The Financial Squeeze in Spain to Intensify

The Greek finance minister says Greek banks should accept the second hair cut of the year out of a sense of patriotism.  They are understandably balking, but may concede if the officials grant them full recognition of deferred tax assets in capital calculations.   

The Greek bond buy back is the main talking point in Europe and upon it rest the hard won agreement to fund Greece so it can keep its creditor whole.  

Spanish banks may quickly take the spotlight.  Earlier this week, the European Commission cleared the last important hurdle to a 37 bln euro injection into Spanish banks by approving the restructuring plans which comprise the conditions of the assistance.  

The restructuring plans are more severe than many market observers seem to appreciate.  It is difficult to see how it won't serve to be another headwind for the Spanish economy.  There are four banks who will receive aid are committed to slashing their balance sheets by 60% over the next five years.  

They will sell 45 bln euros of real estate assets to Sareb (Spain's 'bad bank' that is to be set up next month) at a discount of more than 50%.  They will shutter hundreds of branches (Bankia, the product of an earlier attempt to restructure Spanish banks, will cut is branch network by 40%).  Employment at these banks will be cut by around 30%.  

The restructuring of Spanish banks may impact various non-financial corporations.  As we noted previously,  Spanish banks hold large ownership stakes in Spanish companies.  Bankia, for example, has a 20% stake in Indra, the large technology company, a 12% stake in International Airlines Group and a 5.3% stake in Iberdrola, and smaller investments in an insurance company and a hotel operator.   Such non-core assets will also have to be sold.  This holds out the promise that financial reform in Spain could help spur a wider corporate restructuring as well. 

Some creditors of  the four nationalized banks will also be 'bailed-in".  This is to say that preferred share holders, holders of perpetual subordinated debt and subordinated debt will take haircuts, which combined are valued at around 10 bln euros. 

The IMF says that other banks must stop into the breach and fill the vacuum created by the reduced balance sheets of these nationalized banks.  This is a great deal easier said than done.  Instead, the most likely scenario that the restructuring will exacerbate the credit crunch and further undermine the economy.  

It is here that the Rajoy government seems to be in the greatest denial.  It expects the recession to end by the middle of next year and unemployment to decline.  It expects the economy to contract 0.5% for all of 2013.  That this is largely wishful thinking is easy to demonstrate. 

Rajoy is committed to reducing the budget deficit by 1.8% of GDP in 2013.  What do you want to use as a fiscal multiplier?    The recent mea culpa by the IMF suggests that it has under-estimated it.   It now estimates the fiscal multiplier to be between 0.9 and 1.7.    

The official forecast seems to assume a 0.3 multiplier.  This seems unreasonable.   Still be optimistic, but less, so, assuming that every euro raised in taxes and saved via a cut in spending will take a euro out of the economy, that is a 1.0 multiplier, a contraction of 1.8% should be expected. 

Rajoy is seems to be pinning much on exports.  Through the first three quarters, Spanish exports have risen 3.5%. This is about half of what is needed.  And with the euro area in recession and domestic demand in Germany, judging from today's retail sales report (-2.8% month-over-month  in October), nearly non-existent, and the auto sales declining, it is difficult to see a significant pick-up in Spanish exports. 

In addition to Spain's federal deficit issue and the challenges of the banks, the third leg of Spain's debt stool may move back into focus next week and that is the regional debt.  Roughly half of Spain's states have request support that nearly exhausts the 18 bln euro fund that was established in July.  

Although the media frequently reports that Spain has met this year's funding need, in truth it has yet to raise funds for a third (6 bln euros) for the regional fund.  Moreover, there may be additional requests ahead of the Dec 3 deadline.   

To be sure, all the requests are not met in full, but this just adds to the confusion.  Spanish regions are largely locked out of the capital markets and were able to raise less than 10% of this year's funding needs through bond sales. Rajoy is earmarking 23 bln euros for regional funding next year.  However, Catalonia alone needs about half of this, according to Fitch--the rating firm jointly owned by a US and French company..  

With  Spain's 10-year bond yields slipping to 8 month lows today, Rajoy appears to be under little market pressure to seek greater EU assistance.  As next year's record refunding gets under way, with the economy under-performing, and without the help of a new LTRO, we would expect pressure to mount and Spain to formally request assistance with yields higher than currently prevailing.