Elisabeth Dellinger
The Global View

No One Expects the Spanish Inquisition

By, 10/01/2012

Breaking news: Europe’s leaders are squabbling. Again.

Three years into a debt crisis fraught with politicking, discord among leaders should hardly be noteworthy. But this time, they’ve truly outdone themselves: They’re arguing over whether Spain should request a full bailout.

Never mind that, as a sovereign nation, Spain and Spain alone should decide what it does or doesn’t ask for. If it asks for help, it shouldn’t be because Italy and France told it to. If it chooses to go it alone, it shouldn’t be at Germany’s behest.

Then again, considering many EU officials don’t quite seem to grasp the concept of national sovereignty, perhaps I shouldn’t be surprised by this latest flare-up.

Also unsurprising: Officials and observers alike seem not to grasp that markets, not political will, will ultimately determine whether Spain needs a bailout. And at the moment, considering Spanish yields have fallen by more than 1.5 percentage points since June, it’s entirely possible Spain might not need a full sovereign rescue. Borrowing costs just might remain affordable enough for Spain to muddle though.

Now, common wisdom says investors merely priced in the eventual bailout, and if Spain doesn’t request one, yields will rise again. No doubt some investors do expect Spain to secure a credit line from the ESM, which would enable the ECB to buy Spanish debt on the secondary market—essentially a free put option for bond holders. But lower yields could also reflect prospects for a healthier, more competitive Spain.   

For example, markets could see that Spain has ample resources to bail out its highly indebted regional governments—like the Regional Liquidity Fund (RLF), which goes live this week. So far, it contains €6 billion repurposed from the national lottery, €4 billion from Spain’s Treasury, and €3 billion raised from a private debt sale—a sale that was oversubscribed by Spanish banks. A €5 billion offering is scheduled for October, which would bring the fund’s total to €18 billion. The government expects this to suffice, which seems plausible. As I write, Catalonia and Valencia—the two most indebted regions—have spoken for about €9.5 billion, tiny Murcia is seeking $300 million and Castilla-La Mancha needs €800 million. Andalucia, with the third-highest debt load, is considering requesting €4.9 billion. Should regions need more than the remaining €3 billion, it seems feasible for the RLF to raise further funds through private placements. Or, Spain could turn back to the Instituto de Credito Official (ICO), which handled all regional aid requests before the RLF was formed. The ICO has a banking license, allowing it to secure financing from the ECB—which is still providing cheap liquidity with easy collateral requirements for any eurozone bank in need. Between the RLF and ICO, it’s tough to imagine Spain needing to ask the ESM for additional regional funds.

Markets also no doubt understand Spain has already found a way to address its embattled banking sector. All too often, I see articles suggesting Spain’s banking troubles will force the nation to secure a full bailout—they forget, it seems, the sector’s already been bailed out! Eurozone leaders approved a €100 billion provisional line of credit for Spain’s Fund for Orderly Bank Restructuring. They just haven’t actually paid anything out yet, as they were waiting for stress test results to determine exactly how money the banks will need. Those results, released Friday, showed banks had a total capital shortfall of €57.3 billion, and Spanish Deputy Economy Minister said Spain may request around €40 billion from the EFSF/ESM credit line, leaving plenty extra for any unanticipated needs. As these banks sort out their balance sheets and the recently passed financial sector reforms take effect, investor confidence in Spain’s banking system should start to return, perhaps mitigating the risk of a broader contagion.

Finally, markets see that, despite mounting civil unrest, Rajoy’s dedication to economic reform remains steadfast. It would be all too easy to abandon a politically unpopular reform agenda when thousands are marching against it in the streets—after all, as a politician, he’s no doubt eyeing a future re-election campaign. But Rajoy is pushing forward with a new round of pension overhauls, labor market reforms and private-sector deregulation. Over time, these and the many other initiatives he’s passed since taking office should help Spain’s economy become more competitive—ultimately solving the problem at the heart of Spain’s issues. Over time, a more competitive Spain will be a faster-growing Spain—and faster growth brings higher state revenues and a lower debt-to-GDP ratio. And a Spain with higher tax revenues and an easier debt burden probably finds it pretty darned easy to meet its debt obligations down the road—a possible eventuality markets likely see.

That doesn’t mean Spain’s path is clear—several hurdles remain, and there’s always the risk of something unforeseen stalling the progress made thus far. But as long as markets continue rewarding Spain’s progress with more affordable (albeit still volatile) borrowing costs, in my view, there’s no need for Spain to seek extra help. If risks increase, investors demand a higher premium and Spain can’t get affordable financing on capital markets, then we’ll talk. But for now, let’s take it easy on Spain and not force it to do something markets aren’t demanding.

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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.

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