Spain: The cost of doubt ::BNP Paribas

Spain: The cost of doubt
Uncertainties surrounding banks’ bailout are costly for Spain. Spain’s
10-year spread over Germany exceeds 500 basis points, compared
with half that a year ago. Above all, it is the lack of visibility that
undermines investors’ confidence. They are clearly reluctant to fund a
recapitalisation if they don’t know the extent of the whole problem.
Yet, even if the government undertook the complete recapitalisation
of the banking sector, and assuming it amounted to €100bn, that
would represent 10% of GDP, far short of the 45% of GDP needed in
Ireland. It would be definitely better to get an accurate and final
estimation from an independent body of the total bill for bailing out
Spanish banks than getting gradual and partial news.

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Taken as a whole, Spanish debt is the same as two years ago
(around 260% of GDP). The catch is that its composition has
changed (see chart). Transfers of debt from the private to the public
sector (and vice versa) are a classic phenomenon. When activity
falls, it is usual to see the government taking over from private
demand via stimulus programmes or simply via automatic stabilisers,
with lower receipts and higher spending reflecting a smaller tax base
and increased unemployment. In this case, a wider public sector
deficit creates a window of opportunity for the private sector to
consolidate its finances, and the latter’s subsequent expansion
permits a return to budgetary equilibrium. This two-stage
‘communicating vessel’ arrangement works without putting pressure
on bond markets, so long as the markets expect a reduction in t+1 of
the government deficits posted at t. And that means credible fiscal
consolidation at the point where activity is robust enough to cope with
it.
Despite a possible one-year deadline extension granted by the
European Commission, the deficit reduction timetable for Spain looks
too short. This results from both a lack of economic and political
coordination within Europe and the European partners’ lack of
confidence in each other. In spite of drastic austerity in Spain’s 2012
budget, automatic stabilisers are still weighing heavily on the
government’s accounts and still unresolved problems in the banking
sector are pushing up sovereign risk.
Against this backdrop, Bankia’s recapitalisation is something of a test,
even though the amount involved is relatively modest (€19bn, or less
than 2% of GDP) and Spanish government debt represents ‘only’
70% of GDP. Here, too, the issue is one of credibility. It is unlikely
that the Spanish banking sector’s difficulties are restricted to a single
institution or that losses are concentrated exclusively in assets related
to the property market.
To avoid tapping the markets, officials proposed a recapitalisation
through a direct injection of sovereign bonds into BFA (Bankia’s
parent company) in return for a public equity stake.
Using the bonds as collateral, BFA could then obtain funding from the
ECB and subscribe to the Bankia capital increase. Unsurprisingly, the
ECB was hostile to the plan, as it would effectively mean direct
central bank funding for the Spanish government.
It seems instead that the Bankia recapitalisation will probably involve
the Fund for Orderly Bank Restructuring (FROB) created in 2009,
which would issue bonds guaranteed by the Spanish State. This
solution would necessarily prove costly, making further public
recapitalisation initiatives – a likely prospect – more difficult. The
alternative would be a request for European financial support from
the EFSF and ESM (the latter is to be activated on 1 July), as these
funds are available specifically for bank recapitalisation. But the aid
request would have to come from the government. For now, this
option appears to be politically unacceptable. This is one of the
weaknesses of Europe’s response to the crisis. Appeals to financial
support create stigma and fail to restore investors’ confidence.
Greece, Ireland and Portugal waited until their backs were against
the wall before calling for help. Inevitably this means a greater
financial and social cost in the end, and for both lenders and
borrowers.