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

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.