What Is Next for Spain?
When a minister of finance and economics states that his country “does not need a rescue at this time” and the central bank governor cautions that banks will need more capital “if the economy worsens more than expected,” private bondholders are likely to take notice. As someone who has repeatedly maintained that a prolonged crisis is a necessary spur to solving the euro’s challenges, this author is in a sense encouraged by the recent return of Spain to the financial markets’ crosshairs. But just what Spanish Economy Minister Luis De Guindos and Spanish Central Bank Governor Miguel Ángel Fernández Ordóñez thought markets would make of their recent statements is unclear.
One might take the view that the new Spanish government and central bank governor are simply not up to managing the crisis or its associated message discipline. They could both have committed terrible faux pas similar to the one by the new Spanish prime minister, Mariano Rajoy, in Brussels a few weeks ago. It was then that he unwisely declared a “sovereign Spanish decision” to renege on the pledge to reach a deficit of 4.4 percent of GDP in 2012. The latest comments come just after the economy minister, Luis de Guindos, announced an additional austerity measure of €10 billion in healthcare related “efficiency savings,” which are certain to dampen economic growth, roil markets, and raise doubts about debt sustainability. Thus a sense of drift seems to be emerging in Madrid. Or are they really just clueless?
Another interpretation of recent events and utterances is possible, however. It seems doubtful that the audience they are addressing is the financial markets. More likely the Spanish government is sending signals to the European Central Bank (ECB) governing board in Frankfurt. Recall that ECB Executive member Benoit Coeure in Paris recently stated that “we have an instrument, the securities markets program, which hasn’t been used recently but it still exists.” So when the Spanish government this week doubled down with additional austerity measures, the ECB was listening. The central bank has been very consistent in its demands for fiscal austerity. Even if the markets won’t reward Spain for more austerity, the ECB probably will.
As stated by ECB President Mario Draghi last week at his monthly press conference, when asked about the recent rise in Spanish and Italian bond yields in spite of its Long Term Refinancing Operation (LTRO): “I would read the recent developments not so much as an example of market fragility, but simply as an example that markets are expecting reforms. What markets are saying is that they are asking these governments to deliver, i.e., fiscal consolidation, structural reforms, etc.”
Of course it is not just faceless financial markets that are expecting reforms from euro area governments. But it is convenient for an appointed civil servant like the ECB president to blame markets for the tough political demands put to democratically elected leaders. As was the case in August 2011, when the ECB first considered buying Spanish and Italian bonds through the securities market program (SMP), the political quid pro quo from Frankfurt to euro area leaders remains clear: If Spain cuts spending and undertakes structural reforms, the bank will help out. Prime Minister Jose Luis Rodriguez Zapatero understood the message back then. Prime Minister Silvio Berlusconi of Italy did not. The Rajoy government seemingly does so today.
What else might the ECB “request” in return for renewed SMP purchases of Spanish government debt? Appropriately, Draghi was also focused last week on continued labor market reforms and the need to undo Europe’s dual labor markets: “Much of the growth in countries that are now experiencing a fiscal contraction would have to come from supply reforms,” he stated, “and this drives me straight to the labor market issues.” We can therefore hope that Frankfurt will insist that the Spanish government expand the labor market reforms already announced this year.
Then there is the persistent issue of the Spanish banking system. As indicated by Bank of Spain Governor Miguel Ángel Fernández Ordóñez, the system remains vulnerable to a likely further decline of Spanish house prices and is already mostly dependent on the ECB for funding. If the asset quality of Spanish banks continues to deteriorate, the ability of Spanish banks to borrow from the ECB—even under more lenient collateral requirements—will likely decline, perhaps eventually replaced by “national borrowing” through an expanding Bank of Spain Emergency Liquidity Assistance (ELA) program. However, in light of the ECB’s willingness to push Ireland into the arms of the International Monetary Fund (IMF) in 2010—when Irish banks relied on ECB loans to stay afloat—one hopes the ECB will insist that the Spanish government deal with the lingering real estate related balance sheet problem in large parts of the banking system.
Given the poor macroeconomic outlook for Spain, significant new private capital for the Spanish banking system will not likely materialize soon. This means that public money will have to be spent. The Spanish government, faced with a dire fiscal outlook, would then have to seek a European Stability Mechanism (ESM) Article 151 loan of perhaps €50 billion to €60 billion for the earmarked purposes of recapitalizing its banking system. Such a request would be relatively easily handled by the European Stability Mechanism/European Financial Stability Facility (ESM/EFSF), which would demand conditionality. The treaty setting up the ESM (Article 13.3) states [pdf] how “the content of the [conditionality] MoU [memorandum of understanding] shall reflect the severity of the weaknesses to be addressed and the financial assistance instrument chosen.” It is not inevitable for ESM conditionality to be politically onerous for the Rajoy government.
An Article 15 request for ESM funds to recapitalize Spanish financial institutions would have several benefits. First, its targeted and more limited nature seems an appropriate response to the economic challenges facing Spain, which are smaller than those confronting Greece, Ireland, and Portugal. Second, it would keep the Spanish government funded in the markets. This would save the euro area (and possibly the IMF) a lot of financing, since a standard IMF program typically lasts for years. Third, such a step would probably limit market contagion from Spain to Italy. While hardly well capitalized, Italy’s banks are at least not weighed down by a massive real estate collapse.
What effects would additional ECB secondary purchases of Spanish bonds have on Spanish primary market bond issuance? Following the Greek bond exchange, where the ECB was a senior creditor in a restructuring scenario, further SMP purchases might be seen as pushing remaining and potentially new private bondholders further down the credit ladder. But the inability or unwillingness of the ECB to take any credit losses on its SMP portfolio is only relevant in a sovereign restructuring scenario. Spain remains far from such a restructuring, which suggests that the ECB could purchase sizable amounts of Spanish bonds before any serious concerns about subordination surface.
Finally, there is the issue of real yield value in euro area sovereign bonds. It is essentially inconceivable that Spain would be allowed to default. In the end the ECB would bail it out. One must then ask how long it will take for even modestly improved Spanish data to make Spanish bonds a better value than the new 10-year German bonds, which were offered this week with a criminally low, guaranteed wealth destroying (if you are a pension saver) 1.75 percent coupon. In what world, compared to a Spanish bond at yields around 5 to 6 percent, is this German Bund a good safe investment, considering that Germany’s economy looks likely to push wages and inflation rates higher and may be heading into a recession? Which private investors—and €3.87 billion of buyers did—want to help Germany liquidate its debt through pretty much guaranteed negative real interest rates for the duration of this bond? Fortunately, Madrid won’t have to improve that much to offer a better deal!
1. Article 15 in the ESM Treaty stipulates the circumstances under which loans can be granted to member state governments for the specific purposes of re-capitalizing their national banking systems.