Why Rajoy's 'Delay-And-Pray' Strategy Won't Work

Tyler Durden's picture

The circular rationale for believing that Spain is anything other than a basket case is remarkable. As we pointed out last night, in context the market-based signals that so many are basing their opinion on (including Rajoy, Van Rompuy, and Hollande it seems) are extremely misleading. Fundamentally, as UBS explains, the hope that Spain will request a bailout anytime soon is misplaced as there is no immediate pressure to do so and the government would prefer to negotiate a more favorable MoU. However, two major issues stand in the way of that delayed reality - an insufficient bank recap; and the federal nature of Spanish government creating obstacles to deficit reduction.


Spanish fundamentals


European economist Matteo Cominetta explains why he thinks Spain is not likely to request external assistance in the near future: 1) There is no immediate pressure on Spain and 2) The government prefers to negotiate a favorable memorandum of understanding. Two issues confront Spain. The first is the recapitalization of the banking sector, where we regard the Euro 60Bn recently announced as insufficient. Second, the federal nature of Spanish government creates obstacles to deficit reduction.


1. Many investors accuse the Rajoy government of 'dragging its feet' with respect to its request for official assistance, including via the ECB's recently announced OMT program. What in your view is the reason why Spain has not yet asked for official assistance? Are there events on the immediate horizon that are likely to trigger that request?


Spain will likely miss its 2012 deficit target of 6.3% of GDP by a wide margin. We estimate it to be between 7% and 7.5%. If Rajoy would sign a memorandum of understanding (MoU) committing Spain to the deficit targets agreed with the EU, his government would have to reduce the deficit to 4.5% next year, monitored quarterly by the IMF. As such, Rajoy would have to impose significant austerity and probably take politically-challenging decisions on pensions and other key areas of public expenditure. For this reason, I think the Spanish government is holding up, trying to negotiate softer deficit targets. With low sovereign bond yields and stable bank deposits, the urgency to ask for aid has faded somewhat, courtesy of the ECB’s OMT announcement. Finally, with Moody’s potential downgrade delayed, the next possible triggers for a reemergence of the crisis could be: 1) an escalation in tensions between Greece and EU authorities ahead of the disbursement of the next aid tranche; 2) an uncovered auction for Spanish sovereign paper


2. According to recent 'stress tests' Spanish banks will require nearly Euro 60bn of recapitalization funds. Yet many believe the stress tests are not sufficiently rigorous. What is your assessment of the underlying capital deficiency in the banking system? Whatever the figures, do you believe the Spanish government can assume the obligation for bank recapitalization, or will those funds have to come directly from the ESM


According to our bank analysts, € 100 bln is a more credible level of recapitalization needs for the Spanish banking sector. That figure is broadly in line with the consensus.


I think the Spanish government can keep the costs of the recapitalization on its own balance sheet without debt dynamics becoming explosive. Debt/GDP would peak around 100% according to our simulations, including € 100 bln of bank recapitalization costs. As such, I don’t think there is an immediate need for ESM direct bank recapitalizations. Clearly it would help, but it is not going to be a game changer in my view. The ESM direct recapitalization of Spanish banks is, however, probably not an immediate option, as setting up a Euro-area bank supervisor will probably take years.


3. It is frequently mentioned that Spain cannot impose austerity and structural reform as quickly as international creditors or the troika would like, given very high levels of unemployment. Is that correct or do regional politics play a bigger role in slowing Spain's fiscal and structural adjustment?


Regional politics certainly create an important obstacle to fiscal consolidation in Spain, if anything because almost a third of Spanish public expenditure is managed at a regional level. Regions have indeed missed their deficit targets by a wide margin in the last two years. Regions not ruled by the centrally-ruling PP (Andalucía, Cataluña) have also being particularly vocal in their opposition to the deficit targets requested by the central government, which highlights the political dimension of the regional versus Madrid tensions on fiscal issues.


The other key issue is the loss of public revenues. These dropped by € 56 bln (5.3% of GDP) from 2007 to 2011. For comparison, Italian revenues increased by 13 bln in the same period. This helps explaining why Spain is finding it much harder to implement the austerity plans suggested/required by European authorities. However, imposing yet more austerity may prove counterproductive, pushing Spain in a debt-recession spiral not dissimilar to the one we are witnessing in Greece. According to my simulations, Spanish public expenditures should fall 18% next year for the country to reach its deficit target. This would cause the economy to contract by 3%.


Fixed income strategy


Head of European fixed income strategy Justin Knight also believes that Spain will delay any request for external assistance. But he makes the point that the funding needs for Spain are considerable next year; hence Spain is almost certain to be forced to request help eventually. An additional issue for Spain is the reality of a smaller investor base. Thus far purchases by Spanish banks have offset diminished foreign participation, but Justin believes Spanish banks will be unable to continue to absorb large quantities of Spanish bonds. Finally, Justin discusses the potential for contagion to other countries, in particularly Italy, should risk premia rise again in Spain.


1. One frequently heard argument is that the markets will have to force Spain to seek official assistance, including in the form of the ECB's OMT program. Is that your view and why haven't market pressures built already? Alternatively, if Spain does ask for help, what do you think the market reaction will be?


Yes, we do believe that the Spanish government might wish to wait as long as possible before requesting aid, particularly in the light of up-coming regional elections. One reason could be that in a programme, the Spanish government might have extra reforms imposed on it if it misses targets in the way Matteo mentions. This could happen at the very first review.


But for the moment markets are treating Spain well, as investors seem unwilling to sell bonds ahead of the OMT activation. At the same time, the Spanish government looks as though it will stick to original issuance targets – based on deficit forecasts at the beginning of the year – meaning that it has very little left to issue for the year. However, this also means that the cash reserve of the government may deplete by some €13-20bn.


Next year is a different matter. With large redemptions and the inability of regions to issue bonds themselves, the Spanish government will have a record amount of debt to sell.


The market reaction to an aid request when it comes should be positive to some extent (relative to current yield levels), but this may be limited as there will still be uncertainty as to how and when the ECB will enter the market.


2. As foreign investors shunned Spanish and other peripheral debt markets, the burden of financing the fiscal position increasingly shifted to domestic institutions, including banks. But with deposits shrinking, can the banks continue to plug the gap left by foreign investors? How great is rollover risk for Spain?


It is correct that in 2012 domestic banks took up some of the slack left by foreign investors. However, beyond the first quarter of this year, they did so increasingly reluctantly, as the rise in yields implies. The fall in value of their own holdings (representing some 40% of the outstanding bonds) also caused a collateral squeeze via the daily mark-to-market and margining process of the ECB. Collateral has been in short supply in Spain anyway, and we believe that the memory of this will discourage banks from buying large amounts in the same way as they did in Q1 2012 with the ECB’s LTRO money.


In addition, it seems that the banks receiving capital in the existing Spanish aid package will probably not be able to buy many bonds anyway. Spanish press reports on Thursday, citing the banks themselves, indicated that the EU might want them to reduce balance sheet size by another 40%.


3. Can we trace falling deposits in the Spanish banking sector to concerns about possible Eurozone exit, or do the figures reflect other factors, such as shrinking wholesale markets for debt securities? Overall, how great is the risk of 'liability flight' for Spanish banks?


Anecdotal evidence would certainly point to worries about Spanish euro exit, or indeed at times, to broader euro break-up. For example, some large international companies have stated that they now remove cash balances daily from Spain and other peripheral countries. Shrinking wholesale markets have also played a part in banks’ reliance on ECB funds. From my perspective, this looks like a greater driver, but it is often difficult to split the two.


4. How worried should we be about contagion to other countries? If market turmoil is required to force governments to seek assistance, will that same dynamic affect other countries, such as Italy? If Spain asks for help, will markets immediately shift their attention to the next candidate?


By and large we see the same structural problem with demand for Italian bonds as we do for that of Spanish bonds – many traditional government bond investors have sought the “risk-free-rate” elsewhere and changed benchmarks accordingly. However, in contrast to Spain, the Italian financial system has seen rises in deposits this year, so potential domestic demand for bonds is higher and with a primary surplus, Italy’s fundamentals look better as well. One could expect foreigners to turn back to Italy sooner than they might to Spain.


However, were Spain to lose market access in the near term, we would certainly expect more volatility in Italian bonds, and perhaps in others depending on what the EU-level policy response might be. But in describing the problem in the bond market the language is important I think – problems are caused when investors turn their attention away from a market by leaving it for good, rather than there being an active move to bring yields higher.

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jcaz's picture

...But hey, way to lock in that 6% paper, buyers...... BUWAHAHAHAHAHAHHHA

DoChenRollingBearing's picture

My guess?  Spain is ahead of Italy by 3 - 6 months.  Then Italy will be ahead of FRANCE by 3 - 6 months (maybe sooner if Hollande keeps going crazy).  If/when France goes off the cliff (and by my personal working definition, Greece is just going off the cliff now), then GERMANY is next...  France goes, the tsunami arrives VERY QUICKLY here.


whirlybird rules's picture

maybe...  and eventually, definitely.

Underestimating how far these dogs will go to protect their interests can be expensive.

kaiserhoff's picture

El Toro's revenge.  Coming soon to a central banker near you.

BeaverFever's picture

I hope that BathHouse Barry doesn't see this pic or he'll be ordering up some of his special Reggie Love. "End" result, a cancelled debate, Chewbacca goes on a tear, and plugs Biden fills in as the Joker.

As C3PO would say, "We are doomed"

DoChenRollingBearing's picture

That was kind of an incredible rant!

+ 1

Spitzer's picture

Bet you didn't know this...

3 of the 4 richest countries in the world have no minimum wage laws.

(as per World Bank and Wiki)


Handy for arguments with your communist freinds.

CPL's picture

pay the labour what it's worth and what you can afford.


Worked for 7000 years except the last 100 for some reason.

Parrotile's picture

With the abundant evidence of the rich becoming far richer, whilst the poor (and lower strata of "society") have seen real wage stagnation or net negative movement in real buying power since the 1970's I'd tentatively suggest that it's not a case of paying "what it's worth and what you can afford", rather a case of "paying the very least you can legally (or often not legally) get away with", which of course includes the ever-fashionable "offshoring" strategy of padding the bottom line (and assuring nice bonuses for all the non-Executive Board members . . . . )

GoodMorningMr.VanRumpoy...'s picture

"With the abundant evidence of the rich becoming far richer, whilst the poor (and lower strata of "society") have seen real wage stagnation or net negative movement in real buying power since the 1970's..."

Why do you think this is so?

Inflation is the greatest creator of income disparity.

You can blame bubble boy Ben/Greenspan for that and the Shadow banking system.

DoChenRollingBearing's picture

@ Spitzer

+1  Good observation, nice digging!

Urban Redneck's picture

Switzerland doesn't have a minimum wage and the poverty threshold is the obscenely expensive stratosphere (around 50k/yr which really wouldn't go far here).

Spitzer's picture

I looked.

As far as I know, they do have a minimum in SW. If you have any evidence that they don't , shoot me a comment on my blog.

Spitzer's picture

I looked.

As far as I know, they do have a minimum in SW. If you have any evidence that they don't , shoot me a comment on my blog.

Tango in the Blight's picture

Switzerland is a fabulously expensive country to live in so with 50k/y you are dirt poor there.

Dick Darlington's picture
Debt/GDP would peak around 100% according to our simulations, including € 100 bln of bank recapitalization costs

Here's where this analysis goes "off track". They use the goal seeking Eurostat debt figures which are designed to make govt debt look smaller than it is. Bank of Spain publishes "closer to the truth" data with breakdowns between different levels of government. Currently the difference between Eurostat and Bank of Spain data for govt debt is almost 200 billion ie almost 20%-points in debt/GDP terms.


GolfHatesMe's picture

Is this the day we finally run out of Carpet to sweep this shit under?

I sure hope so, and am looking very forward to a 200+ drop for some Midletons at 4:05

Cold Grub's picture

In cowboy terms, that's called an ivory enema

kaiserhoff's picture

And you never forget your first one?

timbo_em's picture

"We estimate it [the Spanish deficit] to be between 7% and 7.5%"

Yeah right. That number might hold if the year ended a month ago. Double digits, bitchez with more and more regions admitting that they are broke.

ebworthen's picture

Extend and Pretend.

Bleed out the assets of what is left of the middle-class while pumping money to banks.

Cut already taxed and promised entitlements to those who paid and call it "austerity" versus "anal rape".

Lather-rinse-repeat until banks are solvent, bonuses paid, politicians protected, citizens oppressed and disenfrahchised.

Parrotile's picture

Lather-rinse-repeat until banks are solvent, bonuses paid, politicians protected, citizens oppressed and disenfrahchised.

I sometimes wonder just how far the "privileged" would go to protect "their" interests, once push comes to shove. We already know they are quite happy to use non-lethal (supposedly) means - tear gas, rubber bullets, tazers, water cannon, acoustic/microwave weapons - so what would happen when these proved "insufficiently effective"? Seems 0.40 HP might be an early choice in the US, and the Police / Militia, National Guard and fulltime Military have a very large arsenal of anti-personnel toys paid for by the long-suffering taxpayers.

Wonder how long before we start to find out.

seabiscuit's picture

I'm thinking that with the NDAA they will be most happy utilize any means necessary. Or am I simply droning on here?

ziggy59's picture

So the Bull is The Fed, and the Matador is the Public, got it.

Dareconomics's picture

The numbers quoted by both cheerleaders analysts are off. Spain needs to finance at least €60bn based on my calculations with an assumption of a 8.1% budget deficit. Keep in mind, that is a very conservative estimate. The deficit was 4.1% for the first half of the year, and the second half has seasonally lower revenue collections coupled with worsening economic conditions:


DrewJackson's picture

Delay - Pray - Pepper Spray.  No video taping!!   The new normal.

falak pema's picture

Aww; all he needs is 12 months and then Mutti will get elected and then Spain will be saved!

q99x2's picture


Everything is ice-neined together at this point. Markets are like a shatterproof windsheild. If there is a crack the whole thing pulverises.

Poof. Say hello to the real world.

Nothing has been allowed to vary much for nearly 10 months. Instant Karma headed our way.

stiler's picture

why so bullish?

flyonmywall's picture

Europeans need to realize that the dictatorship in Brussels doesn't give a rat's ass about them. Their goal is only to enrich themselves and their banker friends on the backs of the serfs of Europe. Things haven't changed in 500 years, they just dress it up more with fancy words and call it "austerity". It's really EXPLOITATION of the many, for the benefit of the few. Nothing different than Louis XIV. Time for the guillotines again.

Zero Govt's picture

"The circular rationale for believing that Spain is anything other than a basket case is remarkable."

Delusion has set in. And it's prevalent (and 100% predictable) in all monopoly power structures, be it tribal leader, royal families, Govt, central bwankers or monooly corporations

erecting a throne to Lord it over society as Govt is was never going to have much positive outcome but it's got worse than that, this deranged scum is out of control and wrecking everything

it won't end until we end the monopoly

Govt, it's total shit, let's flush it... stop the tax

Manic by Proxy's picture

The photo at the title of this article was the year end winner in 1992's edition of El Toreador y Ani en Fuego magazine. This picture was of a matador who became known as El Grande Cornjolio.