Rajoy scuppers Bankia bailout optimism

Rajoy scuppers Bankia bailout optimism
29/05/12 @ 07:19 GMT by Michael Derks, Chief Strategist

At yesterday’s hastily convened press conference Spanish Prime Minister Rajoy poured some cold water over weekend reports of a EUR 19bn bailout for Bankia, claiming that no decision had yet been taken. Rajoy further contributed to the climate of fear and uncertainty by asserting that Spanish banks did not need recuing (a claim which he surely will regret in due course), while arguing that Spain’s debt sustainability problem needed to be resolved. He also argued that the EFSF and ERM ought to be able to recapitalise European banks directly, rather than needing to go through national governments. Unfortunately, Rajoy’s latest missive only conflagrated existing paranoia regarding Spain’s increasingly desperate financial predicament (see below). The Pandora’s Box that is the dodgy loans on the balance sheets of Spanish banks is now spilling forth into full view, and it is every bit as bad as many of us suspected.

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Commentary

No more than a brief respite for the euro. For a time yesterday, it appeared that something of a short-covering rally might be underway. Two developments encouraged this activity. Firstly, the New Democracy Party in Greece, which favours continued adherence to the terms of the international bailout, had a respectable lead in some of the weekend polls over the hard-line Syriza. Despite stark warnings from leading Greek politicians of the financial calamity that awaits Greece should it decide to leave the eurozone, it may well be the case that circumstances inevitably result in this outcome in any event. According to Charles Dallara, head of the IIF, the financial cost of a Greek exit from the single currency would likely exceed USD 1 trln. Secondly, a Sunday Times article revealed ‘secret plans’ by the EU to set up a rescue fund for European banks, funded by a levy (on the banks). This fund would have the power to take over those banks struggling to maintain their solvency. Work on this proposal is running concurrently with an initiative of Mario Monti, who is exploring a Europe-wide deposit guarantee scheme also funded by a levy on banks, with the likes of the ECB and/or the ERM providing additional financial resources. On one level, it is perfectly understandable that Europe’s mostly fiscally bankrupt sovereigns are trying to force the banks to stump up the cash. However, it will be strongly resisted by the finance sector, especially in the UK, and will hurt competitiveness. Also, it is hard to see how European sovereigns (with only a couple of exceptions) are in any fit state to contribute financially to any deposit guarantee scheme. At a national level, existing deposit guarantee schemes are already woefully underfunded in nearly all instances. Finally, it is worth noting that we are approaching month-end, and after such a dramatic move in the euro (specifically) and risk assets (more generally), some month-end rebalancing may actually benefit both the single currency and markets over coming days.

Spain’s financial death-trap. The financial dominos in Spain are falling very rapidly now, and before too long the sovereign will be forced to apply to Europe for significant assistance. On the first day of the new week, the Spanish 10yr yield rose to 6.5% at one stage, not that far away either from the high reached in November last year or the 7% level that triggered bailout requests from the likes of Greece, Ireland and Portugal. With the local economy imploding, Spain’s ugly financial plight is worsening at break-neck speed. Regional finances are a train-wreck. Catalonia warned last week that it is about to run out of money completely, whilst Valencia stopped paying its suppliers long ago. Debt at the regional level is soaring - now EUR 140bn - and still climbing quickly as large regional deficits refuse to come down despite the best endeavours of the central government. The latter has been exploring for more than two months ways to alleviate the crippling funding pressures being experienced by regional governments, but central government itself is severely constrained in terms of taking on any additional liabilities. As a sovereign, Spain is on the precipice of losing its investment-grade status; S&P for instance has Spain at BBB+. Two weeks ago, a plan was hatched whereby regional governments would obtain loans from the central government backed by local government revenues. In exchange, the regional governments vowed to implement significant austerity measures to reduce the size of their fiscal shortfalls. At the same time, the Rajoy government is thrashing around attempting to resolve the country’s banking crisis. After Bankia’s emergency application for a EUR 19bn bailout last Friday, speculation is understandably mounting that many more banks will require significant injections. Yesterday’s El Mundo claimed that an additional EUR 30bn is required to clean-up Spain’s banks. The latter continue their tardy approach to declaring NPLs – a report from the Centre of European Policy Studies declared that potential write-offs may total as much as EUR 270bn. That said the appointment of independent auditors to stress-test the entire loan book of Spanish banks is clearly forcing bank executives to come clean on their toxic assets. Brussels needs to put the pizza-delivery companies on notice because there could be plenty of all-night emergency summit meetings over coming weeks to decide what to do about Spain. Most of the regions are toast, a number of the banks are toast and the sovereign will be also without outside help. No doubt the UK will have an extremely strong interest in developments in Spain – within Europe the UK is far and away the biggest lender to Iberia’s largest economy, with financial claims of almost USD 400bn at the end of last year (60% of the total for Europe).

More Swiss stress. All things are relative and some of the movements we’ve see on EUR/CHF in recent days have been notable, at least compared to the torpor of recent weeks. There was some initial volatility towards the end of last week, in part on the back of rumours circulating in relation to possible measures the Swiss authorities may take to quell Swiss franc-strength. We’ve had more clarity on this over the weekend thanks to comments from the SNB’s Jordan in relation to the working group set up to look into the issue of franc strength. In particular, much has been made of the comments about capital controls, or the fact that the SNB does not rule out introducing such measures in an attempt to quell further upside pressure on the franc. Given its position, it’s interesting that the SNB is being more open with its thinking around the implications of a possible fracturing of the single currency. It knows that the key threat would be further upward pressure on the Swiss franc, and sale of unlimited quantities of francs by the SNB would not be without domestic implications. At the same time demand from the eurozone for Swiss exports would fall drastically. It would be an unwelcome combination of events for an economy still struggling with shaking off deflation, CPI now down to -1.0%. Furthermore, there is no doubt that the move would not be welcomed internationally and, even though Switzerland’s circumstances are fairly unique, the risk of others following suit would naturally increase. We could be heading back to the 1970s.