“Severing ties with sovereigns is easy. Happens all the time here, when a client forgets to take it off…” – anonymous guillotine operator, Paris 1789
Let’s face it. The real problem for resolution of the Euromess is not moral hazard, nor conflict with existing law, or the Treaties. The real problem is that the ones on the hook simply don’t feel like paying the price to rescue debtor countries.
To this day, all German efforts are directed to the same goal: keep the price tag to a minimum and extract a maximum conditionality in return.
Germany wants it all. It wants its debt paid back through austerity before a rescue is put in place. It wants to control national budgets from then on to make sure this doesn’t repeat. And, of course it wants to keep on exporting at growing rates. But it doesn’t want the ECB to rescue Euro countries. As an old friend of mine, a retired Ambassador to Germany, put it to me once, “These people like to win always, at everything. They don’t understand life doesn’t work that way”.
The EU is a very dysfunctional body without a real decision making process. It uses instead a sound bite system. Different sound bites are tried out and when Germans and French start repeating one, eurocrats know they have found a safe option. Immediately, they start repeating it louder and louder. When Olli Rehn and Jean- Claude Junker start mouthing it, it is an official proposal. By the time Van Rompuy joins the chorus, you know it’s an epic fail.
The last sound bite that seems to catch on in relation to Spain seems to be “sever ties between sovereigns and the banks” Just like that. Suddenly everybody agrees that if only the incestuous relation between the Spanish government and its banks could be terminated, the day could be saved, of course, on the cheap.
The reasoning goes like this:
– The real problem in Spain is private debt held by the banks. The sovereign is just suffering from contamination from the cost of the rescue
– If a rescue is directed exclusively to the banks, the Spanish sovereign will be safe because it will shake a huge liability off its shoulders and it won’t add to its debt.
– This will in turn start a virtuous circle where the sovereign sells its debt a price more related to risk and the banks get some breathing room to slim down.
– Hey! And it’s cheaper!
To wit, there’s a lot of merit to most of this. Any long term solution for Spain will be more solid if it cuts the illicit ties of government and banks.
However, this obviates half of the problem. Going back to the drawing above, it is clear that not only an axe, but also TWO nets will be needed. A direct rescue of the banks is an axe and a net for the fat banker in the picture. But the toreador will fall to his doom if there is not a sovereign rescue package.
Why so? Well, any package for Spanish banks will be limited to the strictly minimum amount, as we have seen it to be the case last week. To keep costs low, many policy makers, from the EU to creditor countries have expressed their strong determination to accompany the bail-out of a bail-in. That is, to wipe out shareholders and possibly bond holders too, in order to minimize the cost to the creditor countries’ taxpayers.
This implies liquidation of troubled banks and radically shrinking the balance sheet of the system. In such a scenario, healthy banks will flood the market with core and non-core assets (to avoid intervention and abiding to rescue conditionality), joining the liquidated banks assets and suddenly depressing prices.
The easiest assets to liquidate will be debt, equities and real estate. In the long term, the Spanish economy will benefit hugely from withdrawal of banks from the real economy, especially if it is not unwind in a more favorable situation. It will bring a more prudent fiscal policy, an improvement of companies management via removal of inept management held in place by the bank network and a much needed price adjustment in real estate prices.
In the short term, however, all three liquidations will create problems in each of these asset classes. In the case of public debt, in particular, the most liquid asset and hence probably the first one to be liquidated, a tsunami of supply could be the last straw on the camel’s back.
Banks have increased their share as holders of Spanish treasuries as foreign holders dumped them during last year.
Spanish T-bond holdings of the Spanish banks jumped 100bn from 12,75% of the total in April 2011 to a 29,24% share in April 2012. In this period, foreign residents dumped 76 bn and cut their share of the total from 53,7% to 37,31%. Moreover, Spanish banks are now the sole source of financing for their government.
A very obvious condition of any direct rescue to the Spanish banks would be to cut down their debt books and refrain from being the main source of financing for the Spanish state.
Now, we have to remember that, while a direct rescue to the Spanish banks, one that wouldn’t increase sovereign debt, is being considered, this would apply to the next one needed, not to last week’s 100 bn package, which has already been loaded on the squalid sovereign’s shoulders.
Without this package, Spanish sovereign debt was expected to reach 80% of GNP by the end of this year. Assuming that the 100bn is used entirely (and it will), the old prevision is automatically bumped up to 90%. This doesn’t take account of the effect on real GDP that credit restrictions to be imposed as part of the conditionality will have. Nor the increased liabilities for the state from additional unemployment, nor the increase in borrowing costs that Spain is undergoing.
It is a fair assumption that Spain’s sovereign debt will be well above 100% of GNP by the end of 2013. But never mind 2013. If ties between the banks and the sovereign are severed without a safety net for the latter, we can expect it to drop hard. Average cost of debt financing in 2011 was 3,85%. Growth perspectives are solidly negative for the foreseeable future. Inertial growth of the Spanish debt is so strong that it will require Herculean fiscal efforts of the Spanish government to bring the total down with increasing primary surpluses.
Of course, if the toreador drops to the abyss, it will be found that the ties hadn’t been severed, after all. With the huge price drop and what not, it will have been impossible to liquidate all sovereign debt held by the banks. Now their capital will get eroded again by the drop in Spanish bonds’ prices… Oh no!