Spain and the Euro: From Contagion to Isolation
Spain is on the verge of a nervous breakdown. The first years of the EMU crisis were characterized by the strong cross-border holdings of European Government Bonds (EGBs) by national banks. The fear of a contagion and a systemic crisis triggered by a potential sovereign default explained the denial of the solvency crisis in Greece and the painful acceptance and implementation of the PSI.
Spain is not suffering from a "contagion-style" crisis. The recent hike in the Bono/Bund did not leave other non-core countries unscathed, but the Spanish under performance highlights the new nature of the crisis: countries are left to solve their own problems. Through the European Banking Authority stress tests and the implementation of tougher Basel III capital requirements, European Banks have sharply reduced their exposure to foreign EGBs: French Banks holdings of Spanish Debt has declined from €14.6 bn to €11.4 bn between July and December 2011 (source: EBA).
Beyond that, the recent debate on Target II (the European equivalent of the US Fedwire) highlighted the strong dependence of countries on central bank liquidity to fund their current account deficits as private capital flows (mostly bank or debt related) have declined since 2008. The two waves of VLTRO have reinforced the temptation for domestic financial repression as many non-core beneficiaries of the 3-year liquidity allotment purchased domestic EGBs, as of late 2011. Prior to both LTROs, Spanish residents - banks and others - already held 58.5% of the total outstanding of Bonos. As a result, the main issue is no longer cross-border but domestic.
Going clockwise, Spain's government deficit surprised on the low side in 2011 as both central and autonomous administrations failed to reach their targets. The drastic budget bill brought hopes of curbing state and autonomous spending even though the central government has no majority control in Andalucia, Catalonia and Pais Basco. The main concern for investors is not so much the willingness of Spanish authorities to carry out reforms and more fiscal austerity but the associated negative impact on growth and the negative feedback loop it may have on the banking system.
Spanish banks have become the main buyers of Spanish bonds (€61 bn between December 2011 and February 2012), notably through LTRO-financed carry strategies. The sharp reduction of Spain's current account deficit suggests that the reliance on external financing has dwindled, but as private flows have dried up, the net external provision of funds comes from the ECB.
In addition, as the economic situation worsens, the risk of further losses for banks on nonperforming loans (real estate) increases the risk of recapitalization requirements. The mechanics are complex, as further recapitalization could come either through the FROB or the State. In any case, it could break the strong tie between banks and public borrowing. One option could be to resort to the ESM to recapitalize banks, but this has been officially denied, and would probably send a bad signal.
The problem is: liquidity is not capital. The VLTRO has enabled banks to avoid a funding crisis (huge redemptions in 2012) but the lack of responsiveness of credit growth suggests that more deleveraging was required to build up a strong capital base. Spain has been praised for the restructuring and revamping of its banking system since 2009 through the merger of cajas, but the recession may hinder the ongoing improvement (see for more detail the official view: http://www.bis.org/review/r120410b.pdf?frames=0 page 4).
The ECB appears ready to act with direct bond purchases in the secondary market [SMP]. Beyond the fact that it remains a temporary liquidity-crisis tool, were internal conflict to limit it, the last resort for banks would be the ELA (Emergency Liquidity Assistance - "providing liquidity support in exceptional circumstances to a temporary illiquid institution within discretion of the national central bank") that would further isolate the country. For example, Greece ELA outstanding is close to €60b…
The recent widening of Spain's spread does not reflect the contagion risk that prevailed in the 2009-2011 period. It highlights the risk of market fragmentation, as countries are not much more self-reliant than before. Without monetary help (except for the ECB), fiscal consolidation/reform efforts will lead to a recession-induced negative feedback loop. This is a new phase of the Euro crisis that requires going beyond the supply side and enhancing Eurozone coordination for growth.