By Satyajit Das, derivatives expert and the author of Extreme Money: The Masters of the Universe and the Cult of Risk (2011). Jointly posted with Roubini Global Economics.
On 11 April 2011, then Spanish Finance Minister Elena Salgado stated: “I do not see any risk of contagion. We are totally out of this.” A little over a year later, Ms Salgado and her party are no longer in power and Spain is well and truly in it.
After weeks of prevarication, Spain will now apply for a bailout for its banking system. Sorry it’s not a “bailout”. As the Spanish Finance Minister clarified: “What is being requested is financial assistance. It has nothing to do with a rescue”.
It is quite a turnaround. The new Finance Minister Luis de Guindos stated on 30 March 2012: “We are convinced that Spain will no longer be a problem, especially for the Spanish, but also for the European Union”. The Spanish Prime Minister Marino Rajoy attempts to maintain confidence a few days later on 12 April 2012 were confusing: “To talk about a bailout for Spain at the moment makes no sense. Spain is not going to be rescued. It’s not possible to rescue Spain. There’s no intention to, it’s not necessary and therefore it’s not going to be rescued.”
But the bailout may not work.
The amount – €100 billion or more depending on the independent assessment of the needs of Spanish banks- may not be enough. On the surface, the amount appears around three times the €37 billion the International Monetary Fund (“IMF”) says is needed. The capital requirements of Spanish banks may turn out to much higher – as much as €200-300 billion.
The IMF assumes only the smaller Spanish savings banks (the Cajas) will need help. In reality, the larger Spanish banks may also require capital.
Spain’s banks have over €300 billion in exposure to the real-estate sector, mostly through loans to developers. Around €180 billion of this exposure is considered “problematic” by Spain’s central bank.
Estimates suggest that there are about 700,000 vacant newly built homes, but including repossessed properties the total could be as high as one million or even higher. At current sales levels, it will take many years to clear the backlog, which will be compounded by more properties being completed and coming onto the market. Housing prices have fallen by 15-20% but are forecast to fall eventually by as much as 50-60%. A severe recession and unemployment of 25% means that losses on Spain’s over €600 billion of home mortgages loans are likely to also rise.
The proposed amount also does not include any provision for write downs on holding of sovereign debt. Local banks are estimated to hold over 60% of outstanding Spanish government bonds.
The bailout will be provided with no conditions, which creates its own problems. The lack of conditions may lead to Greece, Ireland and Portugal seeking relaxation of the terms of their assistance packages. The lack of conditions also prevented the IMF from contributing.
In an opinion piece in the Financial Times, Jin Liqun, Chairman of the supervisory board at the China Investment Corporation, pointedly noted the contrast between the treatment of European and Asian countries. “Viewed from China, the management of the eurozone debt crisis offers a stark contrast to the handling of the 1997-98 east Asian crisis. In that episode, Thailand, South Korea and Indonesia were all forced to implement tough austerity programmes imposed by the International Monetary Fund…. Unlike many of today’s Europeans, the people of east Asia did not have the luxury of large relief funds from outside their countries. The people had to tolerate hardship…In a poignant case, the Korean people contributed gold and household foreign exchanges to the government to help ease fiscal pressure.” Future international support, either bilateral or through the IMF, may be difficult.
The funds will come from either the European Financial Stability Fund (“EFSF”) or the still to be approved European Stability Mechanism (“ESM”). Since 2010, the Euro-Zone has committed Euro 386 billion to the bailout packages for Greece, Ireland and Portugal. In theory, the EFSF and ESM can raise a further €500 billion, beyond the commitment to Greece, Ireland, and Portugal, allowing them to contribute the €100 billion for the recapitalisation of the Spanish banking system. The EFSF/ESM also assumes that it “can leverage resources”. The reality may be different.
For a start, Finland has indicated that it may seek collateral for its commitment, an extension of its position on Greece which the European Union ill advisedly agreed to.
As Spain could not presumably act as a guarantor of the EFSF once it asks for financing, Germany’s liability will increase further from 29% to 33%. France’s share also increases from 22% to 25%. The liability of Italy, which is in poor shape to assume any additional external financial burden, rises from 19% to 22%.
The EFSF’s AA+ credit rating may now be reduced. Irrespective of the rating, the EFSF and ESM will have to issue debt to finance the bailout. Support for any fund raising by these instrumentalities is uncertain.
Commercial lenders have been reducing European exposure. Emerging market members with investible funds lack enthusiasm for further European involvement. Lou Jiwei, the chairman of China Investment Corporation, the country’s sovereign wealth fund, has ruled out further purchases of European debt: “The risk is too big, and the return too low”.
The bailout also does not address fundamental issues.
The funds will be lent to the Spanish government, probably its bank recapitalisation agency FROB, rather than supplied directly to the banks because of legal constraints. This will add 11% of Gross Domestic Product (“GDP”) to Spain’s debt level. The transaction will do nothing to reduce the country’s overall debt level –over 360% of GDP before this transaction.
Spain’s access to capital markets or its cost of debt is not addressed. The last auction of Spanish government bonds saw yield around 6.50% per annum with the bulk of bonds being purchased by local banks. Spain and its banks also face pressure on their own ratings, which are now perilously close to becoming non-investment grade.
The bailout may actually adversely affect the ability of Spain and its banks to funds. Commercial lenders are now subordinated to official lenders. Based on the precedent of Greece, this increases the risk significantly, discouraging investment.
The European Union has stated that they believe that these measures will help the supply of credit to the real economy and assist a return to growth. This optimism is unlikely to be realised.
Restoring the bank’s solvency will not result in an increase in credit. The capital will allow existing bank debts to be written off. Spanish banks have limited access to funding. They are heavily reliant on the European Central Bank for money; a position which the assistance does not address.
But even if the flow of credit improves, it would merely allow half finished building in the middle of nowhere and with no obvious buyers to be completed, compounding the overhang of unsold property. Given that Spain’s problems were caused by a debt fuelled property boom, more of the same does not seem to be a sound solution.
Slowing economic European and economy growth is also likely to limit any recovery and improvement in Spanish employment and investment.
Prime Minister Mariano Rajoy made the quixotic claim that the assistance was a victory for Spain. Opposition Socialist Party leader Alfredo Perez Rubalcaba retorted that: “The government is trying to make us believe we have won the lottery”.
Spain will need to win the lottery – probably its own El Gordo (the big one) the world’s biggest lottery – if it is to avoid a full scale bailout, which may be beyond the capacity of Europe, economically and politically, to undertake.