Spain: Double Barrel Disappontment

The fact that Spanish bank shares have rallied today (3.1% at pixel time) and have easily outperformed the market (IBEX up 0.3%) following Moody's downgrade of 16 Spanish banks should be understood as a bit of a fluke.   Some observers will use this price action as evidence that rating agencies are laggards.  While there can be little doubt that the epithet is true, it is also true that today's correction comes despite some other bad news as well.  This was in the form of the Bank of Spain's latest assessment that bad loans in the banking system rose in March to 8.37%.  

That means that another 8.2 bln euros in loans soured in Q1.  In turn this means that the 30 bln euro that Spanish banks are being required to add to their loan loss reserves will not be sufficient to cover this year's deterioration if it does not slow down.  And there is no reason to expect it to slow as the recession deepens and real estate and house prices do not appear to have bottomed.  

Moreover, the independent audit on Spanish banks will likely reveal weaker rather than stronger institutions.  The stress tests themselves will be conducted in two parts, according to reports.  The first is a stress test that will take about a month to complete.  The second and more important aspect is a detailed analysis of the banks' assets.  

There had been some hope among investors that BBVA and Santander (which by some measures is the largest bank within the euro zone) would be able to escape the fate of the sovereign, which Moody's recently cut to A3.  After all, these two banks have diversified globally and by doing so diluted the impact of Spain's domestic economy on their corporate success.  Sometimes, a company can have a higher rating than the sovereign, but this was not such a case.  Moody's slashed BBVA and Santander by three notches to match the sovereign rating.  

The other area of disappointment comes from a lost opportunity for Madrid to get a tighter hold on the regional fiscal situation.  As we have consistently argued here that the solution to the euro zone problems will come from greater integration rather than less, the same applies to Spain itself, which is the most decentralized member of monetary union.   

The regions account for  around half of government spending and are responsible for health care and education, but it is Madrid that collects most of the taxes.   Ironically, while Moody's downgrade of the banks is the subject of much discussion, considerably less attention has been given to its decision to downgrade four of the regions at the same time.  

Yesterday. Madrid approved the 2012 budget plans of all the regions except tiny Asturias, which has yet to form a government after the recent election (sounds familiar?) and has been given a 15 day extension.  The regional budgets include 13 bln euro in spending cuts and 5 bln euro in revenue increases.  Spending cuts will have to focus on education and health care.  

This is not the end of the story.  By the middle of June the regions are expected to outline their 2013-2014 fiscal plans to Madrid.  In July, Madrid will unveiled a new mechanism to assist the regions that are meeting their fiscal targets in securing financing.  

New "hispanobonos" may be issued, which in effect will be regional debt underwritten by Madrid.  The ICO (Instituto de Credito Oficial) is government's development bank, created in the 1970s.  Institutional capacity (scale) needs to be build but the function in there.  It has already raised 60% of this years 20 bln euro target.  By the end of June it will provide regions with 7 bln euros to cover unpaid bills and 5 bln to cover bond maturities. 

Moreover, as a bank, the ICO can borrow from the ECB and secure lower cost funding that it has to buy currently in the market.   In some ways then the ICO may serve a similar function as the EFSF/ESM does for the euro zone as a whole.  

While this development seems promising, it may be too little too late.  Catalonia and Valencia are the two most indebted regions, with their respective debt equaling a fifth or more of their GDP.  They each face sizable debt repayments over the next few weeks.  The latter has lost its investment grade rating from S&P and has been forced to pay 6-7% to roll-over short-term bills over the past couple of weeks.  

Prime Minister Rajoy missed an opportunity.  Despite the short-term price action, Madrid did not get ahead of the curve here.  Some observers argue that Europe should allow Greece to leave and the crisis that follows will provide powerful incentive to others not to go that route.  In China, they call such tactics, killing the chicken to scare the monkeys.  Madrid failed to do that.  

Rayjoy hinted at more decisive action.  Three regions offered him a opportunity to take stronger action and to get ahead of the curve of expectations.  Madrid could have in effect nationalized Asturias, where an interim government has not agreed on a spending program. 

He could have "nationalized"  Valencia to save it from itself, using its lost of investment grade status and exorbitant interest rates as the rationale.   Lastly, and more risky politically, Rajoy could have found some pretense to reject Andalucia's budget, which was already rejected once.  It is the most populated state and one where Rajoy's Popular Party had failed to capture in a recent election.   

In another parallel to the larger monetary union, the Stability and Growth Pact has existed since EMU began.  In response to the violations, members have been asked to agree to a new and tougher fiscal pact.  A new one may not have been needed as much as the enforcement of the existing one.  

The same is true in Spain.  The problem has not been that the rules were not clear.  The problem lies with implementation and application which Madrid's new agreement and mechanism  does not seem to convincingly address.  

This means that like the banking reform announced last week, there is a lack of closure and that assures that these issues will have to be addressed again.