Saving Spain as it is too big to fail

Madrids trump card is that its default and exit from the eurozone would be catastrophic

The bargaining has begun over a deal to rescue Spain’s ailing banks, confronting Europe with urgent choices about whether to try to enforce onerous bailout terms on Madrid as the crisis spreads to the region’s largest economies.

The question has seemingly become one of when and not if Spain’s banks will receive assistance from European countries, with investors predicting an imminent rescue and pushing up stocks and bonds on both sides of the Atlantic.

Spain, the eurozone’s fourth-largest economy, is too big too fail and possibly too big to steamroll, changing the balance of power in negotiations over a bailout. Political leaders in Madrid are insisting that emergency aid to their banks avoid the stigma in capital markets that has hobbled countries like Greece, Portugal and Ireland after accepting tough rescue terms. They are also fighting to slow the pace of austerity and economic change that have pushed those smaller countries into deeper recessions.

Spain has the added advantage of seeking help in a changed political environment in which calls for growth have begun to outweigh German insistence on austerity. Unlike Greece, Spain’s government did not run large budget deficits before the crisis, giving it leverage to argue that European aid to its banks should not come weighed down with a politically delicate loss of decision-making power over its own economic and fiscal policies.

Madrid’s trump card in this latest game of eurozone poker is that the consequences of a Spanish default and exit from the eurozone would likely be so catastrophic that policymakers in Berlin will be willing to bend their bailout rules for Spain, and are on the verge of doing just that.

German officials have said they are prepared to weather a Greek exit from the euro if necessary, but no such claims are made about Spain. As such, Spanish leaders, who feel Madrid has already made many painful changes and spending cuts, are holding out for a deal that requires only a tightening of oversight on its financial sector and no strings attached to the country’s budget powers.

Spain also appears to be forcing a reckoning about the expensive steps political leaders in Europe need to take if they want to hold the eurozone together. Hopes that the European Central Bank would ride to the rescue, as it did with two waves of generous loans to Europe’s banks in December and March, or at the very least a cut in interest rates, now at 1 per cent, were dashed when the bank’s president, Mario Draghi, said that he did not “think it would be right for monetary policy to fill other institutions’ lack of action.”

“Some of these problems in the euro area have nothing to do with monetary policy,” Draghi said at a news conference, his message to European leaders boiled down to: “Your problem, not mine.”

The wrangling over Spain underlines the way the European Union stumbles to solutions for each problem as it arises. Frustration has grown over the uncertainty afflicting the global economy as a result of Europe’s instability and the toll it takes on an already slowing growth rate.

“The strategy of plugging holes only works for so long,” said Friedrich Mostbock, chief economist and head of research for the Erste Group in Vienna. “Eventually, you come to the point where a common euro area requires a common fiscal policy.”

Spain and Greece

Prime minister Mariano Rajoy of Spain has made clear that he intends to draw a distinction between Spain, which has a lower level of debt as a percentage of gross domestic product even than Germany, and Greece, which has given up a great deal of its fiscal sovereignty to lenders in exchange for assistance.

For Spain, a bailout is more than a matter of pride and sovereignty. “The experience of Ireland, Portugal and Greece is that it diminished their access to commercial markets,” said John Chambers, managing director and chairman of the sovereign rating committee at Standard & Poor’s. “Spain doesn’t want to go that route.”

The Spanish economy minister, Luis de Guindos, made a surprise visit to Brussels on Wednesday to meet with the European commissioner in charge of competition, Joaquin Almunia, a fellow Spaniard, followed by a trip to Paris to meet with Pierre Moscovici, France’s finance minister. That fuelled speculation that Madrid was laying the groundwork to make a formal request for help sooner rather than later.

Because Spain has already made many painful changes and spending cuts, officials in Brussels and Berlin are much more open to a bailout that mostly imposes conditions and oversight on the financial sector in Spain.

Moscovici said that Europe stood ready to help Spain. “If Spain desires, we in the eurozone can mobilise rapidly,” Moscovici said at a news conference in Paris. But de Guindos said there were currently no plans to seek a bailout.

Yet, as recently as Tuesday, Spain’s budget minister told Spanish radio that the financial markets were closed to Spain. The mixed signals coming from Spanish officials seemed to reflect an odd balancing act – trying to reap the advantages of sounding alarmed, but not so desperate that they signal a willingness to let European officials dictate harsh terms and conditions.

De Guindos has spent this week shuttling between European capitals to secure some sort of rescue package for Spain’s troubled banks. The list starts with Bankia, which was nationalised in early May and needs $24 billion of additional funds after restating its accounts, to a 2011 loss of almost $3.75 billion rather than the $388 million profit it had reported in February.

German officials have been privately pressing the Spaniards to take a bailout. On Tuesday, Volker Kauder, the head of Chancellor Angela Merkel’s Christian Democrats in Parliament, said that Spain “has to seek a rescue.” But as long as Brussels and Berlin believe aid is necessary, Spain retains bargaining power – the chance that it self-destructs implicitly holds the rest of Europe hostage until they agree to terms.

One crucial issue is whether emergency lending would be made directly to Spanish banks. That is a line in the sand for German officials, who argue that under Europe’s hybrid structure, banks are the responsibility of their sovereign governments, not the European collective. But making emergency loans to the Spanish government to rescue its own banks, as European lenders did for Ireland, presents other problems, because it would increase government debt and impair Spain’s ability to sell bonds.

The German daily Sueddeutsche Zeitung reported Wednesday that officials here were examining a possible compromise under which rescue funds were paid directly to Spain’s Fund for Orderly Bank Restructuring, known as FROB.

Should Berlin agree to a rescue package with limited conditions, it would allow Rajoy to save face, after repeatedly pledging that Spain would not request a Greek-style bailout.

The ultimate solution will hinge on Germany and how much its leaders are willing to bend. Berlin has an incentive to get the Spanish problem under control before Greek parliamentary elections on June 17, to help contain contagion in the event of instability after the vote, said Holger Schmieding, chief economist at Berenberg Bank.

“I’m naively optimistic that it would be good to have the Spanish problem solved before the Greek election,” he said, “and my impression is the relevant policymakers think the same.”