DON'T let anyone tell you that fear about Europe's sovereign debt crisis is irrational. It was the market 's initial, euphoric rally on the weekend news of Spain's ?100 billion ($A126 billion) bank bailout that read from the wrong script, or at least from an overly simplistic one.
The rally became a selloff because of the way the bailout money might flow. Spain failed to negotiate a direct injection into its banks. The dough will move to them through Spain's own bank bailout fund, which means that Spanish government debt will rise from 80 per cent of gross domestic product to 90 per cent of GDP.
The new money will also rank for repayment ahead of existing private sector Spanish government bondholders if it is sourced from Europe's new permanent bailout fund, the European Stability Mechanism (ESM). It may rank equally with existing debt if it comes from the temporary European Financial Stability Facility, but the EFSF will be replaced by the ESM soon, probably next month.
Key European nations, including Germany, favour using the ESM because it gives them better security, and a new tier of preferred debt makes existing Spanish debt potentially less valuable: in the event of a full, Greek-style rescue for example, existing bondholders are less likely to be paid in full.
Meanwhile, the ability of even a ?100 billion lifeline to breath life back into Spain's banking sector remains up for debate. At the low end of estimates, Spain says it might only need ?40 billion. Credit Suisse says that if property loan losses run to 53 per cent of their nominal value, its worst case scenario, losses will total ?155 billion. Spanish non-property loan loses would expand the crater to ?249 billion.
Spain's banks are in a by-your-bootstraps position. They took 1 per cent, three-year European central bank funding and bought Spanish government bonds in the first quarter of this year, driving yields and Spanish government borrowing costs down.
Fears about their financial health and the ability of Spain to assist them then drove Spanish government bond yields up again, creating losses on the banks' bondholdings, and making the case for their rescue even more pressing. Spain's government hopes they can buy again, and keep a lid on borrowing costs, but the bank rescue itself makes that less likely, and may not be big enough to save the banks anyway.
Greece's new election looms on Sunday, and Italy's moribund economy and 120 per cent debt-to-GDP ratio is on the horizon, and steaming in. Taking money off the table is the right thing to do this week.
AHOLY grail of infrastructure funding moved a small step closer yesterday when New South Wales Treasurer Mike Baird confirmed that State Super, the pooled fund for four New South Wales government defined-benefit schemes, will consider increasing its exposure to NSW infrastructure assets.
State Super has a $31 billion portfolio, with about $2 billion sunk into local and overseas infrastructure. Baird didn't announce any new privatisations yesterday, but he did create a swat team inside NSW Treasury to consider the options, and an increase in State Super's allocation to NSW infrastructure assets improves them.
It's part of the emerging consensus that governments can finance new infrastructure without blowing up their balance sheets by selling existing infrastructure to super funds.
Federal Infrastructure and Transport Minister Anthony Albanese's infrastructure working group is looking at the same thing, and the Business Council of Australia endorsed it last week, saying private ownership of infrastructure assets was the preferred model where there was a contested market, or a regulated one that gave investors an adequate return.
Super funds prefer existing infrastructure to infrastructure projects, There is no development risk and they can more easily price something that already has a track record.
They are, however, charged with preserving and growing asset values and superannuation returns, and government asset sales that re-create the sort of losses taken in the private sector on government toll road and tunnel tenders are going to kill the goose. Governments will need to pitch sales at prices that give super funds confidence that they are locking in secure long-term investment yields.
The funds have always argued that they don't own a lot of Australian infrastructure because there isn't enough of it to buy, but they will have limits of their own, too.
They diversify risk by holding a basket of assets, including shares, fixed interest securities and alternative assets including infrastructure. Current infrastructure allocations are between 5 per cent and 15 per cent, and an increase in available assets from government privatisations won't radically change the mix.
Australia's infrastructure funding shortfall can in fact only be totally filled if overseas equity capital is also imported, often in league with an Australian infrastructure investor, as occurred with the Sydney desalination plant privatisation. Selling old infrastructure to pay for new is a good idea, and an overdue one, but it will drive foreign ownership of Australian infrastructure higher as it is implemented.
Frequently Asked Questions about this Article…
What did Spain’s reported €100 billion bank bailout mean for everyday investors in Spanish government bonds?
The headline €100 billion lifeline initially lifted markets, but investors later sold off because the money is routed through Spain’s own bank-rescue fund. That raises Spanish government debt (from about 80% to 90% of GDP) and, depending on whether funds come from the new European Stability Mechanism (ESM) or the temporary European Financial Stability Facility (EFSF), new financing could rank ahead of existing bondholders. In short, the bailout reduced confidence in the value of some existing Spanish bonds and pushed yields higher.
How does the European Stability Mechanism (ESM) differ from the EFSF — and why does that matter to bondholders?
The EFSF is the temporary rescue vehicle and the ESM is the permanent fund that will replace it. If bailout money comes via the ESM it may create a new tier of preferred debt that ranks ahead of existing government bonds, meaning existing bondholders could be paid after the new money. Money from the EFSF may rank equally with existing debt, but the likely switch to the ESM makes existing bonds potentially less valuable for investors.
Will the €100 billion bailout be big enough to save Spain’s banks?
That’s uncertain. Spain has suggested it might only need around €40 billion at the low end of estimates, but independent analyses such as Credit Suisse’s worst-case look at much higher losses — for example, property loan losses alone could total about €155 billion, and adding non-property loan losses could expand the hole to about €249 billion. The article stresses the rescue fund may not be large enough to fully heal Spain’s banking sector.
How did Spanish banks’ use of ECB funding amplify risk for investors?
Spanish banks borrowed cheap, long-term funding from the European Central Bank and used some of that money to buy Spanish government bonds. That initially pushed yields down, but when fears about the banks and Spain’s ability to support them resurfaced, bond yields rose and the banks incurred losses on those holdings — worsening their balance sheets and increasing the urgency (and uncertainty) of any rescue.
Given the sovereign risks in Europe, should everyday investors “take money off the table” right now?
The article suggests caution: with events such as Greece’s election and Italy’s high debt-to-GDP ratio on the horizon, it recommends reducing exposure this week. For everyday investors that typically means reviewing portfolio risk, locking in gains where appropriate and avoiding concentrated exposure to vulnerable sovereign or bank debt — but any action should fit your personal risk tolerance and investment plan.
What are the pros and cons for superannuation funds buying government-owned infrastructure assets?
Pros: super funds prefer existing infrastructure because there’s no development risk and assets have track records, offering predictable long-term returns. Cons: funds must preserve and grow member wealth — so if governments sell assets at prices that recreate past losses (for example on toll roads), that hurts returns. Also super funds have allocation limits (current infrastructure allocations roughly 5–15%), so large-scale purchases won’t dramatically change their overall mix.
What does New South Wales’ State Super considering more investment in NSW infrastructure mean for investors?
State Super, the pooled fund for four NSW government defined-benefit schemes, runs about a $31 billion portfolio with roughly $2 billion already in infrastructure. The NSW Treasurer created a team to explore increasing that exposure. For everyday investors this signals a broader push toward channeling public assets to super funds as a way to finance infrastructure without expanding government balance sheets — but it also means governments will need to price sales to satisfy long-term return expectations.
Will selling public infrastructure to super funds increase foreign ownership of Australian infrastructure?
Yes — the article notes Australia’s infrastructure funding gap can only be fully filled if overseas equity capital is imported, often partnering with Australian investors (as happened with the Sydney desalination plant). So while selling existing infrastructure to pay for new projects is sensible, it will likely drive foreign ownership of Australian infrastructure higher as the strategy is implemented.
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