As recently as May 28, Spanish Prime Minister Rajoy was claiming that “there will be no Spanish bank rescue”. He miscalculated. He had hoped the ECB would come to his rescue. Not only has the ECB not resumed its sovereign bond purchases, but it did not even throw it a bone by cutting rates, which surely are justified based on the trajectory of the euro zone economy, where conditions have deteriorated markedly since the end of last year and the last time the ECB rates.
There are only two issues now. How much money does Spain need and under what terms?
The IMF’s stress test, assuming about a 4% economic contraction, reportedly revealed that Spanish banks would need another 37 bln euros to cope. However, this does not seem be as much of “worst case” scenario. It had contract 3.7% in 2009 and although the contraction less than half the pace, it looks as if it will be protracted.
While it may seem to be in Spain’s interest to request the least amount of funds, the risk is that a limited program fails to restore confidence. Estimates range from 60-80 bln euros at the low end to 100-120 bln euros at the high end. Yet as we have argued, because real estate and housing prices have not completed the correction from the bubble, the depth of the Spanish banking problems are difficult to measure with any confidence, but estimates of eventual losses run towards 300 bln euros.
When Fitch cut Spain’s ratings by 3 notches a few days ago, it warned Spain was likely to contract this year and next. Even if Spain gets an extra year to reach the 3% deficit target, it means that additional austerity will be delivered for the next couple of years, which weakens the economic outlook. Structural funds and infra-structure projects will likely be too small to really dent the austerity on both the federal and regional levels.
What we have called Spain-lite is an effort to 1) get Spain funds for a bank recapitalization and 2) without the stigma attached to the programs in Greece, Ireland and Portugal.
It appears Rajoy is now willing to seek official assistance. His negotiating position can be summarized in five no’s:
- No loss of sovereignty
- No new fiscal conditions
- No new deficit commitment
- No additional structural reforms
- No IMF
The EFSF/ESM has been authorised to loan to countries for bank recapitalization purposes. By keeping the IMF out, and bringing the EBA in, Spain hopes that it can avoid the worst of the stigma and keep it to a limited bank recap program.
There is a conference call among key officials in Europe shortly. Contrary to speculation, few specifics are likely to emerge, even if there is an agreement in principle. As Spain edges closer to a formal request, Moody’s appears poised to cut is A3 rating for Spain.
And don’t forget the bizarre rules of engagement and the first mover advantage. If Cyprus formally requests aid before Spain, Madrid will have to participate. However, if Spain asks for aid before Cyprus, Cyprus will have to participate in Spain’s assistance.
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