but this is unlikely to
happen in 2012 or even the first half of 2013. Until then, the bank
recapitalisation debt will remain on the sovereign balance sheet.

 300                         Deficit (IMF projections)   Maturing debt

 250

 200

 150

 100

  50

   0
                  2012                           2013                    2014

Fig 2: Spanish funding needs 2012-2014
Source: IMF 2012, Bank of Spain

If markets were effectively to close to Madrid in the second half of
the year or early 2013, there are then three routes to external
support ‘open’ to Spain. The first route is to seek a partial credit
line from the European bailout fund to cover part of upcoming
auctions. The second route is formally to request that the fund
purchase Spanish debt in secondary markets to suppress yields.
Either choice would probably be the nail in the coffin of investor
confidence, especially if Eurozone funds were determined to be
senior to existing private debt-holders. Mariano Rajoy and Mario
Monti will no doubt discuss these options when they meet in Madrid
next week.
The third route is to seek – or to be forced to seek – a full rescue
package from the Eurozone, implying complete absence from debt
markets for two or three years. Spain’s domestic financing needs for
the next three years are likely to be upwards of €200-250bn
annually, on top of the €100bn it has just borrowed to bail out its
banks. For this to even be possible would require a significant

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increase in the resources of the European Stability Mechanism
bailout fund. If the contagion effect from a Spanish bailout was to
force the same course on Italy, which seems likely, then the
resources of the current bailout funds would be totally inadequate.
A Spanish bailout, even if it did not trigger a crisis in Italian
sovereign debt markets, would push the Eurozone into a new and
critical phase.

Madrid and the markets
Why has the Rajoy government found itself in this position? Madrid
places much of the blame with wider market sentiment on the
Eurozone, and they have a point. Spain and Italy are proxies for the
Eurozone as a whole, and markets have become increasingly
sceptical of their prospects as perceptions of the Eurozone’s
progress towards institutional and political solutions to the crisis
have deteriorated. Italian Prime Minister Mario Monti complained
last week that the sovereign debt markets had given his government
insufficient credit for its reform efforts. No doubt Mariano Rajoy
feels the same.
But there is no question that the growing awareness of the scale of
the problem in Spanish banks has materially worsened Madrid’s
position. The fact that the Spanish system was perceived to have
come through the crash of 2008 relatively well – there was much talk
at the time of the value of Spain’s countercyclical capital rules – is
now the central irony of the Spanish situation. High levels of non-
performing debt have built up in the Spanish banking system with
the collapse of the Spanish property market. Yet the reluctance of
both banks and authorities to accept how bad it was getting has
meant that where other European sovereigns shouldered the burdens
of bank recapitalisation early in the crisis, Spain is doing it now.
When market sentiment is volatile, trust in regulators is bust and all
eyes are fixed on Madrid’s balance sheet.
The Rajoy government also surprised many by moving comparatively
slowly to implement its fiscal reform package after its election.
Delaying controversial announcements until the April regional
elections in Andalucia left an impression of political caution from a
Partido Popular government that ironically had an unprecedented
grip on national and regional governments. The upward revision of
deficit targets in March 2012 after a public confrontation with
Brussels marked the start of an uneven relationship with Berlin and
other Eurozone governments. The strategy of some around Rajoy of
openly calling on the ECB to intervene in Spanish debt markets and
even implicitly threatening to leave the Euro has appeared parochial
and inept to many external and domestic observers.
Yet Rajoy is in many respects in a strong position – certainly stronger
than Mario Monti in Italy. He has a large majority, and three and a
half years before he has to face the electorate. The PSOE opposition
is still largely blamed for the state of the Spanish economy and the
excesses of the boom years. Rajoy’s government has been the target

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of energetic and angry street protests, but those familiar with the
politics of the Spanish street point out that for a country that fairly
routinely vents its feeling in street protest, the indignado
demonstrations have not been that exceptional.

Not so much si, as cuándo?
The current interest costs of maintaining Spanish sovereign liquidity
are simply not sustainable forever, or even for much longer. As in
Greece they can and will eventually overwhelm the benefits of
austerity and fiscal adjustment and demand harsher versions of both
that would be politically unsustainable, even if they were not
economically counterproductive.
It remains possible that a good summer tourist season and improving
external demand keep Madrid just inside the market’s definition of
bankable. The euro has weakened and Spanish exports have risen. A
serious shift in confidence would probably also require a dramatic
acceleration of the Eurozone’s banking union timetable, sufficient
to provide the cathartic lifting of bank recapitalisation debt off the
Spanish state’s balance sheet. A third round of ECB liquidity support
might provide a temporary window for debt-raising at lower costs.
So could ECB secondary market intervention.
Madrid could in principle also offer further domestic reform
measures, although the raising of VAT by three percentage points
and €65bn in additional spending cuts and tax rises two weeks ago
did not dent Spanish yields. The stark reality is that the only answer
for Madrid is for yields to fall back to sustainable levels more like
the 5% of the early spring quickly and to stay there. If this sounds
unlikely, then you are drawn to an equally stark conclusion.
Probability of a Spanish bailout? Rising quickly.

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© Global Counsel 2012

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