The odds of Spain requesting a full-blown international sovereign bailout by year-end have jumped amid rising borrowing costs, a yawning fiscal deficit, a slowing economy and banks’ bailout costs, economists say.
Market fears over Madrid’s solvency comes amongst predictions that the end-month summit of eurozone policymakers will prove to be yet another damp squib, exacerbating break-up risks for the single currency.
On Tuesday, Spain sold €2.4 billion of 12-month Treasury bills at 5.074%, up from 2.985% at the previous auction last month. Although the bid-to-cover ratio for the auction stands at a relatively healthy 2.16, market fears over Spain’s debt metrics – and a lack of clarity over whether the recently announced bailout for Spanish banks will impose a fiscal cost – have triggered higher borrowing costs, raising the risk that Madrid will exhaust the European Stability Mechanism’s (ESM) funds.
“We should take some comfort from the fact that Spain is successfully managing to force its domestic banks to gorge on government paper,” says Christel Aranda-Hassel, eurozone economist at Credit Suisse. Spain has funded some 58% of its €90 billion funding needs for the 2012 calendar year, largely thanks to large-scale debt purchases by Spanish banks, which are hugely dependent on European Central Bank financing.
“Like Italy experienced last year, the Spanish sovereign can live with higher interest rates [even if this imposes mark-to-market costs for its domestic banks] for some months,” says Aranda-Hassel.
However, there are two material risks. The first scenario consists of an outright buyers’ strike, triggered by eurozone break-up fears and/or Spanish solvency concerns in light of its recession, weak banks and anemic construction sector. The second, more likely, scenario, say analysts, is that the Spanish government will seek a bailout to arrest the decline in its debt sustainability metrics.
Debt trap
The real rate of Spanish interest payments – with yields on 10-year paper frequently breaching 7% – continues its leap above the real rate of growth of the economy, which is not expected to expand until 2014, on the more-benign projections.
Against this backdrop, the government will be forced to cut spending to achieve an offsetting primary budget surplus, which would dampen growth further and risk a self-fulfilling debt crisis with Spain’s debt-to-GDP ratio rising from 80% currently to 100% by 2014. That is if the Spanish bailout, estimated at up to €100 billion, is borne by the sovereign.
The bank bailout would add some 10% to Spain’s total debt stock-to-GDP ratio to 90%, the eurozone’s average. That is relatively benign compared with Italy’s 120% burden. However, the government is trapped in budget deficit at 8.9% by 2011 fiscal year-end.
Fiscal tightening could knock off 4% of Spain’s GDP in the coming years, after the economy contracted by 1.8% last year, believes Credit Suisse. A one percentage point decrease in the country’s growth trajectory in the coming years could cause Spain’s debt to GDP ratio to hit 120% by 2020, says Aranda-Hassel.
In light of these rising risks, if Spain was forced to raid the eurozone’s crisis stabilization funds by the second half of this year, including banks’ bailout costs, Spain’s funding needs would reach €470 billion by 2014. “This prospect would deplete the ESM’s €500 billion of funds, and leave no money for Portugal, a potential second bailout for Ireland, and Greece.”
Spain is on a knife-edge but the outlook for the financial sector will prove the game-changer. The fortunes of Spanish banks and the sovereign are intimately entwined. Market uncertainty over the true losses facing Spanish banks is one driver for the sell-off in Spanish sovereign and banks’ asset prices. A report by independent auditors on the true extent of Spanish banks’ funding needs, expected this week, has been delayed to September,according to Bloomberg.
As Euromoney has noted, the pressure on Spanish sovereign bond yields highlights the deficiency of the ECB's repo operations against the backdrop of unstable collateral values. However, Aranda-Hassel at Credit Suisse still reckons Spanish banks, whose balance sheet exposures to Spanish sovereign debt is roughly 6% compared with 8% in Italy, still have the firepower to snap up government bonds. What’s more, “Berlin and the ECB reckon there is a clear political commitment in Madrid to reduce the deficit and reform. This makes it more politically feasible for the eurozone authorities to support Spain,” citing measures such as giving the green light for the Spanish central bank to expand the ELA programme, a liquidity facility in which national central banks set the collateral requirements and are directly liable for.
However, without more aggressive measure to shore up eurozone market confidence and a mechanism to ensure the government is not forced to bear the brunt of banks’ bailout costs, internal disinflation, declining economic output and pressure on fiscal targets could trigger Spanish insolvency, say analysts.
In a benign muddle-through scenario, the Spanish government could consider 'financial repression' measures such as consumption taxes, one-off wealth levies or public sector wage cuts, says Roberto Cervello-Royo, assistant professor at the Technical University of Valencia. But faced with the prospect of a contracting economy over a three-year period, a structurally weak euro, and an uncertain outlook for Bunds, the economics of holding Spanish sovereign debt for non-resident investors - which, as of March, hold one-third of the outstanding Spanish debt stock compared with a high of 50% in December 2006 - is unclear, to say the least.
The lack of clarity over Madrid’s financial position will only exacerbate the region’s economic recession, the negative sovereign-bank feedback loop and region-wide domestic discontent, analysts conclude.