A Spanish Bailout Could Burn An €18 Billion Hole In Italy

More details of the bank aid to Spain have been proposed. The details seem to show an evolution in the thinking of officials. Spain would be given a considerably longer repayment schedule than the other aid recipients, fifteen years and a five year grace period.  Spain, when it finally asks for the funds, will be charged 3%.  

However, the old tension between wanting to support the banks and wanting to punish remains unresolved as the reports suggest the banks will charged 8.5% for the aid.  Besides getting past the Greek elections, the next big event for the Spain saga is the private auditors bank assessment due next week.

Recall the IMF’s stress test results (based on 4% economic contraction and 20% decline property prices), but it did not address the value of the bank assets.  Prime Minister Rajoy still seems to be in denial and this is troubling even though Spanish bonds are consolidating the recent plunge today.  

On June 10, Rajoy was still pretending that this year’s new deficit target of 5.3% could still be reached.  Fitch’s warning yesterday that Spain’s deficit will overshoot was gratuitous. Of course it will and not just because it is going to eventually take the EU’s offer.  Even before the offer, the EC warned Spain’s deficit would be closer to 6.4% this year and 6.3% next year.    

The EU’s offer will require Italy, which is having its own difficulties to participate.  Italy share is about 18 bln euros.  Leaving aside the fiscal hole this leaves Italy, but how can it be expected to fund Spain at 3% when costs it considerably more to raise the funds in the first place?  

Italy sold one year bills today, raising 6.5 bln euros but at nearly 4% compared with 2.34% a month ago.  Italy sells bonds tomorrow.    Although Italy has a primary budget surplus, to service its outstanding debt requires it to sell around 35 bln euros a month in bills and bonds.  

There continues to be rumblings about the possibility of another LTRO from the ECB.  This seems decidedly unlikely.  In fact, by further tying the banks and the sovereigns, the LTRO is a bit of doubling up.  The Spanish banks, for example, that gorged themselves on government bonds earlier this year, now are experiencing the virtuous circle in reverse.  The sell-off in Spanish bonds, with yields rising to new EMU-era records, has not only made it more difficult for banks to raise funds, but it is also weakening their balance sheets.   

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