My stance on Spain has been highly negative for quite some time, mainly due to negative growth prospects as a result of the austerity measures and the sovereign debt problems. Still, the large foreign debt holders retrenchment during the last 12 months and the way the ECB handled these outflows allow for an alternative view of the future.
First, here’s a detailed view of the available current account data (which stretch up to May 2012 for now):
The Spanish current account deficit has closed significantly, to -€16.9bn for Jan-May 2012. Given the ongoing deep recession, it is quite reasonable to assume that the annual deficit will not be more than €35bn, lower than 3.5% of GDP. Financing a deficit of roughly €3bn per month, even if it means borrowing from the BdE and increasing Target2 liabilities, should not be considered challenging given the balance sheet size of BdE and the available assets of Spanish MFIs.
What is crucial is to stop the outflows in the financial account, present both in portfolio investment (for both of general government and MFI assets) and other investment (mainly short-term loans of MFIs):
Unfortunately, ‘other investment’ (loans of MFIs) is the most difficult flow to stabilize. It will require the continued support of the ECB, probably through more LTROs (of at least 12-month duration) and it will lead to a large increase in the Target2 deficit. Current RoW deposits of credit institutions are €406bn, while loans to RoW are €267bn, a rough net position of €140bn, although Spanish banks also hold more than €150bn in portfolio assets abroad (securities and shares).
Let’s move to portfolio investment. According to Spanish Treasury data, foreign holders of government debt securities held (on a net basis) €208.6bn in September 2011 (38.5% of total tradable debt securities) which fell to €182.3bn in May 2012 or 31.7% of total. By now, foreign residents should hold less than €160-170bn (their registered holdings dropped by 9bn in June). A big problem is the fact that bonds and notes holdings by the RoW of MFIs and other resident sectors are as large as government securities holdings (€205.2bn and €221.7bn in 2012Q1) government securities and have also registered large outflows during 2012. These holdings pose the largest uncertainty for future outflows, especially since there’s no available buyer of last resort.
In the case of government securities, the RoW holdings most probably set the upper limit of a future ECB intervention in bond markets. A ‘hybrid’ bailout scheme involving the ESM and the ECB could be introduced in which:
- The ESM buys government bonds in auctions. In order to minimize the necessary intervention the ESM could just state certain spreads compared to Euro interest rate swaps for every bond class and place competitive bids based on these spreads which will provide a carry trade opportunity for other participants (who would only need to place lower yield bids in order to acquire the bonds). All interest income above the ESM funding cost should eventually be returned to the Spanish Treasury, probably based on conditionality of program compliance.
- The ECB supports the secondary market through bond purchases (at the short-end part of the curve based on its recent statements). Given that yields pressure will mostly come from non-residents short positions, ECB intervention will basically finance any portfolio outflows in RoW government securities holdings.
The ECB market effect of the SMP portfolio can be enhanced by managing it more like the Fed’s SOMA. In particular:
- The ECB should announce that it will roll-over its debt holdings as long as that is required by financial conditions. Any final discount profits should be remitted to the issuing country Treasury.
- The ECB can set a spread over its total SMP term deposit interest costs and immediately remit any profits to the issuing country Treasury on bond interest payment days (a simpler solution would be to just remit any profits over the ECB main refinancing rate although that will lower the available profits).
If it is carried out in this form, the ESM/ECB ‘hybrid’ intervention will probably not exceed €100bn (if the 2012 funding needs are covered) since a (recapitalized) domestic banking system will be able to participate in bond auctions. Current BdE Target2 liabilities are €415bn, net RoW ‘other investment’ stands at €140bn and portfolio investment excluding government securities is roughly €400bn while the annual current account deficit will be around €35bn. Assuming that outflows from other portfolio investment categories are reasonable, total outflows in a post-bailout environment should not exceed €10-20bn/month, a level that i consider manageable.
The fact that the BdE pays the ECB refinancing rate on its Target2 liabilities places a strong floor on the income deficit created by interest payments. Lending from the BdE in order to finance the outflow in portfolio/other investment does not change the ultimate Spanish net investment position but, as long as the corresponding collateral maintains its value, is cost-limited by the ECB rates (and not market rates). Even if Target2 liabilities were to reach €600bn, based on a 0.75% ECB rate, the total annual cost will be €4.5bn or less than 0.5% of GDP. As long as the ECB/ESM remit any profits to Spain, the same will apply to a possible bailout.
In this context, large BdE lending to the Spanish banking sector and a ‘soft-bailout’ can actually prove to be stabilizing factors by anchoring interest costs in the current account. The main risk continues to be the macro situation and the fact that a bailout will be conditioned on even harsher recessionary measures. What the Eurozone lacks is a ‘growth mechanism’, one that will unconditionally and directly finance investment and employment in countries in recession.
- ‘Other investment’ outflows mainly involve short-term bank loans. Net RoW lending of domestic credit institutions stands around €140bn. The outflows can probably be offset by BdE lending through the MRO and 3-month LTROs (since loans are short-term anyway).
- Portfolio investment outflows are observed in all of the bonds and notes categories, mainly government securities, MFIs and other residents. Government securities outflows can be handled by ECB SMP purchases and ESM primary bond auction bids. Outflows in MFI debt will probably require easing in ECB collateral rules and long-term LTROs (12-month?). The ‘Other residents’ outflows are a problem not easily solvable. Each category is around €200bn or less.
- ECB and ESM intervention if done correctly and remitted profits to the Spanish Treasury can provide support for the bond market, since foreign holdings of government securities are probably less than €160-170bn by now while residents are assumed to rollover their holdings. The size of the 2013 deficit is an open question since the Spanish government might need to also finance regional/local government debt.
- The annual current account deficit stands at less than €35bn, a figure that can be financed relatively easy by domestic sources (by using BdE financing).
- Retail deposits do not seem to be flowing out of the country. As long as there is not adverse shock in that category, the outflows can be contained. NPLs will be handled by the recapitalization loan of 100bn by the EFSF/ESM.
- Regarding BdE financing of outflows (which create corresponding Target2 liabilities) they provide a ceiling on interest payments abroad (equal to the ECB refinancing rate). In contrast with a fixed exchange rate mechanism, the Eurosystem framework of the Eurozone provides for unlimited domestic financing of outflows (with very flexible collateral rules as evident by ELA financing in countries such as Greece) using the NCB refinancing operations, with the ultimate constraint on capital flight being interest payments rather than the actual flows.
In any case, the low RoW holdings of government securities limit any possible future Spanish debt restructuring to maturity extension/NPV haircuts rather than principal reduction, since the latter will entail further loans in order to support the domestic sector while lowering its actual net worth.