This week’s e-mail note is by my colleague, John Petley, and compares Spain with Greece. As the note points out, the situations are very different. No doubt the Spanish banking system has its problems, but there is no certainty that future real estate losses will wipe out its capital. Indeed, if the Eurozone (and hence Eurozone asset prices) were to return to growth as European politicians promise, such losses might be easily manageable. Further, so far Spain’s money supply has not suffered severe contraction, as in the Greek case.
The yield spread between German and Spanish government bonds in the one- year area has recently been about 500 basis points. If the banking situation were normal, with readily available inter-bank lines, and 100% certainty about the contractual stability of banks and sovereigns, this would be a fantastic profit opportunity. (Assume internal management capital allocation to the trade of 5% [whatever the Basle rules say], then the return on capital – from an inter-bank borrowing costing 50 basis points with the proceeds invested in Spanish government debt – would be almost 100%.) The reluctance of German banks, and of other banks, to sell one-year bunds and to buy one-year Spanish government paper speaks volumes about the lack of confidence in the permanence of the Eurozone. Even if the Spanish banks were over-capitalized relative to other EU banks, the uncertainty about the Eurozone’s survival would limit their ability to maintain their inter-bank funding. Ditto., as regards sovereign risk. Even if Spain has low government debt (as a % of GDP) relative to other EU nations, the uncertainty about the Eurozone’s survival undermines the Spanish government’s credit-worthiness. That is the Eurozone’s real problem. In this sense the Eurozone is inherently dysfunctional.
Spain is not Greece writ large
As is well-known, Spanish banks were heavily involved in financing a construction boom in the first decade of the European single currency. They are now said to have inadequate capital to meet the loan losses expected to ensue from falling real estate prices. Bankia, the worst affected, was nationalised in May. Solvency worries are said to be one reason that Spanish banks are having difficulty in rolling over inter-bank borrowings when they come up for renewal. They are understood to have taken up no less than 29% of the facilities offered by the European Central Bank by means of its Long-Term Refinancing Operations since last December. In the latest package €100bn. was made available from EU sources to bolster Spanish banks’ capital.
Newspaper headlines sometimes suggest that Spain’s economy is about to go down the same road as Greece, but – for the time being at least – banking data and money supply trends say otherwise. Both countries saw double-digit annual growth rates of bank loan portfolios and broad money in the 2005-9 period, followed by a collapse into negative territory in 2010. But – as the chart above shows – Spain’s money supply returned to growth in 2011, whereas Greece plunged into a deep contraction, where it remains. Spain’s M3 has suffered a small fall in the last two months, after expanding in January and February as banks used the LTRO facilities to buy government debt. The problem for the future is that Spain’s banks will have to shed risk assets at an accelerated pace if the inter-bank funding pressures persist. It must also be emphasized that, in the first instance, bank recapitalization lowers the ratio of deposits to banks’ liabilities and therefore reduces the quantity of money.
The bank bailout has raised worries about the state of Spain’s public finances, Hitherto, Spain’s public debt to GDP ratio for 2011, at just under 70%, was lower than that of France and Germany, and well below Greece’s 160%. The 2012 figure is estimated to reach 90% as a result of the recent bank recapitalization finance – which the government is ultimately responsible for paying back – but this in itself hardly justifies the yields on Spanish government ten-year bonds topping 7% less than a week after the bank bailout was announced. Much of the trouble arises because – if the Eurozone were to break up – holders of Spanish government debt would suffer windfall losses. Potential foreign investors are therefore not interested in Spanish sovereign paper. Meanwhile the big domestic buyers of short-dated government securities – namely the banks – have the serious problems already discussed. They are having difficulty funding their existing assets, let alone acquiring more.
Unlike Greece, Spain has shown a real determination to tackle is public debt, and its aspirations to reduce its public deficit from 9% of GDP in 2011 to 3% by the end of 2013 were among the most ambitious in Europe. With Spain’s economy estimated to contract by 1.7% this year and unemployment levels high, this target may have to be modified, but Spain’s government has more room for manoeuvre than its Greek counterpart, which faces an estimated economic contraction of 4.7%. On the other hand, a worrying ingredient in the Spanish crisis is the separatist strain in its politics. Catalonia is one of only three regions to contribute to the financial support that most of Spain receives from the centre, and it resents both the cost of this and central government’s interference in its own budget-making.
Political indecision at the European level is a real threat not just to Spain, but to the Eurozone as a whole. Spain’s economy, while going through a difficult time, is still in far better shape than Greece’s and may be able to stay inside the dysfunctional Eurozone for two or three years yet and perhaps for much longer. If so, contrarian investors – who take long positions in Spanish short-dated sovereign paper funded at Eurozone inter-bank rates – could make spectacular profits. Indeed, the apparent reluctance of banks to take such positions symptomizes extreme pessimism about the Eurozone’s continued viability.Tags: Bank of Japan, Central bank, Euro Zone, Europe, European Central Bank, European Union, Federal Reserve System, Janet Yellen, Quantitative easing, United States