Risky manoeuvres on Spain's bailout circuit

While European officials congratulate themselves on Spain's bailout, investors will be worrying the rescue merely reinforces the union's doomed dynamic between indebted governments and troubled banks.

Global markets will begin the week anxiously as investors try to work out the implications of Spain’s move to seek up to €100 billion ($US126.5 billion) in international aid so that it can rescue its ailing banks.

Eurozone officials, of course, are hoping that markets will be reassured to see that Spain has at last agreed on a plan to shore up its troubled banks, which suffered massive losses following the collapse of the country’s real estate bubble.

Spain’s borrowing costs have jumped sharply in recent weeks, with yields on 10-year bonds reaching 6.5 per cent, as investors fretted about the parlous condition of the country’s banks. Last week Spain’s budget minister, Cristbal Montoro, stunned investors by conceding that the country now found itself shut out of capital markets.

What’s more, eurozone officials will be congratulating themselves that a solution for the Spanish bank problem has been found ahead of the crucial Greek elections on June 17, which could trigger the country’s exit from the eurozone.

However, there are many aspects of the Spanish bailout that will unnerve investors.

First, there’s the sheer size of Spain, the eurozone’s fourth largest economy. Markets quickly regained their composure after bailouts were cobbled together for Greece, Ireland and Portugal. But these are minnows compared to Spain, which is nearly twice as large as Greece, Ireland and Portugal put together.

Secondly, because Madrid was unable to win the political battle over the terms of the bailout, Spain’s debt burden looks set to increase by 20 per cent.

In the past few months, Madrid, with the backing of Paris, has argued vehemently that the money from the eurozone bailout fund should be pumped directly into the troubled banks. But Berlin flatly refused to accept this approach. As a result, the eurozone bailout money will be funnelled into Spain’s bank restructuring fund (known as Frob), which will in turn inject extra capital into struggling banks.

But because Frob is a Spanish government instrumentality, the cost of the rescuing the Spanish banks will be added to the €559 billion in debt already sitting on the central government’s balance sheet.
And this is hardly likely to reassure the investors that Spain needs to fund its budget deficit, which is expected to come in at more than 5 per cent of GDP this year.

Investors will also be concerned to find out whether the money for the Spanish bank bailout is coming from the existing €440 billion bailout fund, or from the new €500 billion bailout fund, which is due to start operating next month.

Investors could shy away from buying Spanish bonds if the money comes from the new bailout fund, because loans from this fund have a higher ranking in terms of repayment than other Spanish debt.
But, even more importantly, investors will be worried that the latest Spanish bailout is merely reinforcing the doomed dynamic between debt-laden governments and troubled banks that lies at the root of the eurozone’s problems.

In some instances – such as Ireland – government balance sheets have been blighted by the cost of rescuing reckless banks.

In other cases – such as France – banks are under extreme pressure as a result of their decision to load up on the bonds of debt-laden countries such as Greece.

The latest €100 billion bailout of the Spanish banks will do little to arrest this downward spiral. Berlin’s decision to force Madrid to pick up the tab for bailing out its troubled banks means that market confidence in Spain will remain fragile. And this will continue to weigh on the Spanish banks, which hold massive portfolios of Spanish government bonds.