Spain's External Debt: Solvency vs. Liquidity

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Includes: EWP, FXE
by: Bruce Krasting

I wrote an article recently and quoted a CIA report on Spain’s External Debt as being $2.4 trillion. A reader commented that I was full of crap and spreading false information. The reader made clear that the external debt of Spain was $1.25 trillion (euro 900 billion). The following graph from the Bank of Spain was sent to me to prove the point.

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Here’s the data I relied on from the CIA World Fact Book:

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I think of the difference in these numbers ($1.15 trillion) as a gross and net calculation. Spain has 2.4x of external debt, but the financial institutions in the country have ~$1 trillion in foreign assets. (It is much more complex than this simple arithmetic.)

Many economists, (notably Stieglitz) have used the net number and multiplied it by ‘real’ interest rates and have concluded that the resulting debt service number, as a percent of annual GDP, is manageable. The conclusion from that camp is that there is a necessity for some budgetary action, but there is certainly no cause for alarm or, heaven forbid, panic.

In the early 1980’s damn near every country South of Texas went belly up. I know. I ran part of Citi’s (NYSE:C) FX biz during that period. All my public and private sector Latin American customers were shut out of the capital markets. Their existing debts traded for pennies on the dollar.

From my seat I saw that the problems always started with the domestic banks. Their offshore funding lines were canceled one by one. They could not reduce their balance sheets fast enough; they went to the local Central Bank who said “No Mas” and the next day all the lights went out.

Things are much different today than 30 years ago. But there are some similarities. Financial institutions in every country have enormous cross border exposure. If you want to measure solvency it is appropriate to base the calculation on a country’s net external debt number. But if you want to measure a country’s liquidity risk you have to look at the gross number.

Every financial institution sets a country risk limit for its own foreign investment activity. This limit is further divided into exposure to the public and the private sectors. At the first whiff of trouble these lenders/investors try to pare back their risk to a country. The first place they go is to the private sector banks. They pull lines and deposits.

In the case of Spain, Banco X will record foreign liabilities; they will also have foreign assets offsetting it. If the market were to turn on “Spanish” sovereign risk and the availability or the cost of external borrowed capital were to become prohibitive, Banco X can simply reduce its balance sheet of the external assets. But think of the market conditions that would exist if this were to evolve. There would be trillions of assets looking to go through a very small hole.

The CIA data points to both the strength and weakness of our global system. The strength is the diversity, the weakness is the codependency. The external debt of all countries was estimated by the CIA to be $57 trillion as of 12/31/09. It was $61 trillion in 2008. An interesting YOY drop of $4 trillion. In 2009 there was an explosion of global debt. The US alone added a few trillion. The drop in cross border holdings is therefore even more significant. It suggests that the willingness of the global system to absorb more and more external debt is in substantial decline. 10% is a reasonable estimate. This makes sense, given the global economic conditions. But it is a very troubling direction.

Also of interest is that in 2008 world GDP was $60 trillion, almost exactly the same as the $60.7 trillion of cross border debt. As this declined in 2009, so did global GDP. Does this confirm the statement: Debt=Wealth?

We owe each other $60 trillion. So long as all of these IOU’s keep changing hands in an orderly way there should be no problem. But unfortunately there is a problem. It is currently playing itself out in the second tier European countries. The global de-leveraging is continuing. Today it is Spain and Ireland. As of now only a small percentage of the $60 trillion is moving around. But there is every reason to believe that this movement of the deck chairs is going to accelerate. De-leveraging is never pretty. We went through that in '08-'09.

The economists like Stieglitz are wrong. There is a reason to be worried. Bernanke’s weapons are spent. Treasury has no chance for a TARP II. Yet we are looking at a very deflationary outcome if the present trends continue.

We have seen credit spreads and CDS pricing widen out significantly for the PIIGS. A reasonable market reaction. If this trend extends to other classes of debt including high grade corporate, Agency MBS, or other higher quality sovereign names, look out. That will be the sign that the unwind of the 60T is accelerating. With it will go wealth and GDP.

Disclosure: No positions