Since Friday, Spanish bond yields are clearly over the 7% threshold making market access and debt sustainability a challenge. I ‘ll take the opportunity to look into more details on the Spanish balance sheet regarding other residents.
The first table includes main liabilities to RoW based on BdE balance of payments data which are only available till 2012Q1 (they will be updated on 31 July):
What is clear is that the main driver of capital flight is a drop in securities investments. Money market instruments also show a large drop, mainly in the general government sector, although the relevant positions were already quite small. In my view this is a clear case of an asset class not being considered ‘safe’ anymore (in the Gary Gorton terminology) with investors moving out of it. Both the Spanish government and economy are now viewed as a higher credit risk instrument, with funding dropping both in the bond (Held to Maturity) and money market areas.
The same is evident if one looks at monthly flows of direct investment (with portfolio investment being the one mainly hurt):
The first observation is the significant drop in RoW deposits in credit institutions, deposits which should mainly be considered as part of money market funding. The drop in securities liabilities is much lower than the one observed in the balance of payments data, suggesting that resident banks found new domestic sources of funding (most probably with the help of BdE).
On the government debt front, Treasury data show a large drop in RoW (permanent) holdings, which is covered by an increase in holdings by domestic credit institutions. By subtracting the Net position from the outright holdings, one can calculate the outstanding repo funding from the RoW. Repo funding reached a high in September 2011 but has dropped significantly ever since, especially during 2012. This is another indication of elevated counterparty/collateral risk which leads to a large ‘haircut’ in funding.
Adding up the drop in outright holdings and repo transactions, a large part of the external position (and target2 liabilities increase) deterioration can be explained by foreign investors moving away from the Spanish bond and repo market. The repo/money market drawback is evident in the balance of payments other investment data as well:
Clearly a warning sign is the large decrease in turnover in the outright transactions (bond) and repo markets since February. This was the main pattern observed in the Greek case, with outright trading coming to a halt and price discovery moving to the CDS market with bond yields following CDS spreads (instead of the opposite) since the derivatives market became the most liquid. One thing to keep an eye for is the CDS net notional. If that starts dropping with opposite movement in the gross notional that will mean that market participants are not creating any new net contracts (which ultimately require a short position on the underlying instrument) but only leverage existing contracts by shorting CDS while covering the position with an older long position. This would indicate an unwillingness to take the original credit risk and a difficulty in covering a short position in the bond market. The intermediation trade is probably a nice arbitrage trade since collateral will be provided by the original seller or the new buyer of the contract (depending on how CDS spreads move).
This chart for the Spanish CDS net notional (from ftalphaville) is not good. Current gross/net notional is $171.6/13.7bn while they were $163.2/13.9bn a month ago.
A positive number is the total government deposits available which stand at a little over €90bn. Given the current government debt redemptions schedule and net funding needs, the government does have some leverage in the short-term until probably October (when redemptions are €27.4bn), even if it cancelled all new auctions (except for T-Bills) since most of the redemptions actually concern t-bills (which i think can be covered by domestic credit institutions in any case). With that in mind, i don’t see an immediate reason for a full bailout, at least not until the ESM is allowed to be activated by the German constitutional court in September (since financing through the EFSF for sovereign needs would mean removing the Spanish guarantees). One can probably safely acquire (outright or as collateral in a repo transaction) any debt maturing until October.