Goldman On Spain's Tension-Inducing Arrogance

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Spain needs external financial support – a view that is now clearly held by the consensus. A swift and smooth move by Spain to request external support is needed to validate the recent improvement in market sentiment towards Spain (and an improvement in financial markets more broadly). Mr Draghi's announcement of the ECB's new Outright Monetary Transactions (OMT) scheme offers a vehicle for that support. Goldman believes that the Spanish authorities now need to get on board the vehicle by requesting EFSF support.

Goldman Sachs: Tensions With Spain Set To Increase, Sooner Or Later

Spain's larger size implies that this external support needs to be more flexible than was the case for Greece, Ireland and Portugal. This flexibility is what the ECB's OMT scheme provides: the ECB's balance sheet can be used to purchase short-dated sovereign debt when a country has accepted the conditionality that accompanies a request for parallel support from the EFSF.

Yet the effectiveness of the ECB's initiative requires governments to act responsibly: both over the longer term in making the fundamental reforms to meet the conditions set by the EFSF and in the shorter term by moving smoothly to accept EFSF conditionality.

We had previously expected Spain to make a request for EFSF support at the Eurogroup meeting at the end of this week. This has proved overly optimistic and we therefore revise our view. While a later formal request to the EFSF ahead of Spain's end-October redemptions should prove sufficient to contain re-emergence of intense market pressures, some disruptions cannot be ruled out. And while Spain is seen to prevaricate on the basis of domestic political concerns, German public and political opinion can become further inflamed. With German sentiment already sensitive to announcements, seeking protection in the form of tighter conditionality may only make Spain more reluctant to request help and therefore intensify the difficulty.

 

Near-term and medium-term risks becoming evident

Beyond the weak economic fundamentals that imply Spain will ultimately require further external support, the main risk currently stemming from Spain is that the government loses the incentive to reform if it is guaranteed that the ECB will purchase its debt.

  • Near-term risk – current deliberations over Spain’s agreement to conditionality suggest Spain is willing to push to the limit the market’s tolerance for a slower transition to EFSF support.
  • Medium-term risk – even when Spain is subject to conditionality within an EFSF programme, the imperfect nature of monitoring could tempt Spain to exploit the ECB’s preparedness to buy its debt.

In European Economics Daily ‘The ECB’s new measures: Bridging and/or breaking Europe’s ‘red line’’, we forecast that Spain would submit a formal request for external support at this week’s Eurogroup meeting. That request would then be followed in the second half of September with broader agreement on EFSF support with other Euro area member states. We also noted an alternative view where Spain delays seeking EFSF support so as to meet domestic political constraints. On account of signs of that reluctance – against a background of improved market conditions – we believe that the risk of this delay is materialising. Other interpretations of the delay are possible: Spain may be delaying on account of the publication of bank-by-bank stress tests at the end of September. Nonetheless, we are revising our view of the base case.

We also highlight, however, that the timing of any formal request will depend on market tensions, which in the past have proved a forcing mechanism for (often overdue) political action. We continue to believe that Spain will need to submit a request for EFSF support before its redemptions on October 29 and 31.

While – as we have seen in the case of Greece – various forms of cash management allow Spain to avoid a hard 'cash flow' constraint should support not be in place prior to the October redemptions, we would see a failure to deliver the anticipated programme request by then as disruptive.

Beyond the near term, a problem with incentives

As we have pointed out in the past, we continue to believe that a move by Spain to require EFSF/ESM support will ultimately prove inevitable. This suggests that the more substantial risk is the medium-term risk of a more awkward relationship developing between Spain and the broader Euro area. Based not merely on the latest signals from Spain but also on the incentives we have noted above, we believe this risk applies. Applying conditionality is always difficult in practice – still more so when a country has a large primary deficit, as Spain does, and can be perceived as taking undue advantage of central bank financing.

Beyond Spain, beyond the near term

Looking beyond Spain – specifically to Germany – brings together the two factors we have highlighted:

  • The risk of a near-term delay in Spain’s request for EFSF owing to a reluctance to be submitted to conditionality.
  • The ‘moral hazard’ risk that Spain slackens in its efforts to meet conditionality once external support is sought. We do not expect major changes to Spain's current reform programme, although there is a risk of additional structural reforms being requested, particularly if Spain delays further.

The opposition seen in Germany in response to Mr Draghi’s preparedness to buy sovereign debt implies that current posturing in Spain will not wear well with the politics of signing a Memorandum of Understanding in Germany. The more the Spanish administration indulges domestic political interests and is perceived to be taking undue advantage of external support, the more explicit conditionality is likely to be demanded. This would add to any existing tensions, given Spain’s opposition to conditionality. This is disappointing partly because it is avoidable if Spain were to accept the external support on the terms currently available.

Spain will have the opportunity in the coming weeks and months to demonstrate that it wishes to avoid these incipient risks. But we continue to believe that some of the incentives created by Mr Draghi's preparedness to act could prove difficult to resist.