Comments on Spain

I have seen some comments on Spain with which I do not wholly agree.

1. “The bank bailout doesn’t fix the fundamental problem.” This is right, as far as it goes: the fundamental problem is the variation in competitiveness within the Eurozone or, if you like, the absence of any mechanism to deal with it. But that has been the fundamental problem for some time now, and various markets have gone up and down in that time. From a trading point of view, the interesting thing is that a major problem may be being solved, at least for the time being (although, given that it was obviously soluble in the way that has now happened, I continue to believe that it is Greece, not Spain, that has really caused the latest sell-off).

2. “Spanish banks have been loading up on Spanish government debt, just making the problem worse.” This is a strange thing to worry about. It is quite normal for banks to buy their own governments’ bonds. The question is one of equilibrium. There is a good equilibrium in which governments sell their bonds to banks, and banks hold government bonds, and everyone is solvent. There is also a bad equilibrium. Weakness in the banks undermines the government, or weakness in the government undermines the banks, and the situation develops into a downward spiral until neither the government nor the banks are able to borrow in the public markets. This is the equilibrium that Greece has reached. The question for Spain is not whether Spanish banks are buying government bonds; it is whether the spiral can be arrested and the country returned to a good equilibrium, or whether it will spiral towards the bad equilibrium.

3. “A bailout is a bailout.” This is, of course, not true. A recapitalisation of the Spanish banking system, albeit via the government, is different from a loan to the government in order to allow it to continue to pay its bills.

Why are Spanish yields rising?

What is the problem for Spain’s government? Fundamentally, it is an end to foreign capital inflows. Foreign banks are reluctant to put money into either the Spanish economy or the Spanish government. Why, then, does Spain still have access to the markets at all? It is because Spanish banks are still prepared to buy the government’s bonds. Why? I have tended to assume that the reason that Ireland and Greece have lost access to the markets was that the banks had lost faith in their own governments’ solvency. But I wonder how far this is the most important factor, and how much it was the banks’ capacity to lend to the government that was the most important thing. Obviously, Irish and Greek banks experienced significant deposit flight before their respective countries were forced into EU bailouts, but I have tended to assume that, since deposits were replaced with ECB funding, it must have been banks’ willingness, rather than their ability, to buy their own governments’ bonds that was the most important factor. The 3-year LTRO, however, showed that banks were much keener on 3-year funding than on one-year funding. In spite of the fact that the ECB continues to offer one-year liquidity with full allotment, and in spite of the fact that it is hard to argue that Spain is insolvent, the country’s bonds have moved towards crisis territory. Does this demonstrate that I have focused on the wrong aspect of the situation? Is it in fact the case that the ability of Spain’s banks to lend to the country is significantly constrained by the lack of stable funding (either because of their own feelings of comfort, or because they have an eye on the new stable funding requirements under Basel III)? This would certainly cohere with the fact that deposit flight and sovereign bailout seem to go hand in hand.

I do not find this account of things very satisfactory, however. The fundamental question is: why are Spanish yields rising AT THE SAME TIME AS the government retains access to the primary market? If banks are losing stable funding and replacing it with short-term funding, and if they require stable funding to buy 10-year government bonds, then how was Spain able to auction 10-year government bonds only a few days ago? I suppose it is possible that they all went to non-bank purchasers, or that banks had had other assets mature, but I have not seen any evidence of either of those things and it feels as if the explanation is becoming rather Ptolemaic. Is there a deeper problem, that banks feel themselves to be capital-constrained? But in that case, Spain should not be able to auction any bonds at all; and the increase in Spanish yields last autumn, when concerns about Spanish banks’ capital were less acute than they are at present, remains unexplained.

It is generally not helpful to approach a market in this bottom-up way. There are many players, their actions and motivations are hard to lay out in detail, and the system as a whole may be too complex to be predictable, even if it could be laid out in full. The obvious response to this problem is to look for a different kind of model. What model can help us to understand the problems of Spain? How about this one: there is a market that attempts to price the risks to the Spanish sovereign; recently, the risks have increased, because of i) government’s failure to hit its deficit target in 2011, ii) the worsening recession, iii) its having become apparent that the banks need more capital than previously thought and iv) the Greek situation. On this model, factors (i) and (ii) are unchangeable in the short term, but (iii) is being dealt with and (iv) will come to a head in the next few days. Until (iv) is resolved, Spanish yields should not be expected to plummet, but they should fall somewhat because of (iii) (although perhaps not immediately, as the details of the plan are still being worked out).

This kind of thinking also accounts for why countries have previously received bailouts. Portugal, Ireland and Greece were able to borrow in the market, but the market had priced the risk of their defaulting as being quite high. If this account is right, then the most important thing to prevent Spain from having to have a bailout is to demonstrate to the market that the risks to Spain have fallen. Since Spain is solvent under reasonable scenarios even in spite of (i) and (ii), a solution to the banking problem, in the form of recapitalisation, should reduce Spanish yields to a manageable level provided that the Greek situation can be contained. This takes me back to my existing view.

Can the ECB help?

I have long said that the European crisis can only get as bad as the ECB allows it to get. But the ECB has shown that it is not prepared to act as sole lender to a government indefinitely — it is only prepared to do so until a bailout can be arranged. In other words, it is prepared to allow the crisis to get bad enough that Spain, say, would have to request an EU bailout if its bond yields rose to unsustainable levels. If the market were to price Spanish risk above the commonly-assumed threshold of 7%, then the ECB likely would, in the short term, buy Spanish bonds in order to bring the yield below that figure, preventing a self-fulfilling upward spiral in yields. But only for a time. If the market were to push Spanish yields consistently into territory where the ECB was inclined to buy, I would expect the ECB to pull back from its purchases, as it did for the countries that have already received bailouts.

Data

  • French IP 1.5% b.e. Apr.
  • UK RICS house price balance -16% d.e. May.
  • French non-farm payrolls 0.1% QOQ Q1 a.e.
  • UK manufacturing production -0.7% d.e. Apr.
  • UK industrial production 0% d.e. Apr.

 

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