Spain: Serving Too Many Masters

In recent weeks, we have been highlighting the twin challenges Spain faces: the banks and the regions. Separately either could force Madrid into the arms of the Troika. However, Prime Minister Rajoy appears to have staked his political credibility on not seeking international assistance. This hubris will prove his nemesis, and this is an area in which postponement will likely produce a larger bill, when the piper calls and rest assured the piper will call. 

Spain, recall, is the world's 12th largest economy. This means that the magnitude of its problems are going to be substantially larger than Greek, Irish and Portuguese challenges. If the Spanish economy was going, the bank and regional problems would be severe, but the fact of the matter is that the Spanish economy is contracting. Moreover the pace of contraction may be accelerating. The 9.8% year-over-year contraction in April retail sales, reported earlier today, is a record pace and on a price adjusted basis, is even worse (-11.3%). The PMIs due out in the coming days may underscore the deepening Spanish recession.

Rajoy insists that despite the recession, Spain will adhere to its agreement to slash the deficit to 5.3% of GDP from a revised 8.9% last year. And this is despite unemployment already at nearly 25% and a relatively tight monetary policy. As Spain has repeatedly done, it will most likely overshoot this year's target.

Consider that Spain's Jan-April deficit came in at 25.5 bln euros, up from 19.7 bln euros deficit in the Jan-March period. Making conservative assumptions, it would suggest Spain is on track for about a 6.5% deficit this year.

Two weeks after Madrid accepted all but regions' 2012 budget, Catalonia says it needs help. At the end of this week the Rajoy government is expected to unveil new mechanism to support the region's debt. The regions' debt is 140 bln euros and face some 15 bln in redemptions this year. Catalonia is among the most indebted of the regions. It has paid about 8.3% to borrow for a little more than a year.

There is an ironical parallel between Madrid and the regions and the euro zone. Some of the more indebted regions in Spain, including Catalonia, are arguing for the "mutualization" of their debt, in the same way the some of the debtors in the euro zone are calling for joint bonds.

In the middle of May, Madrid arranged a syndicated loan from banks to a fund to help the regions and towns settle unpaid bills. When it was clear that such funds would be available, the regions and towns "discovered" previously unacknowledged past obligations.

In addition to the regional demand on Madrid, addressing the banks' problems will also tax the Rajoy government. It has consistently under-estimated the cost of stabilizing the banking system. Look at what has happened to Bankia. The 4.5 bln euros of preferred shares were converted to common shares. The price tag, however, continued to rise and by the end of last week it was 19 bln euros and the risk is that the true costs are still being under-estimated. 

Twice now since Rajoy was elected late last year, Spain has asked banks to increase their provisions. The first "request" was for almost 54 bln euros in Feb and then earlier this month, the second "request" was for another 30 bln. Yet, outside estimates warn that the total bank losses could be closer to 270 bln euros.

We have argued that Spain's property and housing bubble makes its particularly difficult to project the ultimate losses of the banking sector. Some studies have suggested that property and housing prices have "only" corrected about half of what will eventually be needed to clear the excess supply (estimated now at more than a million houses).

Rajoy is arguably being obstinate. It is increasingly clear that Spain needs international assistance. It cannot simply create limitless money by recapitalizing the banks with government bonds that could then be used for collateral at the ECB. At the same time, because of the official sector refusal to participate in the Greek hair cut any EFSF/ESM funds dilute the seniority of current investors and, in turn, could scare off future investors (or expedite the foreign exodus as foreign share of Spanish bonds has fallen from about 50% at the end of 2011 to about 37% at the end of April).

Rajoy has essentially delivered three no's. No bank failure. No region failure. No international assistance. Something has to give and the international assistance seems to be the most likely to yield in the face of political and economic reality. There is some concern if the EFSF/ESM has sufficient funds. 

Remember what is involved here is not what was the case for Greece, Ireland and Portugal. International assistance to recap Spanish banks and to help fund the regions is much cheaper than funding the next three years of Spain's borrowings. In fact, by receiving some assistance, there would be greater clarity of Spain's fiscal situation and might succeed in arresting the erosion of investor confidence.