Seeking Alpha
Value, contrarian, bonds, long-term horizon
Profile| Send Message|
( followers)  

This is a thematic post, I am also putting outside the paywall because there is a lot of chatter today about Spain needing to tap EU bailout funds this year. The messaging in the analyst community follows the thematic prediction I made in October 2010 about periphery countries missing targets and this creating a renewed crisis in the euro zone. Just to quote briefly to fix on how this will proceed, I wrote On the Troika's Coming Occupation of the Periphery:

Translation: continue fiscal austerity until you reduce your deficits significantly. If the depression this creates causes you to miss your fiscal targets, redouble your efforts under the watchful eye of the Troika.

Portugal is out making additional cuts and increasing taxes (link in Spanish). Nevertheless, Olli Rehn has already indicated that Portugal runs the risk of not making its 2011 fiscal targets (link in Portuguese). Even Spain, not under an IMF program, will miss fiscal targets.

So, it is only a matter of time before what is happening in Greece happens at a minimum in Portugal and probably in Ireland as well.

While Ireland and Portugal are already in IMF programs, the worry now is that Spain will follow. Let me break down the different threads briefly. Here are the principal stories I am hearing.

Troika Program: The rumor roiling markets is that contingency is being made for Spain to access the Troika programs. The government has denied these rumors. But they persist nonetheless. And this is not the first time we have heard this. Read On the alleged plans for a Spanish bailout from November of last year. I am sceptical but this is what's being said.

El Pais wrote just today that the European Commission is actually trying to force Spain into the bailout fund so as to help restructure the banking system there. I will have more to say about this below but the bottom line is that EU officials are not convinced the Spanish government's plan for recapping the banks will be enough. In any event, Spanish 10 year bonds are at 5.36% and the stock market is down nearly 10%. German officials are saying you reap what you sow because Spain unilaterally flouted its deficit target and it is now paying the price. "The yields are the proof. They are paying the price". Fitch has said the unilateral move to miss the target has damaged Spain's "fiscal credibility".

But let's be clear this has been in the works for months now. As an aside, I should point out that it was clear these targets were too high for Spain. Read Edward Hugh's October 2010 post "Is A 6 percent 2011 Deficit Realistically Within Reach For Spain?" He predicted in real time that Spain would not make the 6% hurdle. More than that though, I wrote in November and December and January where the Spanish were preparing us for just this.

So let's not act like this is a surprise. The Europeans are in a policy bind here because their stated goal is austerity and growth at the same time. There is no way the periphery is making targets. Either the EU has to relax the targets and let them go for growth or continue down the line of crushing austerity, redoubling efforts if targets are missed. I predict they will do the latter because countries like the Netherlands which have proved deficit fetishists are also in jeopardy. I anticipate the Dutch will redouble efforts and will require the same of the periphery.

Hidden/Contingent Debt: Spain has a government debt to GDP level lower than Germany or France. And it is this fact which holds them in good stead. However, if one looks closer, one sees a lot of contingent liabilities that are liable to come due shortly. Edward Hugh has been banging on about this for a while now (See the August 2010 post "Controlling The Uncontrollable: Spain's National Addiction To The Use Of "Dinero B"". Now this issue seems to be entering mainstream discourse. Edward framed it this way in 2010:

What Spain's central, local and regional government does is take advantage of loopholes in Eurostat accounting regulations to generate debt that really is debt, but is not classified as such according to the Eurostat excess deficit criteria. Key areas involved are debts on the balance sheets of state (or regionally, or locally) owned companies, overdue payments for receivables (very common practice in Spain), and public-private-partnership-type leaseback-arrangements. None of these are (typically) classified as debt, though they do all have to be paid at some point, which means there is a stream of revenue (flow) impact rather than a debt (stock) one (unless and until Eurostat changes the rules). Which means that while they do not impact that critical debt to GDP number, servicing these liabilities does exacerbate the annual fiscal deficit one. Which is why ultimately bringing Spain's fiscal deficit under control will almost certainly prove to be much harder work than it seems.

Long story short, Spain's debt levels will be a lot higher before it peaks, maybe as high as 100% debt to GDP.

Weak banking system: And remember, we are talking about debt that is on the books already. There are the contingent bank liabilities as well, the sort of thing that has got Ireland into trouble, when it assumed it's banks' debt. First, the discussion in the media recently has been about Spanish bank addiction to the ECB lending facilities. What is happening is that Spanish financial institutions are playing the carry trade in a major way. The banks are borrowing from the ECB (against Spanish sovereign collateral in all probability) and then buying Spanish sovereign debt, which has a much higher yield. They can do this for another three years as the LTRO facility is a three year program. This scheme has been beneficial in two respects. First, it provides the banks with cheap funding that they can use in a carry trade to recapitalise on the sly over the next three years. Second, it is a backdoor monetisation of sovereign debt as it is intended to be. Italian banks are playing the same game, as I predicted they would in November.

This arrangement will not last in my view. At some point, as peripheral countries begin to miss targets, the crisis will flare. In January I said the fireworks will start with Spain or Italy. But now Spain and Portugal look to be the countries where the euro crisis is now most acute.

Housing: Where Spain's banks are vulnerable is in housing and land. Land and property values are still sinking in Spain (as they are in the US and Ireland, two other former bubble economies). This will continue to be a drag on growth. However, the more pressing concern is how this impacts financial institutions' balance sheets because Spanish banks have not taken the credit writedowns the Irish banks have done. Willem Buiter of Citigroup has come out with a missive that says things will get a lot worse and that Spain will need to get into a Troika program just like Greece, Portugal, and Ireland.

Buiter opines:

The decline in Spanish land and property prices appears far from complete (probably less than half complete). The General IMIE Index, an indicator created by Tinsa, increased its year-on-year decline in February, and fell by 9.5% - returning to the levels of 2004. The cumulative decline in the General IMIE Index from the top of the market in December 2007 was 27.1%.In addition to the hidden legacy losses carried by the Spanish banks, new property- and real estate-related losses are likely to come their way as a result of further property price declines. The Spanish banks are unlikely to be able to absorb these losses. If these institutions are deemed too important to fail, these losses could migrate to the public sector, which could have severe problems carrying them.

Preparing for this contingency may be one reason that the Germans have relented on increasing the size of European bailout funds (by running the EFSF and ESM concurrently). In the context of the other hidden liabilities and missed targets, losses migrating to the sovereign would be fatal for Spanish sovereign debt, even with the ECB monetisation scheme in place.

Local government: Spain's central government does not have control over the spending of autonomous regions in Spain. In the past, there has been a lot of chatter about forcing these governments to consolidate because their deficits are accounted for in the Spanish deficit figures. The problem then is that these local governments are not consolidating. In Andulucia, where unemployment runs even higher than the national 21%, the Partido Popular failed to get an absolute majority and they were therefore defeated in elections this past weekend by a coalition from the left to be led of the socialist party (PSOE). PSOE is not going to go along with the austerity train in Andalucia. And so the fear is that this will make the deficit targets difficult for 2012.

Bottom Line: Willem Buiter gets the nod here

The risk of a Spanish debt restructuring is higher now than it's been since the beginning of the crisis, said Citigroup Inc. chief economist William Buiter in a research comment published Wednesday. "Spain looks likely to enter some form of a troika program this year, as a condition for further European Central Bank support for the Spanish sovereign and/or Spanish banks," said the former Bank of England Monetary Policy Committee member.

I am not sure the die is cast. I am always optimistic. But, admittedly things are certainly deteriorating for Spain. This is a situation which has the potential to cause significant portfolio damage if not contained appropriately.


Source: On Spain's Coming Under The Watchful Eye Of The Troika In 2012