Bank woes in Spain continue to deepen

As Spain’s deepening financial problems make a European bailout a more distinct possibility, a looming question is where the money will come from.

Spain is the eurozone’s fourth-largest economy, after Germany, France and Italy, and the cost of a rescue would strain the resources of Europe’s new 700 billion euro ($867 billion) bailout fund that is to become available this summer.

That would leave little margin for any additional bailouts. Spanish and European officials hope a bailout will not be needed. But each day, financial turmoil mounts over the government takeover of the giant Spanish mortgage lender Bankia, the flight of money to safer borders and a worsening recession.

Compounding Spain’s problems has been an outflow of foreign capital from the country, meaning the Spanish banks in recent months have been the only major buyers of its government bonds needed to finance the nation’s budget deficits. With those bonds now plummeting in value, the fate of Spain’s banks and government are intertwined in a financial tailspin.

Because Spain is the eurozone’s fourth-largest economy, its problems pose a far greater challenge to European policymakers than do those of Greece, which is much smaller. Hoping to ease the pressure, the European Commission on Wednesday urged Spain to take market-calming measures, and Lael Brainard, an undersecretary at the US Treasury Department, arrived in Madrid for talks with government officials as part of a regional tour. Worries about Spain helped send stock markets down broadly in Europe, with Wall Street retreating in afternoon trading.

In the bond market, the Spanish government’s borrowing costs are approaching the symbolically dangerous level of 7 per cent on 10-year bonds. The rise has stoked worries that Spain might need bailouts similar in scope – although many times larger – than those extended to Greece, Portugal and Ireland. Interest rates in that range had pushed them out of the debt markets that governments rely on to finance their operations.

“At 7 per cent, it will be very hard for Spain to obtain funding,” said Santiago Valverde, an economics professor at the University of Granada and a research consultant for the Federal Reserve Bank in Chicago. “It’s not just the government either, but big banks and companies, as well. The markets will close.”

The yield on Spain’s 10-year bond rose 0.21 percentage point Wednesday, to 6.61 per cent. In Italy – a country whose debt burden of 120 percent of gross domestic product is much higher than Spain’s – the yield on 10-year bonds rose about 6 percent, hitting a 10-month high.

Since the nationalization of Bankia on May 9 signalled the perilous state of Spain’s banking industry and drew attention to the limited ability of the government to shore up the banks and prevent the flight of capital from the country, the prime minister, Mariano Rajoy, has insisted that Spain will not need a Greek-style bailout.

No head of state would welcome such intervention, because as Athens, Dublin and Lisbon have found, those rescues come with demands for deeper budget cuts and fiscal rigor.

Engineering a bailout

But Rajoy’s administration has been floating the idea of engineering a bailout by other means. These include getting Europe’s rescue fund to provide money directly to the country’s banks or to buy Spanish government bonds on the open market, without Europe’s demanding new levels of scrutiny and tough payback conditions.

Economists estimate that if Spain were forced out of the bond markets by its high
borrowing costs and had to rely on funds from Europe and the International Monetary Fund to survive, the cost could reach 500 billion euros over several years.

At the root of Spain’s crisis has been a drastic flight of foreign capital from the country – one that, paradoxically, has been accentuated by the European Central Bank’s program of providing low-cost three-year loans to European banks so that they might buy their governments’ bonds.

In the case of Spain, while the programme bought time, it has made the country’s underlying problems worse. Spanish banks have by far been the most aggressive participants in the cheap-loan program, having borrowed more than 300 billion euros from the central bank. And much of that money was spent on Spanish government bonds.

In the short term, those bond purchases helped the government by bringing down interest rates – by reducing Madrid’s cost of borrowing. But as a result, Spanish banks now own a larger share, about 67 per cent, of their own government’s debt than the banks of any other country in the eurozone, according to research by BNP Paribas. Now the value of those bonds is declining – prices fall as yields rise – and further weakening Spanish banks.

In recent months, some of the biggest sellers of those bonds back to Spain’s banks have been foreign banks and investors eager to take their money and run. In March, foreign bond investors owned only 26 per cent of Spain’s bonds, according to a recent analysis by JPMorgan, down from about 40 per cent a year earlier.

“There has been a great retreat here, and you can see it in the reduced foreign ownership of Spanish government bonds,” said John Whittaker, an economist at Lancaster University in Britain who tracks capital flows within the eurozone.

Burdened as they are by problem loans from the collapse of Spain’s real estate bubble, banks now have the additional onus of carrying large holdings of government bonds that are losing value by the day. Among the largest holders of Spanish bonds are the country’s international banking giants Santander and BBVA, which, through February, owned 60 billion euros and 49 billion euros.

Given those big banks’ diverse overseas operations and stronger capital positions, these holdings do not represent an immediate threat. But for Spain’s many domestically focused banks, including the bailed-out Bankia, which had 29 billion euros worth of government bonds as of last year, such exposures are more problematic.

It’s not just Spain, either. Italian banks have also been enthusiastic buyers of their government’s bonds, and they own 57 per cent of bonds outstanding. As in the case of Spain, foreigners have been obliging sellers and have sold 242 billion euros worth of bonds to local banks, bringing their share in Italian bond holdings down to 35 per cent as of this March compared with 51 per cent late last year.

Just before the restructuring of private-sector Greek debt in March, foreign investors owned 32 per cent of the bonds outstanding, a higher proportion than what foreigners now own in Spain.

If Spain does eventually need to seek a European bailout, it might have trouble meeting the various conditions – most prominent of which would be hitting budget deficit targets.

And on that score the news is not good. Through the first four months of this year, Spain’s budget deficit was 26 percent higher than it was a year earlier, because of increased payouts to its debt-plagued regional governments, collapsing tax revenues and the soaring cost of unemployment benefits.

The prospect of Spain’s bringing its deficit down from its current level of 8.5 percent, to the 5.3 percent target set for this year by Europe, now seems unlikely. “We are a highly leveraged nation,” said Valverde. “What we need is a Europe-wide solution.”