Thoughts on Spain's Stress Tests and ESM

Currency in Crisis

Spanish officials will likely find comfort in the results of the latest stress tests.  They can still feel as if the 100 bln euro line from the EFSF/ESM will be more than sufficient.  In fact, a formal request for the funds may be made within days.  

Recall that the IMF's stress test was based on 4% economic contraction and a 20% decline in property prices, with a core Tier 1 capital of 7% (the Basel III requirement by 2019).  It concluded that under such conditions Spanish banks would need about 37 bln euros.  

The stress tests reported today assume a 6.5% decline in GDP, another 26.4% in house prices, and 9% Tier 1 capital.     Thus the tests are a bit more rigorous than the IMF's,  Wyman estimated Spanish banks would need 16-25 bln euros in base vase and 51-62 bln in the adverse situation.   Berger estimated Spanish banks would  need almost 52 bln euros under the stress conditions.  

The markets did not appear to respond much to the news.  The local market was closed or nearly so and the euro put the lows in for the session about an hour after the news. 

It is still not clear what Spain is going to do.  It has been reluctant to set up a bad-bank as say Ireland has done, but the EU may insist.  Bank of Spain Governor Restoy has confirmed that the auctions of seized banks, Caixa, Catalunya and Novagalcia, have been postponed. 

A more detailed audit on of Spanish banks on an individual level was due at the end of July and now looks to be postponed until September.  This is being suggested to be a proper valuation of the banks' assets and classification of those assets. 

Where is Spain going to get the funds for the banks?  The EFSF and ESM.  European officials prefer using the permanent institution, the ESM.  Here is the problem:  it does not exist.  Of the 17 members, only five have approved (France, Netherlands, Greece, Finland and Slovenia).    

Yet, those currently receiving aid cannot be expected to contribute.  Spain's share is 12% or 60 bln euros.  Can Italy, where a Treasury official told parliament today that it will overshoot its budget deficit target by 4 bln euros (and that might be optimistic), be really expected to provide Spain with 18 bln euros, which is its proportionate share of the 100 blnl ? 

Germany's share is 27%.  Today the German Constitutional Court put a wrench in Merkel's plans.  The Chancellor will met with opposition parties earlier today to ensure that the June 29 vote approves ESM.  The SPD and Greens understand that Merkel needs them and in politics, needs are the basis for concessions.  They will push for the financial transaction tax and, perhaps, easing pressure on German states to cut spending. Merkel also agreed to push for another 100 bln euro of funding on the EU level, which seems broadly consistent with the growth pact proposal of Hollande and Monti. 

The German court declared that it would need at least three weeks to consider the thorny legal issues raised.  This "at least three week" period  is be after the parliament vote but before German President Gauck signs the bill.  This delay is more embarrassing that substantive and will likely eventually rule in favor of the ESM.  This is because the German parliament will have an effective veto over any disbursement of ESM funds (Germany has a blocking vote on the ESM board). 

The fiscal pact, which is also tied into the legislation for ESM may be more precarious from a constitutional point of view.  It gives the European Court of Justice the authority to uphold and enforce the fiscal rules over potential German parliament efforts to overturn or violate them.   Media reports suggest the a legal challenge on June 29 to the fiscal pact is being planned.