More Thoughts on Spain-Lite

Currency in Crisis

Greece has been the model for Portuguese and Irish aid.  This may or may not have been fair and appropriate.  After all, the nature of the Portuguese and Irish problems were dissimilar from Greece and each other.  Spain's is more like Ireland's.  The key differences include Spain's size, officials have progressed on a learning curve, and the now perceived greater vulnerability of the whole EMU project. 

Spain will offer a new model.  Despite the claims made by the Rajoy government, it will borrow funds to help it recapitalize the banks.  What appears to be being worked out is the dimensions of the aid and the terms.  If Greece was the model and Spain would be given aid sufficient to keep it out of the capital markets until the end of 2014, it would need 375 bln euros, which assumes around 100 bln for the banks.  This would make a major dent  the 500 bln ESM that is to be launched next month. 

The Spain hopes, and European officials appear willing, to allow it to borrow for a limited purposes in exchange for limited conditionality, which it is hoped can minimize any associated stigma.  It is not clear what concessions Spain is making to push through such an agreement.  It looks like it missed an opportunity to show its good faith.  

Consider this inside story:  The Bank of Spain Governor stepped down a month earlier and the Rajoy government needed to replace him.  ECB's board member from Spain, Gonzalez-Paramo's term ended last month and ECB officials were pressing for his appointment as governor of Spain's central bank.  Instead, Rajoy has appointed Linde, who had previously managed the central bank's international affairs and  country-risk division.  Linde had retired at the start of the year, but was called back recently.   

Since the Rajoy government came to power at the end of last year, the socialist Ordonez had been sidelined.  Ordonez's resignation coincided with Linde's return.  Given Linde's age and central bank rules, Linde can only serve 3 years, which means he is unlikely to see Spain through to the other side.  

The amount of money Spain needs for its banks is not yet clear.  The IMF conducted a stress test, assuming a 4% economic contraction in late April and it will formally issue a report on June 11.   It has already been reported that 70% of Spain's banks passed the stress test.  

Spain has also hired private auditors to examine the banks' books.  Their report is due before the end of the month.   Fitch estimated Spain's banks need 60-100 bln euros.  S&P's estimate is 80-112 bln euros for 2012-2013.  The Center for European Policy Studies says Spanish banks need 270 bln euros to cover what it projects to be as much as 380 bln euro in losses.  Moody's estimate bank losses at 306 bln euros.  

The challenging with estimating the needs of Spanish banks is that the real estate and housing market, the key assets on the banks' book have not completed unwinding the bubble.  The Bank of Spain itself classifies 180 bln euros of 300 to bln real estate related loans as "troubled."   

This does not include mortgages for which Spanish banks have lent around 655 bln euros. Residential mortgages are still carried a full value by the banks even though house prices have fallen more than 25% since the bubble peaked in 2007.  Only 2.8% of residential mortgages are considered non-performing.  With nearly 1 in 4 unemployed in Spain and still falling property and house prices, one need not be cynical to suspect a greater problem lurks here. 

Through Socialist and now Conservative governments in Spain, officials have repeatedly under-estimated the cost of bank support.  The risk is that they again stay true to this pattern.  It also seems in European officials interest to minimize the problem as well. It will preserve more funds for the ESM, which does not yet truly exist.  It will justify a break from the Greek model.  

As part of the "deal" Spain is likely to be given another year to reach the 3% deficit target.  It will also receive some extra infrastructure funding.   However, Europe's ability and willingness to "shock and awe" seems quite limited.  Some creative accounting may also be necessary to allow the sovereign to borrow but not count as the sovereign's debt or deficit.