The problem for Spain, part 3

Markets recognise and seek to price the challenge that absent vigorous political will to address the challenges on a pan-Euroland basis, Spain’s problems will only become more pressing, and its voters will demand change.

Clearly, the Spanish electorate is already becoming more agitated and the demands for independent action can only grow as the economy continues to spiral downward, which it is now universally expected to do for at least the next 18 months.

As the economy’s plight intensifies and political unrest goes, so the probability of an eventual Euro exit will surely increase and hence the capital outflows will likely intensify and the balance of payments deficit will presumably become ever wider, from what is already a simply incredible and unprecedented level.

Moreover, there is always the chance that the demands for action will be met and Spain will unilaterally opt to leave the currency regime.

The potential alternative – that Spain is forced to put up with higher interest rates forever has little or no historical precedent.

In a purely mechanistic sense, of course, those economies in Euroland that run surpluses can continue to grant Spain necessary and effectively unlimited monetary aid to cover its deficits. This could be via unsterilized intervention chiefly by the ECB and by extension the Bundesbank, through the ELA and TARGET. There could also be fiscal aid through bank recapitalisation rescue packages and similar.

But with Germany’s TARGET loans having reached €728bn as at 30th June, the latest data we can access, and its fiscal exposure and contingent liabilities continuing to expand, the rating agencies are firing a shot across the bows. Against this backcloth, we can expect that Germany’s preparedness to fund continuously and unconditionally is limited.

Joining the dots and projecting forwards, if Germany were to cease providing its financing via the TARGET system, then Spanish rates would soar as interest rates did in Hong Kong in 1998. This would be the consequence of needing to match supply and demand and the impact on Spain’s economy would be dire with the onset of severe recession and depression until Spain chose to leave the system.

In practice, what we have in Spain are three connected problems. First there is the current and projected balance of payments deficit which is huge, unsustainable and growing. Secondly there is the deteriorating economy with the prospect of the recession getting deeper and lasting longer. Thirdly, there is the extraordinary scale of foreign central bank ‘intervention’ required to keep the country in the Euroland system.

The tensions in keeping the show on the road look immense for both Spain and the core economies. The agenda needs to shift firmly to a focus on growth and meanwhile the core must continue to fund.

Arguably continued core support for peripheral economies is a greater risk right now than a revolt by Spain itself.

The problem for Spain, part 1
The problem for Spain, part 2

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

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The Local Authority Treasurers’ Investment Forum September 25th, 2012, London Stock Exchange
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