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The Spanish Inquisition (Part 2)
Malaysia Perspective | 24 July 2012
By:

By Yeow Mei Kei

Investors now know that Spain has been extended a lifeline by the Eurozone – a €100 billion bailout for its troubled banking sector. In doing so, the credit rating of Spanish sovereigns were cut several notches by both Fitch and Moody’s as well as resulted in rising yields on Spanish sovereign bonds.

In our July 2012 issue, we highlighted the problems affecting Spain. We talked about the bursting of the housing bubble, which added plenty of pressure and toxicity to loans in the Spanish banking sector as well as resulted in a high unemployment rate and a recession that is deepened by harsh austerity measures. While it is impossible to expect any of these structural issues to be resolved over night, the unforgiving nature of markets has punished Spain through shutting the door on the sovereign’s access to debt markets. On 18 June, the yield of 10-year Spanish issue was at a high of 7.158%

Why The Rise In Spanish Bond Yields?
In mid-July, Spanish yields have risen to a record Euro-area high that had seen the likes of Portugal, Ireland and Greece required assistance and bailouts. While Spain is in relatively better shape, the shambles that its banking sector is currently undergoing is the main worry and cause for its rising yields. The Spanish banking sector has yet to fully write-down toxic assets and losses related to the property and construction industry as well as mortgages. With an already weakened balance sheet and impending further write-downs upon the conclusion of an independent audit by third parties commissioned by the Spanish government, the sector has little to no means of rescuing itself, solely leaving the onus on the sovereign.

The recent announcement that the Eurozone would lend Spain up to €100 billion to fix its banks and allow the banks to absorb losses that lie ahead, is by no means guaranteed to be sufficient for the troubled banking sector. It has proven to be a double-edged sword for Spanish sovereign yields. While this means that the Spanish banking sector will in all likelihood be saved, the question of on whose shoulders will the cost of the bailout fall on, has contributed to Spanish debt yields getting higher. The introduction of an additional €100 billion to Spanish debt could see the country’s ratio of debt to gross domestic product (GDP) spike to over 83 percent from an end-2011 ratio of 68.5 percent. Taking into account the economy’s contraction of 0.3 percent in first quarter 2012, it would see investors requiring a higher yield from Spain in return for the added risk.

Thus, as it is, Spain is in a tight spot and needs to win an extremely delicate balancing act as it needs sufficient funds to recapitalise its banks. Yet, the size of the programme needs to be not large enough to derail the sustainability of Spain’s public debt.

Implications To Investors
With markets effectively shutting the Spaniards out of the debt market, the country has had no choice but to seek assistance from the Eurozone to bailout its banking sector. With refinancing needs of €347.9 billion due by 2016, Spain needs to be able to access the debt market. However, the risk premium on 10-year issues as compared to the safe-haven German bunds, reflects the market’s concerns over the Spanish situation and has restricted Span’s ability to refinance via the debt market.

Chart 1: Spanish debt distribution

Chart 2: Risk premium for Spanish bonds rising

Given the current situation, there are only two possible scenarios for Spain: yields continue to remain above 7 percent, or, yields fall to lower levels.

Scenario 1: Yields Remain Above 7%
Should yields continue to remain or rise higher above the 7 percent mark, Spain would have little choice (sooner or later) but to follow in the footsteps of Portugal, Ireland and Greece in seeking a full bailout from the Eurozone. Austerity would be the price that the Spaniards have to pay, while some growth measures would likely be included in the bailout package as the Eurozone learns from its past mistakes.

Scenario 2: Yields Fall To Lower Levels (Most Likely)
The current situation does not possess the necessary ingredients that could give rise to a situation with which the yields on Spanish sovereign debt can come down significantly by itself. Rather, in order for yields to fall to more normalised levels, the inclusion of and participation by European institutions such as the European Central bank and European Stability Mechanism (ESM) is required in the near term. Various programmes and channels are available to them, such as the Securities Markets Programme, Longer Term Refinancing Operations and perhaps even the specific recapitalisation of banks by the permanent ESM.

Given additional time (2 to 3 years), the painful reforms recently undertaken by Spain will likely see their effects begin to reap benefits for the country as the labour market and other economically important areas get restructured in a bid to become more competitive.

Conclusion
While the situation in Spain definitely warrants our attention, it currently appears unlikely that the Iberian nation will go down the same path as Portugal, Ireland and Greece. Rather, it is of our opinion that the country will most likely be the first to tap the ESM. This would allow Spain to recapitalise its banks without the need for a full bailout, which was the case for the other three countries in order to cover their funding needs. Hopefully, this will enable the Spaniards to break the negative feedback loop between its banking sector and sovereign yields, thus giving it the opportunity to borrow from the debt market, buying it some time to fix itself, and allow for reforms to take effect.

We continue to remain wary of the troubles afflicting the continent, despite the positive results of the Greek election, and advise investors to underweight the region relative to the faster growing and more attractive Global Emerging Markets and Asia ex-Japan regions.

Yeoh Mei Kei is a Research Analyst at Fundsupermart.com


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