Spain has endured an extremely trying 2 months since our first article highlighting the problems the Spanish faced in The Spanish Inquisition – Part I. In a short period of just 2 months, investors have seen Spain extended a lifeline by the Eurozone which has offered the country a EUR 100 billion bailout for its troubled banking sector, the credit rating of Spanish sovereigns cut several notches by both Fitch and Moody’s and rising yields on Spanish sovereign bonds.
Previously, we highlighted the problems afflicting Spain; a housing bubble that burst and has added plenty of pressure and toxicity to loans in the Spanish banking sector, a high unemployment rate, and, a recession that is being deepened by harsh austerity measures. While it is impossible to expect any of these structural issues to be resolved over night, the unforgiving nature of markets has punished Spain through shutting the door on the sovereign’s access to debt markets, as indicated by the current yield of 7.158% on the 10 year Spanish issue as of 18 June 2012.
In this article, we shift our focus and examine the reasons behind, as well as the implications of the current state of Spanish sovereign yields.
Why Have Spanish Bond Yields Been Rising?
Spanish yields have risen to a record Euro-area high of 7.158% in recent weeks, a level which has seen the likes of Portugal, Ireland and Greece require assistance and bailouts. While the sovereign is in relatively better shape, the shambles that is its current banking sector has been the main worry and cause for its rising yields. As per our previous article, the Spanish banking sector has yet to fully write-down toxic assets and losses related to the property and construction industry as well as mortgages. With an already weakened balance sheet and impending further write-downs upon the conclusion of an independent audit by 3rd parties commissioned by the Spanish government, the sector has little to no means of rescuing itself, solely leaving the onus on the sovereign.
The recent announcement that the Eurozone would lend Spain up to EUR 100 billion to fix its’ banks and allow the banks to absorb losses the lie ahead, is by no means guaranteed to be sufficient for the troubled banking sector, has proven to be a two edged sword for Spanish sovereign yields. While it means that the Spanish banking sector will in all likelihood be saved, the question of on whose shoulders will the cost of the bailout fall on has contributed to send Spanish debt yields higher. The introduction of an additional EUR 100 billion to Spanish debt could see the country’s debt-to-GDP ratio spike to over 83% from an end 2011 ratio of 68.5%, taking into account the economy’s 1Q 2012 contraction of -0.3%, a ratio which would see investors require a higher yield from Spain in return for added risk as indicated by the debt-to-GDP ratio.
Thus, as it is, Spain is in a tight spot and needs to win an extremely delicate balancing act as it needs sufficient funds to recapitalise its banks, yet, the size of the program needs to be not large enough to derail the sustainability of Spain’s public debt.
With markets effectively shutting the Spanish out of the debt market, the country has had no choice but to seek assistance from the Eurozone to bailout its banking sector. With refinancing needs of EUR 347.9 billion due by 2016, Spain needs to be able to access the debt market. However, the risk premia on 10 year issues as compared to the safe-haven German bunds, reflect the market’s concerns over the Spanish situation and has restricted the Spanish’s ability to refinance via the debt market.
Chart 1: Spanish Debt Distribution
Chart 2: Risk Premia For Spanish Bonds Rising
Given the current situation, there are only two possible scenarios for Spain: yields continue to remain above 7%, or, yields fall to lower levels.
Scenario 1: Yields Remain Above 7%
Should yields continue to remain or rise higher above the 7% mark, Spain would have little choice (sooner or later) but to follow in the footsteps of Portugal, Ireland and Greece in seeking a full bailout from the Eurozone, with austerity the price the Spaniards would pay, while some growth measures would likely be included in the bailout package as the Eurozone learns from its past mistakes.
Scenario 2: Yields Fall to Lower Levels (most likely)
The current situation does not possess the necessary ingredients that could give rise to a situation with which the yields on Spanish sovereign debt can come down significantly by itself. Rather, in order for yields to fall to more normalised levels, the inclusion of and participation by European institutions such as the European Central bank and European Stability Mechanism is required in the near term through various programs and channels available to them such as the Securities Markets Program, Longer Term Refinancing Operations and perhaps even the specific recapitalisation of banks by the permanent European Stability Mechanism.
Given additional time (2-3 years), the painful reforms recently undertaken by Spain will likely see their effects begin to reap benefits for the country as the labour market and other economically important areas get restructured in a bid to become more competitive.
While the situation in Spain definitely warrants our attention, it currently appears unlikely that the Iberian nation will go down the same path as Portugal, Ireland and Greece. Rather, it is of our opinion that the country will most likely be the first to tap the European Stability Mechanism which would allow it to recapitalise its banks without the need for a full bailout which was the case in the other 3 countries which covered their funding needs. Hopefully, this will enable the Spanish to break the negative feedback loop between its banking sector and sovereign yields, giving it the opportunity to borrow from the debt market, and buying it some time to fix itself and allow for reforms to take effect.
We continue to remain wary of the troubles afflicting the continent, despite the positive results of the Greek election, and advise investors to underweight the region relative to the faster growing and more attractive Global Emerging Markets and Asia ex Japan regions.
A Greek Exit v "More Europe"
The Spanish Inquisition - Part I
European Update: Some Progress is Better Than None
European Review: 3Q 2011 GDP Dodges the Bullet