Lingering Spanish Banking Woes Being Resolved
A major cause of the lingering concern towards the euro has been angst about the health of Spain’s banking system, resulting in an outflow of deposits to safer havens and disruption to funding markets. Hence, the decision by the Spanish government, after months of dithering, to seek €100bn of outside assistance to recapitalise its banks has come as a relief in some quarters. The initial response to the bailout news was a short-lived rally in global equity prices. At least markets now supposedly know the size and source of bank recapitalisation funds.
The equally important issue of restoring fiscal sustainability to Spain has not, however, been addressed. Markets have paid attention to the fact thatSpain’s public debt-to-GDP ratio could rise even further under the bailout. ForSpain, it is a key metric for fiscal sustainability, imparting a significant influence on the sovereign cost of capital.
How Much Assistance Is Really Needed?
The exact amount of financial assistance offered to Spain’s banks will be determined by the result of an audit currently being undertaken. Based on year-end 2011 data, the International Monetary Fund (IMF) recently concluded that at least €37bn of capital injections was required, assuming a cumulative -2% decline in real GDP in 2012 and 2013, along with a -9% decline in house prices. The IMF’s analysis did not, however, assume further degradation of bank asset quality from year-end 2011 levels, as well as higher default rates on loans.
The cost of recapitalising the banks will be far higher if the IMF’s adverse scenario of a -5.7% cumulative contraction in real GDP in 2012 and 2013 transpires, coupled with a -24% fall in house prices. Small wonder why the IMF is recommending Spain accepts the €100bn funding offer as an insurance buffer against the adverse scenario!
More Public Debts
The bailout, regardless of its size, will also add debt to the public sector because the funds will not be injected directly into the banks. The funds will probably be sourced from the European Financial Stability Fund (EFSF) or European Stability Mechanism (ESM) and channelled into the government entity (FROB) established to clean up the banking system. General government debt in Spain has risen from just 40% of GDP in 2008 to almost 80% in 2012. The IMF estimates general government debt will reach 89% of GDP in 2015, even before accepting the bailout. It is already on an unsustainable fiscal path.
Tough to Achieve Fiscal Sustainability
Spain has been struggling to meet the basic conditions of the Stability Pact. If Spain accepts a €100bn bailout, general government debt would immediately rise by 9.5 percentage points relative to GDP. Under the IMF’s baseline forecasts, general government debt would then be close to 100% of GDP by 2015, raising potentially big concerns about fiscal sustainability and sovereign borrowing costs. Things would get very ugly under the IMF’s adverse scenario due to nominal GDP contacting a cumulative -6.3% in 2012-13. There are clear implications for the Spanish government bond market. The bailout will not necessarily lower Spanish government bond yields.
Implications for Capital Markets
If the IMF is recommending that Spanish banks should be recapitalised to be able to endure the adverse scenario, then the implications for budget deficits and bond markets are potentially huge. A cumulative -5.7% contraction in real GDP in 2012-13 would increase projected budget deficits significantly. The Spanish government’s borrowing requirements will undoubtedly rise as the tax base shrinks. Given that the EFSF and ESM will have more senior ranking in terms of financial claims on the Spanish government, there is a significant risk that spreads on Spanish government bonds could widen dramatically under the adverse scenario.
In the short-term, the bailout has provided the Spanish government with some breathing space: the terms of these funds are far less onerous than tapping the private sector via higher issuance of sovereign bonds. The bailout does not help to put Spain on a more sustainable fiscal policy path by reducing public debt. It is not a panacea!
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