The Eternal Fount of Bad News

If anyone required empirical evidence that the size of a bust is often related to the size of the preceding boom, Spain provides it in spades.

This week it turned out that the ongoing recession is actually deeper than was hitherto assumed. Growth estimates for both 2011 and this year had to be revised lower (the economy did still eke out 'growth' of 0.4% last year, but this demonstrates only how flawed a measure GDP is. Unemployment, bad loans, and bankruptcies all soared while this 'growth' occurred).

Then an ominous hole in Spain's budget was discovered. The FT reports that abacus-wielding economists have discovered a significant discrepancy:

“Economists have uncovered a hole in Spain’s budget that threatens to allow the country’s regional governments to overspend this year, calling into question the credibility of Madrid’s deficit reduction plan agreed with Brussels.

The discrepancy in this year’s spending plans for Spain’s 17 autonomous regions—which have become one of the main battle grounds for prime minister Mariano Rajoy’s austerity program—could allow the regions to exceed their agreed budget deficit for 2012 by almost 10 percent.

Under the regional spending plan signed off in May by Cristobal Montoro, Spain’s budget minister, the regions have been approved to claim back 9.7 billion euros ($12.1 billion) in bills generated last year but left unpaid. Yet this sum exceeds the total of 8.5 billion euros of 2011 unpaid spending declared by the regions last year.

The resulting 1.2 billion euros hole amounts to about 8 percent of the 15 billion euros deficit the regions are allowed to run this year, based on an agreed total regional deficit of 1.5 percent of Spanish gross domestic product (GDP) for 2012.

“The government has either made a significant error in the accounts, which damages the credibility of the budget plans, or they are trying to hide something,” said Juan Rubio-Ramirez, a professor of economics at Duke University who has examined the accounts in a study for Fedea, a non-profit economics research foundation.”

Either way this is bad news – whether it is incompetence or an attempt to hide something, it casts more doubt on the budget.

However, even more bad news soon emerged from the autonomous regions. This staccato of Job's news seems almost designed to divert peoples' attention. One gets inundated with bad news to such an extent that a certain saturation effect  eventually sets in. “What's up in Spain today?” “The usual”.

Sadly though the problem just won't go away. This sticky issue is the lynchpin around which the future of the euro now revolves, with Italy waiting in the queue right behind Spain.

The large region of Catalonia (see 'The Catalonian Blunder' for a previous article on the regions) made it known that it would be the third region to ask for aid (read: a bailout) from the central government. Everybody knew that it would happen eventually, but it seems the problem is once again bigger than expected. Catalonia wants €5 billion.

Spain's regions in distress. Note the stunning speed at which their mountain of debt has been growing in recent years – click for better resolution.

As can be seen above, regional debt in Spain has roughly doubled since 2008 – and not only that,  the debt mountain's growth is actually accelerating. They're basically the anti-Apple: their debt is piling up as fast as cash is piling up on Apple's balance sheet. Maybe Apple should buy them as a tax write-off and put them on its front lawn.

Banking System Distress Worsens

Not surprisingly, Spain's banks continue to be under considerable duress as well. The latest news – admittedly these data are always arrive with a considerable delay – is that the flight of deposits from the banking system has accelerated as well.

Moreover, finance minister Louis de Guindos let it be known that Spain would tap about €75 billion in rescue funding for its banks. The last time he spoke about the topic he was still talking about an immediate requirement of €30 billion, so in the meantime it seems to have become somewhat clearer how big the hole actually is in reality. Unfortunately the hole keeps growing, due to the moving target problem (more and more loans become non-performing as the economy weakens and the excesses of the bubble are wrung out).

The capital flight meanwhile means that Spain's banks are forced to rely on ever bigger amounts of funding from the ECB, as they would otherwise be forced to shed assets commensurate to their loss of funding. This creates an additional problem: the banks are running out of eligible collateral to pledge. Hence there is now a notable increase in ELA funding (emergency liquidity assistance). ELA funding growth is starting from a small base, but the rate of growth is notable, as we have detailed here on occasion of the last NPL update.

The decline in private sector bank deposits at Spain's banks, via CLSA – click for better resolution.

A detailed month-by-month depiction of corporate and retail deposit flow in Spain's banking system shows that July has seen the biggest outflow to date (via Goldman Sachs) – click for better resolution.

Gross and net ECB lending to Spain's banks, via CLSA – the net figure deducts the deposits of Spain's banks with the ECB, which have precipitously declined after the initial 'LTRO' spike – click for better resolution.

MRO and LTRO funding extended by the ECB to Spain's banks disaggregated, via Goldman Sachs – click for better resolution.

What is clear from all this is that private sector debt deleveraging is bound to continue and will likely accelerate. There will be no new boom driven by credit expansion in Spain until this painful but necessary process has run its course. This raises the not unimportant question whether hewing to the euro-group's austerity prescriptions will be politically doable. Spain's government is hoping that the upcoming ECB intervention will lead to an improvement in both the government's funding costs and economic confidence.

However, there are a great many economic reforms that still have to be undertaken if there is to be a chance for Spain to regain its competitiveness and lay the foundations for future growth. The government will have to be quite bold in implementing them. The problem is that nearly all the urgently required reforms that will improve the long term outlook are bound to produce additional pain in the short term.

Mr. Rajoy's political opponents are sure to make hay from this, and the easiest way to do so is to ride on the growing wave of anti-euro and anti-EU sentiment, stoking it even further in the process.

It should however be clear that returning to the peseta will not solve the underlying issues. What a return to the peseta really means is 'devaluation and inflation'.  No country has ever grown richer by adopting these methods. They are a way of avoiding some short term pain (though obviously not for savers, who will be immediately paying for it through their noses as the value of their savings is cut down), but they cannot relieve the long term structural problems besetting the economy – they can only make them worse by removing the incentive for reform.

Growing Bifurcation in Spain's Government Debt Market

Lastly, the ECB's promise to intervene in the short end of the Spanish yield curve once Spain knuckles under and applies for an EFSF/ESM bailout continues to steepen the Spanish yield curve. Investors are buying short term debt but are shunning long term debt. This is inevitably going to compound the debt rollover problem, as the government will shorten the maturity profile of its outstanding debt even further as rollovers occur. Meanwhile recent debt auctions at the short end of the curve have of course gone quite well, with three and six month borrowing costs dropping sharply.

Spain's 2 year government note yield has retained most of the 'ECB announcement effect' – click for better resolution.

The effect was far less pronounced in the 10 year yield, which has recently bounced up again and remains in a rising trend – click for better resolution.

The stock market has rebounded strongly after the ECB announcement, but has now gone into 'wait and see' mode, pulling back slightly from the recent rally high. So far the entire move from the low looks corrective to us, but that assessment is potentially subject to change as new evidence comes forth.

The IBEX index pulls back slightly, going into 'wait and see' mode – click for better resolution.

Addendum : Why Deposit Flight in Spain Has Accelerated So Much – A One-Off Effect Due to Falling Credit Ratings of Banks

After we had written this article, a friend forwarded some information to us that further clarifies why the loss of deposits at Spain's banks has accelerated by such a large amount recently.

Here is the gist of it:

„There is a very interesting one-off effect that has had a tremendous impact on these [decline in deposts] figures. They would have still been negative but not by such a  significant margin.

As all Spanish banks are now in triple B territory or below, all the securitisation SPV's [special purpose vehicles] in Spain need to find alternative banks for their deposits. They can only operate with single A rated banks [or better]. As there are none left in Spain, these SPV's have shifted their deposits to foreign banks (in the euro area).

Securitisation SPV deposits are very significant in Spain. An SPV would typically hold about 3% of the outstanding nominal value of the securitisation transaction in a bank deposit. This is because as securitisation loans pay down, the cash is held in deposit until the next bond coupon payment occurs (usually quarterly).

With more than €200bn of outstanding securitisations in Spain that's €6bn of deposits that have disappeared overnight as the SPV's have shifted their accounts to foreign banks. This applies also to any other rating-sensitive corporate, financial company or investor, although it is much more difficult to track these deposit holders as they don't publish their criteria.”

Charts by: CLSA, Goldman Sachs,WSJ, StockCharts, BigCharts

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