Throughout this crisis, the liquidity or solvency of various sovereigns has been determined to a large degree by market sentiment. For Spain’s borrowing costs to recede again to sustainable levels, Spain needs to regain investor confidence. Looking ahead at the calendar of events in Spain and the EZ over the next few months, from where is the good news going to come? The answer isn’t at all obvious.
Bad News Up Ahead for Spain
As Spanish government bond yields began to soar in early April, the government announced on April 9th an additional €10bn in spending cuts. This came just days after prime minister Mariano Rajoy announced €27bn in austerity measures and tax hikes in the 2012 budget. Markets weren’t at all impressed by the additional cuts and bond yields rose further, proving that the Spanish government is truly in a no-win austerity/recession spiral.
If the Spanish government does not announce further austerity measures, the markets think it is not serious about hitting its fiscal targets and shun Spanish sovereign debt. If the Spanish government does announce additional austerity measures, however, the markets fret that the swingeing cuts will push Spain further into recession and shun Spanish government debt. No matter what the Spanish government does, investors are spooked, and this is unlikely to change over the next year unless Spain shows signs of being on a path towards sustainable growth.
How likely is it Spain will show signs of a return to sustainable growth any time soon? Not very. Spain’s unemployment rate hit nearly 23% in the final quarter of 2011 (youth unemployment exceeded 50% for the first time in January). The latest purchasing manager’s index (PMI) for Spain for March showed the worst result in 11 months at 44.5 (a reading lower than 50 indicates a contraction compared with the previous month). Worryingly, there was a substantial reduction in new orders, an indication that Spain’s PMI score will continue to deteriorate in the future. The Spanish property market has not found a floor yet, and will continue to undermine the quality of household and bank balance sheets. The government is implementing aggressive austerity measures and structural reforms, both of which significantly undermine growth in the short-term. When Spain releases flash GDP figures for the first quarter of 2012 on April 30th, do not expect the result to calm the markets. Furthermore, worse than expected GDP figures are likely to significantly undermine Spain’s progress on hitting its budget deficit targets. There is very little chance Spain will manage to reduce its overall deficit to 5.3% of GDP this year or 3% of GDP in 2013.
Good news is also unlikely to come from the Spanish banking sector over the next year. Even if Spanish banks manage to meet the new Tier I core capital ratio requirements in mid-2012, the Spanish banking sector remains a black hole and a source of huge uncertainty for investors. As unemployment continues to rise and property prices continue to fall in Spain, mortgage defaults will crystallise. Spanish banks will undoubtedly require further recapitalization, but it is hard to guess the timing or magnitude.
EZ-Wide Developments Won’t Help
Developments outside of Spain could further cause investors to shun Spanish government debt. It is very unlikely that a EZ firewall will be finalised at the IMF spring meetings on April 20-22nd. EU leaders completed negotiations on the EFSF/ESM contribution to the firewall in early April. While they announced they had raised the ceiling of the EU bailout funds, much of the funding has already been earmarked and the overall lending ceiling has not actually been increased at all. G20 leaders have suggested they are only willing to contribute to an IMF-led EZ firewall if the EZ first demonstrates that it is willing to help itself. The EFSF/ESM fudge does not bode well for significant G20 contributions. With no firewall in place, the risk of a disorderly default in the EZ will rise significantly and with Spain in the spotlight of the EZ crisis, investors could rush to dump their Spanish sovereign holdings.
If Spain is unable to regain market confidence, will it be pushed into a bailout programme? Not immediately, but this does seem inevitable. The good news as far as Spain is concerned is that the country has already pre-funded half of its debt rollovers for 2012. Even if Spain faces unsustainable borrowing costs, it will not actually run out of cash this year.
Furthermore, the ECB will not stand idly by while Spain is forced into a bailout programme. At the very least, the ECB will step up its Spanish bond purchases through the securities markets programme (SMP). While additional long-term refinancing operations (LTROs) are unlikely so soon after the three-year LTROs were offered, the ECB may take further steps to prop up the ailing Spanish banking system.
While ECB intervention could buy some more time for Spain in the short-term, it is extremely unlikely to fundamentally change Spain’s fiscal or economic trajectories. In the absence of economic growth, Spain will eventually be forced to request official financing, potentially as early as next year.