Why Spain may be More Worrisome than Italy

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Most market participants are more concerned about Italy's debt burden than Spain's. Since July '11, Italy's benchmark 10-year yield has risen through Spain's. In August '11 the price of Italy's 5-year CDS surpassed Spain's. The rating agencies agree and all three of the main agencies give Spain a higher credit rating than Italy.

There are several reasons why Spain may ultimately be more worrisome than Italy. Spain, unlike Italy, has a housing and real estate bubble. The full magnitude of the cost of this is still unclear. Investors and policy makers have a greater sense of Italy's financial burdens than Spain's.

In the middle of December, for example, the Bank of Spain indicated that bad loans in the Spanish banking system were 7.4% of all loans. This is a 17-year high and is still rising. Property price and house prices do not appear to have bottomed and the deterioration of the economy, which likely contracted in H2 11 and appears poised to contract in the H1 12, warns of the downside risks.

The government fund for bank restructuring (FROB) has already injected 30 bln euros into the banks. The EBA says Spanish banks need to raise another 26 bln in capital in H1 12. Spain's new Economics Minister has indicated that Spanish banks may put aside another 50 bln euros (~4% of GDP) aside for provisions for bad property loans.

Investors' focus has been on the challenges that Italy's largest banks face in raising capital. They have yet to turn the attention to Spanish banks capital needs. In Q4 11, the largest Spanish banks indicated they could meet a could part of the EBA's identified needs by simply adjusting their risk asset models.

The linkages between the private sector (banks) and public sector (sovereign) are a subject of great interest, as Ireland's experience, among others, has shown. At the very end of last year, the new government in Spain revealed that the 2011 budget shortfall would be 8% (and an official suggest maybe even a bit more)of GDP rather than the 6% target of the prior government and the EC forecast of 6.6%. The target for 2012 is 4.4%.

In order to achieve it, PM Rajoy unveiled a 15 bln euro tax and savings plan--roughly 40% tax increase and 60% spending cuts on December 30. Rajoy still will need another 30-40 bln euro in savings to reach the fiscal target assuming the government's GDP forecasts are not undershot.

Spain's autonomous regions are a major challenge for the country's overall deficit and debt levels. In the first three quarters of 2011, the regional debt rose 22% from the year earlier period. This does not include the debt of the municipalities, which estimates put near 3-3.5% of GDP.

The Valencia region was in the news this week as it had delayed 123 mln euro payment to a German bank. The Wall Street Journal reported that the payment was finally made because the central government convinced an unspecified bank to make a bridge loan to the region. In December the region's debt rating was cut below investment grade by Moody's following a failed bond auction. This region appear to be to Spain's housing market bubble what Las Vegas was to the US housing bubble.

Italy also has some municipal government debt issues, but again, without the bubble, they seem to be more of a known quantity.

It is true that Rajoy's Popular Party dominates a majority of the regions. Some think this may make it easing to rein in the regional spending, but as often is the case, disputes within parties can be more vicious than between parties. The Andalusia region holds an election in March.

The technocratic government in Italy under Monti seems more in a position to implement structural reforms than in Spain. Italy's capital markets are deeper and there has not been the surge in debt as there has been in Spain. The average maturity of Italy's debt is around 7 years, which means it can sustain higher yields than other countries, including Spain. In addition, given the linkages between the public and private debt, it is noteworthy that when combined, Italy has among the lowest debt in Europe. Moreover, more of Italy's debt is owned domestically than Spain's.

At the end of last year, Italian 10-year yields were more than 200 bp on top of Spain. The spread has narrowed in recent days, but is still well beyond the euro era average of about 10 bp and the late 2008 extreme near 65 bp. There is more room for Italy to outperform Spain.

Lastly, although yesterday's rumors that Spain was considering asking for international assistance were quickly denied, it seems more conceivable that Spain rather than Italy receives assistance. Spain's economy is about 70% of the size of Italy's and its debt (or simply a bank recap scheme) seems more affordable for the IMF/EFSF than securing a multi-year assistance program for Italy.