Spanish sovereign and bank risk

Most of the market and commentators’ focus today seems to be on the Spanish bond auctions and whilst the European Central Bank’s two long-term repurchase operations (LTROs) had a hugely positive effect on Euroland’s peripheral sovereign bond markets that effect has diminished. But it does not follow that yield will return to the highs seen in November 2011, when 10-year Spanish government bond yields reached 6.7%. That said, whilst the yield dipped briefly to under 5% in early March, there has since been a surge back to about 6%, which is distinctly eye-watering.

As we see it, the major cash shortages for sovereigns and banks in the periphery were filled over the last few months through LTRO-subsidized purchases, but as these purchases fade there is a significant gap between these continuing needs and the private sector sources willing to fill them. Over the last few weeks, that gap has been revealed in pricing, and given the large needs and the deteriorating market action, another round of policy action may well prove necessary soon. Spain and Italy may still have some levers to pull that can buy time, such as increasing issuance of short-term debt rather than more indigestible longer-term debt or drawing down cash reserves.  However, it looks as if cash balances are only sufficient to fund Italy for about a month and Spain for perhaps three months.  With large monthly deficits and significant maturities falling due, Italy and Spain still need funding, and there is the possibility of the private sector funding gap widening to unacceptable levels in the next few months. So it’s no surprise that markets and commentators are jumpy, which by itself is one reason for fearing that the LTRO exercises will fail.

Taking a few steps back to consider the big picture, Spanish banks’ borrowings from the ECB/the Eurosystem increased sharply in February and March, provoking much adverse comment, and indeed according the Bank of Spain’s website, average net borrowings by Spanish banks climbed to €227.6bn from €152.4bn in February, and the figure was well under €100bn as recently as last summer. Spanish lenders took 29% of the total LTRO facilities. But there was nothing surprising about these large increases because the meaning and purpose of the LTROs was that commercial banks in such countries as Spain, with serious difficulties in funding their assets, would take up lines from their national central banks (i.e., the national central banks that together constitute the Eurosystem) in order to replace inter-bank lines. It seems entirely plausible that when fully drawn down the Spanish banks’ borrowings from the ECB reach or even exceed €500bn.

To put this in context, using the IMF database and expressed in purchasing-power-parity (PPP) terms, in 2011, Spain accounted for 12.6% of Euroland GDP, which in turn was 14.3% of world GDP. Euroland’s share of world output would be higher in current-price and current-exchange-rate terms. There are some wrinkles in understanding the data – for example, distinguishing the Spanish banking system from the worldwide business of Spanish banks is a complex matter given their overall LatAm and other regional activities – but at any rate, the total liabilities of Euroland’s banks, excluding the central banks that constitute the Eurosystem, are given in the latest Monthly Bulletin from the European Central Bank as €33,721m, whilst the total assets of Spain’s ‘credit institutions’ are given in the most recent Bank of Spain publication at €3,226.7m at the same date. So roughly speaking, Spain accounts for 10% – 12½% of Euroland.

As for the historic context, in the first decade of the single European currency (i.e., the decade to 2009) Spain complied with the fiscal policy terms of Growth and Stability. Fiscal policy was a model of prudence, even though Spain as a nation was borrowing abroad on a massive scale and its current account deficit was more than 5% of GDP for many years. In fact, its ratio of public debt to GDP remains similar to that of Germany and France, despite at present running a budget deficit of over 8% of GDP.

Spain’s main problem today is not excessive public debt by European standards, but worry that its banks’ solvency is threatened by prospective declines in real estate prices and that the Spanish state will have to assume the banking system’s losses. There is also the concern that banking system losses could take the public debt/GDP ratio up to 120% or more, leading to a slide in fiscal sustainability comparable to that in Greece.

An added complication is tension between the central government in Madrid and some regions, such as Catalonia, and the central government is trying to limit regional financial autonomy, which may provoke resentment, not least because Catalonia and Navarre are relatively wealthy in the Spanish context.

Turning to the structure of Spanish banks’ liabilities, Spain’s banks have been borrowing from abroad, both from the inter-bank and by securities issuance, for decades. The country was poor by European standards in the 1950s, and the build up of external payments deficits, largely mediated through the banking system, was to be expected. Borrowings helped to finance investment in infrastructure and housing. Spanish banks continue to have roughly a quarter of their funding from the international inter-bank market and at start 2012 these external liabilities amounted to just over €860bn.

We can map this number against the likely drawdown of LTRO facilities by Spain’s banks and we know that Spanish banks’ borrowings from the ECB/the Eurosystem (which in fact are identified from the Bank of Spain’s balance sheet) increased sharply in February and March, and average net borrowings by Spanish banks climbed to €227.6bn from €152.4bn in February, and as against well under €100bn as recently as last summer. Spanish lenders took 29 percent of the total LTRO facilities. But there was nothing surprising about these large increases given that the intent of the LTROs was that commercial banks in countries like Spain, with serious funding difficulties, would take up lines from their national central banks (i.e., the national central banks that together constitute the Eurosystem) in order to replace inter-bank lines, and the matching liabilities to the ECB loans to the peripheral banks are of course deposits held mostly by German banks. It seems plausible that when fully drawn down the Spanish banks’ borrowings from the ECB may exceed €500bn and the likely Spanish take-up of the LTRO facilities may rise to half of Spanish banks’ external inter-bank finance in late 2011. The LTROs are large enough in the Spanish context to enable Spain’s banks to fund their rollover and funding requirement shortfalls.

The LTRO facilities were unlimited in size and deliberately very cheap. The banks were supposed to calibrate the take-up of the facilities to ensure that asset disposals could take place outside a crisis atmosphere, while banks were rebuilding capital over time. The offer of such facilities may have long-term adverse effects on economic efficiency and raises issues about the risk of favouritism in the interface between financial officialdom and private sector profit-making banks. Nevertheless, Spanish banks should not now be large-scale, forced sellers of assets, including government securities, as they were in the precarious conditions of October and November 2011.

We can be sceptical about the wisdom of the European single currency project, but at least until the LTROs run out in early 2015 (by when many more squabbles and bust-ups between Germany and the PIIGS will have taken place) it may be that banks that bet on Spain’s continued membership of the single currency make large profits (and a bumper return on capital) by financing their holdings of government securities with ECB money (and/or inter-bank lines, when they can get them). This is a bet that may make defensive investors appear to have been overly cautious with the benefit of hindsight. For now the bet on Spanish calm is a risky bet that we won’t take.

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla