Spain: The Next EU Sovereign Debt Crisis, Coming Soon

by: Cliff Wachtel

Over the past weeks, there have been at least 3 separate reports (FT Deutschland, Frankfurter Allgemeiner, and El Economista), that Spain was seeking an EU/IMF aid package. Spain has denied the reports. Here’s why we suspect the reports are true. In short, both fundamental and speculative evidence is becoming overwhelming that Spain will not last long without aid.

The Fundamentals

First, Spain’s economy is arguably in terminal decline without significant aid on a pure fundamental basis.

As well summarized by Michael Snyder here, via, there are numerous reasons that Spain can arguably be considered a default waiting to happen unless it receives serious help that will dwarf the latest so called ‘shock and awe’ EU/IMF package of €750 bln that was meant to cover smaller economies like Greece. However, Spain’s economy is about 5x as large, comprising 11.5% of EU GDP and is the 10th largest economy in the world. If a mere Greek default threatened to destabilize European banking, a Spanish default would likely destabilize even Europe’s largest banks.

Reasons Spain’s economy is in terminal condition per Snyder include, (we quote):

  • Over 20% of the workforce is unemployed: Even before this most recent crisis, unemployment in Spain was approaching Great Depression levels. Spain now has the highest unemployment rate in the entire European Union. More than 20 percent of working age Spaniards were unemployed during the first quarter of 2010. If people aren’t working they can’t pay taxes and they can’t provide for their families.
  • Deficit equal to 11.4 percent of GDP: In an effort to stimulate the economy, Spain’s socialist government has been spending unprecedented amounts of money and that skyrocketed the government budget deficit to a stunning 11.4 percent of GDP in 2009. That is completely unsustainable by any definition
  • Total debt equals 270 percent of GDP: The total of all public and private debt in Spain has now reached 270 percent of GDP.
  • Rampant credit downgrades: The Spanish government has accumulated way more debt than it can possibly handle, and this has forced two international ratings agencies, Fitch and Standard & Poor’s, to lower Spain’s long-term sovereign credit rating. These downgrades are making it much more expensive for Spain to finance its debt at a time when they simply can’t afford to pay more interest.
  • Unsold housing inventory levels SIX TIMES WORSE than America: There are 1.6 million unsold properties in Spain. That is six times the level per capita in the United States. Considering how bad the U.S. real estate market is, that statistic is incredibly alarming
  • Caught between austere misery and a credit downgrade: Spain’s national debt is so onerous that they are now caught in a debt spiral where anything they do will harm the economy. If they cut government expenditures in an effort to get debt under control it will devastate economic growth and crush badly needed tax revenues. But if the Spanish government keeps borrowing money their credit rating will continue to decline and they will almost certainly default. The truth is that the Spanish government is caught
  • IMF forecasts NO POSITIVE GROWTH until 2011: But even now the IMF is projecting that the Spanish economy is going nowhere fast. The International Monetary Fund says there will be no positive GDP growth in Spain until 2011, at which point it will still be below one percent. As bleak as that forecast is, many analysts believe that it is way too optimistic considering the fact that Spain’s economy declined by about 3.6 percent in 2009 and things are rapidly getting worse
  • The strikes and protests are just getting started: The Spanish population has gotten used to socialist handouts and they are not going to accept public sector pay cuts, budget cuts to social programs and hefty tax increases easily…The truth is that financial shock therapy does not go down very well in highly socialized nations such as Greece and Spain. In fact, the austerity measures that Spain has been pressured to implement by the IMF have proven so unpopular that many are now projecting that Spain’s socialist government will be forced to call early elections.

Even if we somehow ignore these gruesome fundamentals, it’s clear that the recent build in speculative fever alone may push Spain to seek aid regardless of whether it might have otherwise been needed.

Speculative Momentum: Spanish Sovereign Debt Yields Are Exploding Higher

Fundamentals aside, in the short term it’s all about expectations, and these are getting just as bad as the fundamentals.

A few weeks ago Spain had a successful €3 bln 10 year bond sale on June 17th, but at the cost of higher yields that were just below 5%, considered a red-line maximum it can afford for this maturity. It also sold a smaller amount, €479 mln, of 30 year bonds at just below 6%.

S&P announced on Monday that it had raised estimates for loan losses for Spain’s banking sector, feeding anxiety levels and ultimately their borrowing costs.

Of more concern, perceived credit risk on Spanish debt is rising at an accelerating rate.

1. Note the 5 year Spanish bond chart (click to enlarge), and the rate of increase in 5 year bond yields since April (when the EU sovereign debt concerns became a full blown market crashing crisis):

(via Dave White here )

2. Its recent sale of 3 year bonds was at double the yield for those sold just this past April.

3. For reference, note how the Spread on Spain’s 5 year bonds has changed in the course of the past day. Here’s a chart (click to enlarge) showing the spread increase and Cumulative Probability of Default (CPD%) for June 22nd:

5 Year Credit Default Spreads as of June 22nd 2010 Table Courtesy of 12jun23

4. Here’s one for yesterday, June 23rd (click to enlarge). Note that Spain’s spread has risen another 6.35% and that its CPD% is up from 18.76% to 20.87% – all in just 24 hours. Unusual movements like this are just the kind of thing traders (or their computers) are tuned to spot. Left unchecked, that should build further momentum buying of Spanish sovereign debt default insurance, further raising spreads and yields, and ultimately the borrowing cost of the July bond sale.

5 Year Credit Default Spreads as of June 23rd 2010 Table Courtesy of 14jun23

The reason Spain is of special concern is that it has a large debt redemption in July, about €24 bln, and thus is especially vulnerable to rising rates should it need to sell bonds to raise cash for this redemption. Spain has claimed it has the cash on hand and need not sell any bonds, and is not seeking aid from the EU/IMF. Of course, Greece said the same thing just before the very opposite occurred.

Clearly the debt markets are betting otherwise

In short, the timing of this deterioration couldn’t be worse.

Nor may it be entirely accidental. Months ago Goldman Sachs (NYSE:GS) was advising clients to buy CDS instruments on Spanish and Italian banks. There is serious money betting on trouble.

Ramifications and How To Profit

We can’t tell when there will be official confirmation, but we expect it within the coming weeks, if for no other reason than to attempt to scare off buyers of CDSs on Spanish sovereign debt, drive down borrowing costs, and ideally allow Spain to access credit markets at affordable rates if/when needed.

Markets are already very nervous about Spain given the above fundamental and speculative troubles, as well as the likely strain of any Spanish bailout given the sheer size of Spain’s outstanding public and private debt.

Thus, even though any announcement will come with assurances that all is under control, the very fact that, once again, the EZ has been less than fully honest about its troubles, is likely to spook markets and interbank lending based on the sheer rising level of distrust.

How to profit? Short positions of virtually any risk asset will do well in the short term, especially anything related to the EZ and the already troubled Euro. The recent rally in risk assets and the Euro has provided an excellent chance to enter new short positions in the EURUSD, EURJPY or FXE for those preferring ETFs.

Obviously Spanish and other PIIGS group major banks will work, as will short positions on major stock indices, especially European ones.

Disclosure: No Positions