Spain: An Unnecessary Problem
The FT reports that the clowns at the ECB have rejected Spain’s bank recapitalisation plan (the one I mentioned, with approval, yesterday). Apparently it would breach the prohibition on “monetary financing”. Note to ECB: intelligent central bankers relax the rules in a crisis.
If this was plan A, then Spain appears to be moving to plan A’: borrow the EUR 19bn (probably EUR 14bn, since there is about EUR 5bn in the country’s bank bailout fund) and use the cash to recapitalise the banks.
Will Spain be able to borrow enough to do this? It should be able to — from its banks. Even if these banks cannot obtain funding — and Bankia, for one, will probably not be able to — the ECB is still offering one-year LTRO’s with full allotment, which means that banks can borrow as much as they want for a year. The plan would work like this. The banking system borrows from the ECB; it buys a new government bond using the borrowed money; then the government injects the money into the banking system. The upshot of all this, after you have worked out how everybody’s balance sheet changes in each step and added up the changes, is:
Assets: +bond +reserves
Liabilities: +equity +loan
As long as Spain’s banks consider the government to be solvent, there should be no limit to the government bonds they will buy. The problem with this, of course, is that the ECB is only offering one-year LTRO’s. The banks may be unwilling to take on the financing risk of buying longer-dated government bonds than this — so the Spanish government may have to recapitalise its banks by borrowing short (this problem could be reduced with another 3-year LTRO, but that seems to be off the table). This might not be entirely a bad thing, of course: the main worry about Spain is its banks; if the banks were recapitalised, then its borrowing rates should be lower in a year’s time; and thus it would be good to be able to refinance.
It is possible that I have the wrong model here: perhaps there is some other limitation on Spanish banks’ willingness to buy government bonds (although that has not been evident so far). In that case, we move towards plan B: use of the ESM. Will Germany be prepared to move on the question of direct bank recapitalisation (call this B1)? I do not know — it is an obvious thing to do, but the alternative (direct lending to Spain — B2) would not provoke a collapse, and would give the EU more control over Spain’s future fiscal policy. The Germans have been reluctant to move from their entrenched positions unless absolutely necessary. If Germany will not move, then Spain will have to come under an ESM programme.
What will that mean, in practice? In other countries, coming under an EU programme has meant that they have been cut off from the bond markets. The Spanish case is different, however, because Spain is (probably) fundamentally solvent. My relative lack of concern about Spain rests on this premise. If Spain is fundamentally solvent and has resolved its problems with the banks, then it ought to have access to the bond market (in the form, mainly, of its own banks). So I do not see a programme for Spain as necessarily meaning it could not continue to borrow in other ways. The market ought to see the ESM assistance for what it is: lending for the specific purpose of bank recapitalisation.
This brings me back to my original view: the Spanish situation is manageable. If plan A’ will not work, then plan B1 or B2 should work as well.
One thing that comes out of this analysis is a reminder of a point I have been making for some time: the euro crisis can only get as bad as the ECB allows it to get. For the time being, it is allowing it to get worse — probably because it is concerned about politicians rowing back from their fiscal commitments and would prefer it if Spain had to tap the ESM so that the EU could exert more control over the country. I still believe, however, that it will, in extremis, act to prevent collapse.