Sidestepping a Spanish crisis

All eyes will be on Spanish prime minister Mariano Rajoy this week as he battles desperately to dampen speculation that his country will be next in line for a bailout.

Despite suffering a surprise setback in a regional election on Sunday, and the prospect of a general strike on Thursday, Rajoy is adamant that his 2012 budget, due to be unveiled on Friday, will be a "very, very austere budget”.

Spanish bond yields have risen sharply in recent weeks after Rajoy attempted to get around European Union rules by relaxing his deficit target to 5.8 per cent of GDP in 2012, from the previous target of 4.4 per cent. After tense negotiations with Brussels a revised target of 5.3 per cent was agreed.

All the same, many economists believe that Spain's dismal economy will make it near impossible for Rajoy to meet his revised deficit. The country is slipping deeper into recession, unemployment is rising, and the problems in the Spanish banking sector are being exacerbated by further steep declines in housing prices and growing loan defaults by businesses and households. They argue that harsh austerity measures will only serve to deepen the economic downturn, causing tax revenues to collapse even further.

In a recent note, GaveKal analyst Francois-Xavier Chauchat points out that Spain is currently grappling with two long-festering problems – ballooning regional debt levels and unrecognised bank losses. These twin problems, he says, threaten to turn the country into the next eurozone bailout country "unless debt rationalisation comes to the rescue.”

Chauchat points out that the Rajoy-led government that came to power in December inherited a worse-than-expected deficit of 8.5 per cent of GDP, which was well above the 6 per cent target. The higher deficit, he notes, was largely due to a blowout in regional and local government deficits.

At the same time, Spain is having to face up to the consequences of the collapse of its property bubble. In February, the Rajoy government forced banks to make an extra €50 billion ($US66.6 billion) in provisions to cover their troubled property loans.

But with the economy falling back into recession, and land prices plunging, Chauchat believes that this will not be enough. "We estimate another €25-50 billion will need to be added to €50 billion imposed in February and the €66 billion of specific provisioning done over the 2008-2011 period.”

Even worse, the Spanish banking system appears to be just at the beginning of a huge deleveraging process. "It is generally estimated that the loan book of Spanish banks and cajas [unlisted savings banks] will need to decline by €300-400 billion over the coming years, or 20 per cent of the total loans outstanding.”

Of course Spanish banks, and the Spanish bond market, have been huge beneficiaries of the €1 trillion flood of liquidity released by the European Central Bank through its longer-term refinancing operations.

According to Chauchat, by the end of February the ECB provided €152 billion in loans to Spanish banks. By January, the Spanish banks had used this money to buy €52 billion of Spanish government bonds.

Meanwhile, the ECB also snapped up around €50 billion of Spanish government bonds between August and November last year. As Chauchat notes, this means that "directly and indirectly, the ECB has thus already de facto bailed out Spain by at least €100 billion.”

This ECB largesse has allowed Spain to reduce its dependence on foreign investors. At the end of 2008, more than 50 per cent of Spanish bonds were held by foreign investors, now it's down to less than 25 per cent – or around €150 billion.

As a result, if Spain did need a bailout, Chauchat calculates that it would only need around €200 billion: €150 billion to cover the debt held by foreign investors, plus around €60 billion for its banks. This shouldn't be too difficult for the eurozone's new firewall, which should have a capacity of around €750 billion.

All the same, Chauchat believes that the eurozone will be keen to avoid a Spanish bailout as it "would risk opening another very painful episode in the euro crisis.”

He argues that we may be close to the point where Spain has re-nationalised enough of its debts to avoid a major sovereign debt crisis that would rattle eurozone financial markets.

But he adds the warning that Spain will clearly need "lasting and possibly increased support from at least the ECB in order to maintain a firewall between its ailing banking sector and its public finances.”