Spain Scenarios- Bring on the Bailout

7/29/2019 Spain Scenarios- Bring on the Bailout

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RoubiniGlobalEconomics2011AllRightsReserved.Noduplicationorredistributionofthisdocumentispermittedwithoutwrittenconsent.

May4,2012

SpainScenarios:BringontheBailout

ByMeganGreene,KatharinaJungen,JenniferKapilaandDavidNowakowski

ExternalandPublicDebtSustainability:Spainwouldhavetoundergoenormousprimaryandcurrentaccountadjustmentstoput itselfonapathtowardfiscalandexternaldebtsustainability.Basedon

our forecasts forSpanishgrowthoverthenextfewyearsandourmostforgivingdefinitionoffiscal

sustainability,Spainwouldstillneedtoengendera4.5%ofGDPprimaryswing in2013anda4%of

GDP swing in 2014. To stabilize its external debt without fresh sources of external funding, Spain

wouldbeforcedtoadjustitstradebalanceby5.4%ofGDPthisyear.Theseadjustmentsarenotonly

unrealistic,but theywouldbeselfdefeating. In theabsenceof theseadjustments,Spainwillneed

officialsupport.

TheBankingSystem:Weestimatelossesintherangeof130billion300billion,underthreedistinctframeworks for assumptions; assuming all losses are taken today and ignoring taxes, the required

equityinjection

to

maintain

a

9%

core

Tier

1

ratio

is

some

30

billion

40

billion

below

the

relevant

loss estimate. Yet, in the near term, we are more concerned about banks funding pressures and

dwindlingcollateralbuffers.Wearedoubtfuloftheircapacityandappetitetosupportthesovereign,

particularlyamidratingdowngradeswhichincreasehaircutsanddepositwithdrawals.

Households and Corporates: Despite considerable net assets, household and corporate balancesheets are burdened by high debt and concentrated exposure to the distressed property sector.

Deleveraginghasbegun,butthereisfartogomanyhundredsofbillionsofeuros,4050%ofGDP.

Thissavings impetuswillcontinuetocontracttheoncehugecurrentaccountdeficitbut,withouta

devaluation,isnotenoughtogenerateasurplusandabsorbimmensecapitalflightandnegativeFDI.

RGEsScenariosforSpain:o BaseCase(60%):Abailoutforbanksfailstoregainmarketconfidenceand,intheabsenceof

growth, the sovereign needs a bailout too. The securities markets program (SMP) is

reactivated and is accompanied by the European Financial Stability Fund (EFSF) in buying

Spanishsovereignbonds.Asovereignbailoutbuyssometime,butnotenoughforSpainto

implement structural reforms and return to growth. When the bailout runs out, Spain

restructuresitsdebt(2015).

o Upside(15%):AproactiveSpanishbankrecapitalization isaccompaniedbyapolicyshiftattheEUleveltofocusongrowthratherthanausterity,furtherliquiditymeasuresbytheECB

and government bond purchases by the ECB and/or EFSF. Consequently, a bank

recapitalizationhelpstorestoreinvestorconfidenceinSpain,andafullblownbailoutforthe

sovereignisavoided.

o Downside(25%):TheSpanishgovernmentresistsabailoutand,inthemeantime,contagiontakesthecrisiswellbeyondSpain,toItalyandthecoreeurozone(EZ)countries.Ratherthan

throwmoregoodmoneyafterbad,EZleadersopttousetheEUIMFfirewalltosupportan

orderlysovereigndebtrestructuring forseveralcountries, includingSpain,andto facilitate

theexitofsomeEZcountriesinlate2013attheearliest.


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Figure1:ExternalDebttoGDPCanVaryEnormouslyFromPublicDebttoGDP(%)

Source:Haver

Note:SolidlinesrepresentpublicdebttoGDPratios,dottedlinesexternaldebttoGDPratios

PrimaryBalanceGapAnalysisHere, we examine the swing in primary balance that Spain has to achieve to fulfill two different definitions of

publicdebtsustainability.Forbothcases,weassumethatSpanishbankswillneedtoberecapitalizedbyaround

10%ofGDPbytheendof2012,andthatthefundingforthoserecapitalizationswillcomethroughthesovereign.

Inourfirstcase,weassumethatSpainwillcomplywiththefiscalcompact,whichdemandsthatacountryreduce

itspublicdebteachyearbyonetwentiethofthestockofdebtover60%ofGDP.Inoursecondcase,weassume

Spain stabilizes its public debt at2012 levels. We thenexamine theprimary balance required to stabilize debt

usingcyclicallyadjustedunderlyingassumptions.

Spains

public

debt

trajectory

remains

highly

sensitive,

not

only

to

potential

bank

recapitalization,

but

also

to

its

growth trajectoryoverthenext fewyears.ThegovernmenthasbeenpushedbytheEuropeanCommissionand

themarketstoimplementaseriesofausteritymeasuresandstructuralreforms.Thesemaywellsupportgrowthin

the medium to long term but, over the next few years, they will significantly undermine it. A key underlying

assumptioninourpublicdebtsustainabilityanalysisisthereforethat,afterdippingbackintorecessioninH22011,

SpainsGDPwillcontractfurtheroverthenextfewyears.

Theothermainparameterdeterminingthedebttrajectoryis,ofcourse,thefiscalbalance.Spainhasmissedtarget

aftertarget,whichPrimeMinisterMarianoRajoyhasblamedlargelyontheinabilityofthepreviousadministration

toreininfiscalslippageattheregionallevel.Fornow,thecenterrightgovernmentseemsdeterminedtostickto

theEUagreedfiscalconsolidationagenda,whichrequiresareduction inthebudgetdeficitfrom8.5% in2011to

3%by2013.Wedonotexpect thegovernment tosucceed inthismissionastheaggressiveausteritymeasures

requiredtocomplywiththistargetwillfurtheraggravatetheeconomicrecession.

Whilesecondarytogrowthandfiscalfigures,assumptionsoninterestpaidonexistingdebtandinflationarealso

important. Here, we assume that the average interest rate will rise strongly as Spain will have to roll over

approximately30%of itsdebt in thenext twoyearsaloneandabout50%over thenext fiveyears.We expect

consumer price inflation to decelerate over the next few years as austerity measures and privatesector

deleveraging undermine domestic demand. The downward stickiness of wages that has been observed across

0

50

100

150

200

250

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Argentina

Japan

Greece

Spain

Italy


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peripherycountriesoverthepastyears,eveninthemidstofeconomicdepression,meansthatoutrightdeflationis

unlikelytomaterialize.

Figure2:PrimaryBalanceGap

UnderlyingAssumptions 2011 2012 2013 2014

RealGDP

growth

0.7%

2.1%

1.6%

2.0%

Inflationrate 3.1% 1.9% 1.6% 1.0%

Averageinterestrate 3.7% 3.9% 4.2% 4.9%

Bankingsectorrecapitalization/GDP 0.0% 10.0% 0.0% 0.0%

BaselineScenario 2011 2012 2013 2014

Fiscaldeficit/GDP 8.5% 6.5% 5.2% 3.9%

Governmentdebt/GDP 68.5% 83.9% 88.4% 92.7%

Case1:ReduceDebttoGDPRatioto60%Over

LongTerm,inComplianceWithFiscalCompact(a)2011 2012 2013 2014

Publicdebt 68.5% 83.9% 82.7% 81.6%

Primarybalancerequired 2.6% 4.7% 6.0%

Primarybalanceexpected 2.6% 1.0% 1.0%

Primarybalanceswing 0.0% 5.7% 5.0%

Case2:StabilizeDebttoGDPat2012Level(a) 2011 2012 2013 2014

Publicdebt 68.5% 83.9% 83.9% 83.9%

Primarybalancerequired 2.6% 3.5% 5.0%

Primarybalanceexpected 2.6% 1.0% 1.0%

Primarybalanceswing 0.0% 4.5% 4.0%

Source:RGEestimates,BankofSpain

Note:(a)

as

apercentage

of

GDP

InbothCase1andCase2,weexpecttheSpanishgovernmentwouldbeforcedtorecapitalizethebanksby10%of

GDPinlate2012.Giventhatbankrecapitalizationswillalmostcertainlybeaddedtopublicsectorliabilities(rather

thancomeintheformofdirectinjectionsfromtheEFSFortheEuropeanStabilityMechanism,ESM;seeScenarios

forSpainsection,below),weestimatethiswouldboostSpanishdebttoGDPto83.9%.However,wecanseethe

impact on the potential adjustment under a wide range of scenarios in Figure 3 below. Large recapitalization

estimatesandstringentfiscaldebttargetswillbeimpossiblefortheSpanisheconomytoswallow;however,ifdebt

canbeallowedtostabilizeatahigherlevelandachievedoveralongerperiodoftime,thesovereigncouldswallow

largerbankrecapitalizationcosts.


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Figure3:PrimaryBalanceAdjustmentin2012UnderVariousScenarios

Source:RGE

estimates

InCase1,weassumethatSpainreducesitsdebttoGDPratiofrom83.9%ofGDPin2012to60%ofGDPoverthe

longterm,inaccordancewiththeguidelinessetoutinthefiscalcompact.Toachievethis,Spainwouldbeforced

tomakeaprimarybalanceadjustmentofaround5.7%ofGDPin2013andaround5%ofGDPin2014.

InCase2,weconsideramoreforgivingdefinitionoffiscalsustainabilitythanthatenshrinedinthefiscalcompact.

At 83.9% of GDP, Spains public debttoGDP ratio is roughly even with that of fiscally responsible Germany.

Arguably,Spaincouldbeaonapathtowardfiscalsustainabilityifitcouldstabilizeitsdebtatthislevelforthenext

fewyears.Evenwiththismorerelaxeddefinitionoffiscalsustainability,however,Spainwouldbeforcedtoadjust

itsprimarydeficitby4.5%ofGDPin2013andafurther4%ofGDPin2014.

EventhoughCase2involvesamoregradualfiscaladjustment,westillthinkthisisunrealistic,particularlygivenour

underlyingassumptionsaboutSpanishGDPoverthenextfewyears.Ineitherofthesecases,thereisasignificant

risk that the fiscal adjustmentcould become selfdefeating.Cuttingexpenditure sharply underminesgrowth, in

turn reducing tax revenues. Boosting tax rates sharply prompts the private sector to retrench, and overall tax

revenuesconsequentlyfall.WehaveseenthisdynamicinGreece,asausteritymeasureshaveunderminedgrowth

andmadepublicdebtdynamicsevenmoreunsustainable.

GivenSpainsdismalgrowthoutlookaswellasthesharpincreaseininterestratesonexistingdebtthatweexpect

to occur in the short to medium term, we also carried out a cyclically adjusted debt sustainability analysis for

Spanish government debt using trend growth rates as well as mediumtolongterm interest and inflation rate

estimates.Weconsidertwopossiblecasesforcyclicallyadjustedpublicdebtsustainability:OnewithGDPgrowth

of1%

and

the

other

with

GDP

growth

of

2%.

Using

these

assumptions,

we

expect

Spain

to

achieve

the

primary

balancenecessarytostabilizeSpainspublicdebtat2012levelswith1%growthandweexpectSpaintoexceedthe

adjustmentwith2%growth.ThishighlightsthesensitivityofSpainspublicdebtdynamicstoGDPgrowth.However,

weexpecttheSpanisheconomytocontractoverthenextfewyears.

40%

35%

30%

25%

20%

15%

10%

5%

0%

5%

50 100 150 200 250

PrimaryBalanceSwingin2012

BankRecapitalization(,billions)

60%Debt/GDP

70%Debt/GDP

80%Debt/GDP


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Figure4:CyclicallyAdjustedPublicDebtSustainabilityAnalysis,StabilizingDebtat2012Levels

UnderlyingAssumptions 2011 2012 2013

Inflationrate 2% 2%

Averageinterestrate 3% 3%

Bankingsectorrecapitalization/GDP 10% 0%

Case3:GDPGrowthof1% 2011 2012 2013

RealGDPgrowth 1.0% 1.0%

Publicdebt 68.5% 78.5% 78.5%

Primarybalanceexpected 0.0% 0.0%

Primarybalancerequired 0.0% 0.0%

Primarybalanceswing 0.0% 0.0%

Case4:GDPGrowthof2% 2011 2012 2013

RealGDPgrowth 2.0% 2.0%

Publicdebt 68.5% 76.8% 76.8%

Primary

balance

expected

1.0%

1.0%

Primarybalancerequired 1.0% 0.7%

Primarybalanceswing 0.0% 1.7%


ResourceGapAnalysisJustasdifferentcountriescansustainverydifferentlevelsofpublicdebt,theycanalsosustaindifferentlevelsof

externaldebtdependingonthewillingnessandabilityofforeigncreditorstofinancethestockofexternaldebtas

wellasthecurrentaccountdeficit.Historically,the levelsseenasunsustainable inemergingmarketshavebeen

around60%ofGDP;however,Spain,likeotherEZcountries,isadifferentcaseinthatitissueddebtinacurrency

useddomestically,

but

which

it

does

not

control.

InordertodeterminetheswinginthecurrentaccountbalanceSpainmustmakeforitsexternaldebtlevelstobe

sustainable, we define sustainability to mean that Spains external debt is stabilized at 2011 levels. We then

determinetheswing intradebalancerequiredtostabilizedebt intwodifferentways.First,weuseourforecasts

for Spains GDP, interest rates and FDI as underlying assumptions. Second, we conduct a sensitivity test on

cyclicallyadjustedfigures.


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Figure5:ResourceGapAnalysis

UnderlyingAssumptions(%ofGDP,unlessotherwisespecified) 2011 2012

Externaldebt 115.5 115.5

Case1:DebtStabilizationat2011Levels 2011 2012

Realinterest

rate

2.5

2.8

RealGDPgrowth 0.7 2.1

Netnondebtcreatingcapitalinflows 0.7 2.0

Tradebalanceneeded 7.7

Tradebalanceexpected 0.2 2.3

Adjustment 5.4

Case2:DebtStabilizationat2011Levels,20%RealDepreciation 2011 2012

Realinterestrate 2.5 2.8



Trade

balance

needed

8.8


Adjustment 6.5

Case3:CyclicallyAdjustedDebtStabilizationat2011Levels,GDP

Growth1%y/y2011 2012

Realinterestrate 2.5 2.0



Tradebalanceneeded 2.2


Adjustment 5.5

Case4:CyclicallyAdjustedDebtStabilizationat2011Levels,GDP

Growth2%y/y2011 2012

Realinterestrate 2.5 2

RealGDPgrowth 0.7 2


Tradebalanceneeded 0


Adjustment 4.3


Usingour

real

underlying

assumptions,

Spain

would

need

to

adjust

its

trade

balance

by

5.4%

of

GDP

in

2012

to

stabilizeitsexternaldebtlevelsat2011levels.Thisisclearlyunrealistic,andwillonlybecomemoresoasSpainis

forcedtocontinuepursuingaprogramofinternaldevaluation.Accordingtothetroika,theweakercountriesinthe

EZmustundergoaninternaldevaluationtoregaincompetitivenessandreturntosustainablegrowth.Thesizeofa

realdepreciation inSpainnecessary for thecountry to regaincompetitivenessdepends inparton the shareof

foreigndebtheld ina foreigncurrency. IfallofSpainsexternaldebtwereheld in foreigncurrency, thenSpain

wouldaimtoundergoa20%realdepreciation.LetsassumethatSpainsucceeds inachievingthis in2012.While

thetroikawouldhailthemeasuresimplementedinSpainasuccess,Spainsexternaldebtwouldrisefrom115.5%


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ofGDP in2011to138.6%ofGDP in2012(Figure5:Case2).Tostabilizeexternaldebtatthishigher level,Spain

wouldneedtogenerateanevenhighertradesurplusof6.5%ofGDP.

Our sensitivity analysis using cyclically adjusted figures also indicates that Spains trade balance adjustment is

unrealistictostabilize itsexternaldebt. InCase3,weassume longtermpotentialGDPgrowth is1%y/y. Inthis

case,Spainmustadjustitstradebalanceby5.5%ofGDPtostabilizeitsexternaldebtat2011levels.Evenwhenwe

assumelongtermpotentialGDPgrowthof2%,Spainmustadjustitstradebalanceby4.3%ofGDP.

Thisindicatesthat,evenwithlongtermpotentialgrowthof2%(whichisoptimisticinourview),thesizeandpace

ofthetradebalanceadjustmentSpainmustundergoisnotonlyunrealistic,butalsoselfdefeating.Intheshortrun,

afallindomesticdemandcanservetoquicklyimprovethetradebalanceandclosetheresourcegap.However,in

themediumterm,Spaincanonlyserviceitsforeigndebtifitfindssustainablegrowth.

As foreigncreditorsseek tocut theirexposure toSpain,therewill inevitablybe largecapitaloutflows from the

countryin201214.Wehavealreadyseenthisinthefirstfewmonthsof2012(Figure6).

Figure6:FinancialAccountShowsSignificantOutflowsFromQ42010(,billions)

Source:Haver

Thesecapitaloutflowswillneedtobebalancedoutbyanadjustmentinthecurrentaccountbalanceandbycapital

inflows.Aswehavedemonstrated,theformer istoo largetoachievewithoutanominaldevaluation.Thecapital

outflowswillthereforeneedtobeoffsetlargelybycapitalinflows,someofwhichcanandwillbeprovidedbythe

ECBthroughitsrepooperations.WeexpectthereisalimittothedegreetheECBiswillingtoplugtheholeinSpain

leftbyfleeingforeigndebt,andconsequentlywebelieveSpainwillbeforcedtorequestofficialfinancing.

BankRecapitalizations:ItsAllAbouttheAssumptions

Acentralcomponent inbothourprimarygapanalysisandscenarioanalysis(seebelow)onSpain isthepotential

costofresolvingthedomesticbankingsystem.Spainscreditboomcametoanabrupthaltasthetideofcheap,

externalfinancethatfueleditbegantoebb(Figure7);asunemploymentroseandgrowthcontracted,bankasset

qualityfollowedsuitandbegantodeteriorate.Butthiscrisis isworsethanpreviouscrisesandhistory isof little

help;adjustmentwillnotcomethroughanominaldevaluation,andreversingtheexternal imbalanceacrossthe

40

30

20

10

0

10

20

30

40

Mar02 Jan03 Nov03 Sep04 Jul05 May06 Mar07 Jan08 Nov08 Sep09 Jul10 May11

FinancialAccountExcludingBdE MovingAverage(12Month)


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privateandpublicsectorswillbepainful.Someofour lossestimatessuggestmoreaggressivebankrestructuring

shouldbeentertainedtoreducethe impactonthepublicpurse;yet,withmuchoftheunsecureddebtresiding

with the two Spanish champions, BBVA and Santander, this seems unlikely, unless secured creditors and

depositorsareforcedtotakelossesorthegovernmentrenegesonitsguarantee.AsshowninthecaseofIreland,

thisisahighlyunlikelyandchallengingproposition.

Figure7:ACreditBoomFinancedbyExternalDebt

Source:Haver,BancodeEspaa,RGEestimates

Note:Rebasedto100atend2001

Weconductanumberofanalyses togauge the sizeof thepotentialhole in theSpanishbankbalance sheet;

betweenJune

2008

and

December

2011,

domestic

banks

had

already

written

off

112

billion

in

the

form

of

provisionsand,asattheendof2011,constructionandrealestateexposures totaled400billion.We focuson

domesticloanbooks;theassumptionhereisthatsubsidiariesarefinancedbylocalfinancingandwillultimatelybe

theheadacheofthehostsovereign.Althoughnotdiscussedhere,oneneedstoconsiderthat,ifthereisaserious

loss of confidence in theparent, the foreign subsidiariesmay suffer acrisisofconfidence.Nordowe consider

lossesinaSpanishdebtrestructuring;withholdingscurrentlyat250billion,a20%haircutimpliespretaxlosses

of50billioninadditiontotheestimatesweprovidebelow.

BottomUpAnalysis:135Billion1

Our bottomup analysis forecasts a target peak nonperforming loan (NPL) ratio from the aggregated Spanish

bankbalance

sheet

and

then

estimates

the

potential

additional

losses

generated

from

the

end

of

2011.

We

have

notemployedamodelbasedonhousepricesorunemploymentforseveralreasons.First,withlowmortgagerates

generating severe relief for debt servicing, default is primarily driven by unemployment. NPLs in Spain are

currentlyvery tightly related tounemployment ratesbasedonasimple regression,andwearealreadybeyond

where we should be given NPL levels. Second, house price indexes in Spain are not indicative of transaction

prices.Three,previouscrisesdonotprovidemuchguidancegiventhemassiveroleexternalfinancehasplayedin

1Estimatedpretaxlossesinthegivenscenario.

100

150

200

250

300

350

400

Mar02 May03 Jul04 Sep05 Nov06 Jan08 Mar09 May10 Jul11

ExternalDebtof

NonOfficial

Sectors

LendingtoNFN

exCRE

Lendingfor

Construction and

REActivities

OtherLending


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thecurrentcrisis.Overthepastdecade,totalexternaldebthastripledinSpainandthenegativenetinternational

investmentposition(NIIP)hasquadrupled,withthebankingsectoraccountingforalmost50%ofthelatter.

Forconstructionandrealestateloans,weassumethattwothirdsofconstructionandrealestateloansareorwill

be NPLs, which assumes some further deterioration beyond the 54% of loans that are already identified as

problematicbytheBankofSpain;additionally,weassumethatallassetsdeemednoncurrentassetsheldfor

saleonthebalancesheetareforeclosedproperties;finally,wedoubleNPLratesfromthelevelsreportedatthe

endofDecember2011andareslightlyharsheronretailexposuresformortgages,thisfiguresquaresnicelywith

the idea thatahighproportion ofunderwatermortgages default.This generatesnewpotential losses of some

135billion.At the end of2011, theSpanish banking systemhad a reportedcoreTier 1 ratio of9.5%,andan

estimated1.9trillionofriskweightedassets. Ignoringfutureearningswhichcontinuetodecreaseandtaxes,

thelosseswegenerateimplyrecapitalizationneedsofroughly110billion,toreachaCT1ratioof9%.

Figure8:NewNPLAssumptions(,billions)

Total

Loans/

Assets

NPLRate

atEnd

2011

Target

NPL

Rate

Implied

Increase

inBad

Loans

Target

Loss

GivenDefault

Total

Additional

Losses

Loansto

Other

Resident

Sectors

Total 1,783 7.6% 21% 244 50% 122

NFNex.CRE10million 352 3.0% 6% 10 40% 4

Construction 99 17.7% 65% 47 50% 23

Realestate 298 20.9% 65% 132 50% 66

Mortgage 613 2.7% 7% 25 40% 10

Consumer 38 5.8% 14% 3 90% 3

Other 188 5.3% 11% 10 60% 6

Other NoncurrentassetsHFS 25 0.0% 100% 25 50% 13

Total

1,808

269

135

Source:RGEestimates,BancodeEspaa

DecreasingDomesticLeverage:230Billion300Billion

Another way to estimate losses would be to consider the impact on the banking system if households and

nonfinancial entities rapidly deleveraged. To bring Spains household leverage in line with the U.S. level of

householddebttogrossdisposableincome(1.13)ordecreaseleverageasmuchastheUKortheU.S.havethusfar

(1213%), Spanish household debt would need to decrease by 110 billion130 billion. Nonfinancial sector

leveragewelookattheratioofnonfinancial(NFN)debttogrossoperatingsurplus(GOS)2hasbeendecreasing

aggressively,duetothehighproportionofcommercialrealestate(CRE)lendinginSpainandtheaggressivewrite

offof

such

loans.

To

bring

the

ratio

of

NFN

debt

to

GOS

down

to

the

level

of

a

European

peer

with

elevated

leverage,theUK(7.4)impliesareductionof200billionoflendingforbanks3.Alessaggressiveapproachwouldbe

totargetaratioof88.5,the leverageoftheNFNsector inSpainbeforethepaceofleverageacceleratedsharply

frommid2004;thissuggestsareductionofroughly120billion,respectively.Intotal,thisdeleveragingofthereal

2EBITDAisapreferablemetric,butnoteasilyfoundacrossanumberofcountriesforcomparisonpurposes.

3Domesticbank loansaccountforapproximately42%ofSpanishNFNdebtoutstanding.Weassumeproportional lossesonly

accruetoloansandnotbonds.


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economytomoredesirable levels impliesa230billion300billionreduction inbank loansand,assuming it is

directlywrittenoff,impliesacapitalshortfallintheorderof200billion250billion(notconsideringtaxeffects).In

reality,wewouldexpectdeleveragingtooccurovertime,allowingearningsandregulatoryforbearancetocushion

thefullforceoftheblow.

ReducingExternalDebtDependency:LowerBoundRangeof115Billion230Billion

Afinalwaytoestimatepotentiallossesistoconsiderthebalanceofexternaldebt;otherMFIs(monetaryfinancial

institutionsotherthantheBankofSpain)relyuponroughly660billionofexternaldebtofwhich450billionis

classified as deposits and 210 billion4is classified as bonds/notes/MMF. This total rises to almost 1 trillion

roughlyonethirdofdomesticbankassetsandalmost100%ofGDPifweincludeborrowingsfromtheECB.The

net position, i.e. deducting external assets of some 400 billion, is roughly 260 billion. To bring the external

balancedowntozerointheabsenceoffurtherofficialECBfundingimpliesa9%decreaseindomesticassets.

Yet, intheshortterm,weexpectthisdeleveragingwillbepostponedasECBborrowingcontinuestoreplacethe

roll off of external finance and private interbank finance. However, the capacity to forestall this deleveraging

criticallydependsuponavailablecollateralandcentralbankriskmeasures,whichfluctuatewithmarketvolatility

andratings.

We

do

not

think

domestic

banks

have

enough

ECB

eligible

collateral

to

finance

the

exit

of

660

billion

ofexternal financeandwillneed toaggressivelydeleverage, taking lossesonassetsalesorwritingdown loans.

Residual ECBeligible collateralwhich includes 100 billion of additional governmentguaranteed bonds banks

maybeableto issueundertheguaranteescheme5couldatbest,coverhalfofthetotalexternaldebt.Perhaps

25%ofexternalassetscanbecalledwithoutany loss.This leavesafundinggapofsome230billion;suchagap

quicklyrisesassovereigndebtvaluesdecrease,ratingsarecut,andtheEuropeanCommissionorECBcallstimeon

theissuanceandacceptanceofguaranteeddebt.

Bankscaneitherwritedownthevalueofloans,letloansrollofforattemptsignificantassetsales;however,banks

would need to retain encumbered collateral, meaning the collateral that is sold would be external assets or

domesticassetsofverypoorquality(primarilyNPLsorhighloantovalueloans)orlargeNFNcorporateexposures.

Loss

rates

on

asset

sales

could

then

be

as

high

as

40

60%,

suggesting

losses

of

115

billion.

In

the

absence

of

buyersforthoseassets,assetswouldhavetobeaggressivelywrittendown,reachinglossesclosertothefullvalue

ofthefundinggap.Yet,thiswouldonlybethetipoftheicebergasanyfurtherdebtredemptionsthatcouldnotbe

financedwithnewissuanceordepositwithdrawalswouldneedtobefinancedviaanassetsaleorwritedown.

HouseholdandCorporateDebt:TheRestoftheNationalBalanceSheetIsStretched

SpainshouseholdwealthindicatesthatSpaniardsaresomewhatlesswelloffthantheaveragefortheEZ,butstill

possess considerable net assets, totaling 314% of GDP or 3.4 trillion: 4.8 trillion in real estate and financial

assets, and debt of 1.4 trillion (125% of GDP). According to a study by Credit Suisse Private Bank (OSullivan,

October2011),wealthhasrisenfrom2.0trillionadecadeago,butdebthasrisenmuchfaster,fromamere0.32

trillion in 2000. These trends, and comparisons with other countries, are shown in Figure 9. However, a

concentrationof

exposure

to

property

due

to

a

homeownership

rate

of

over

80%,

and

the

continuing

housing

bust,

indicatesthathouseholddeleveragingisanearcertaintyinthemonthsahead.

4AsatendofDecember2011,OtherMonetaryFinancialInstitutionshadexternaldebtof716billion,ofwhich223billion

wasintheformofMMForbondsandnotes.Suchexternaldatadebtisreportedonaquarterlybasisandwithasignificantlag.5UndertheEuropeanCommissionapprovedguaranteescheme,theschemesoverallbudgetiscappedat100billion,which

canbe increased to 200 billion, if themarket conditions request it.By theend of March 2012,Spanishbankshad issued

roughly100billionofgovernmentguaranteeddebt.


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Figure9:HouseholdWealthHasGrownImmensely,butSoHasDebt

Source:CreditSuissePrivateBank(GlobalWealthDatabook2011),RGE

Moreover, while the household debttoGDP ratio of around 100% is in the middle of the pack in Europe,

comparing Spain with rich, financially deep and very wealthy countries like Denmark and the Netherlands, or

overleveragedIreland,

is

hardly

reassuring.

The

trend

since

euro

entry

is

alarming:

The

ratio

of

assets

to

debt

shown in Figure 9 deteriorated from 6.1x to 3.5x in Spain from 200111, while the deeper problem is the

distributionof thedebtand itsability tobeserviced inaneconomygenerating25%unemploymentand in the

middleofacreditcrunch;this is indicatedbySpanishhouseholdsveryhighdebttoincomeratio(Figure10).To

reducetheratioto8,asitwasbeforethelargeriseto12,meansthatdeleveragingisonlyhalfwaydone:Another

240billionor22%ofGDPofbalancesheetrepairremains;atthecurrentpace,thismeansthesavingsratewill

continue to stay elevated for another fourtofive years, and personal bankruptcy and foreclosures will also

contributetothedebtreduction.

0

50

100

150

200

250

300

2001 2003 2005 2007 2009 2011

GrossAssets(EURbn)

UnitedStates Greece Ireland Italy Portugal Spain Germany

0

10

20

30

40

50

60

70

80

90

100

2001 2003 2005 2007 2009 2011

Liabilities(EURbn)

UnitedStates Greece Ireland Italy Portugal Spain Germany


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Figure10:HouseholdDebttoGrossDisposableIncomeRatios

Source:Haver,

RGE

estimates

Finally,muchofthehouseholdwealththat ismobilehasevery incentivetofleebefore itissubjectedtopunitive

wealthtaxes,whileraisingpropertytaxesashasbeendone inItalyandtheUKrecentlywillonlyfurtherdamage

thatalreadycrippledmarket,andcausecashflowproblemsthatwilldampenconsumptionandraiseforeclosures.

SpanishNFNcorporatedebtisinsomewaysanalogoustothehouseholdsituation:Leveragehasbeengrowingata

headypaceoverthepastdecade,fromaround100%ofGDPin2000toalmostdoublethatlevelin2010,according

totheIMF.ButSpanishcorporatedebtisnotanoutlierrelativetothatofothercountries,asshowninFigure12.

TheinsanityinSpainwasclearlyconcentratedintheconstructionandrealestatesectors,withindustry,retailand

services,andenergydisplayinggenerallyhealthyratios,asIMFsSpain:SelectedIssues,July2011,shows(Figure

4intheIMFdocument,p.10).Thus,itisinthepropertyrelatedsectorthatthedeleveragingisoccurring,andwe

estimate the totalsas follows,bybringingdown the ratios tomorenormal levels.Weestimatea totalof800

billion inconstructionandrealestateactivitydebt,witharatioof1:3betweenthetwoandroughlyhalfofthe

exposuredirectly inbank loans.Bringingthedebttoassetratioofthesector(now400%,reminiscentofKorean

chaebol)anddebttoEBITDA (1520 range) toa sustainable level isconsistentwithourearlierestimateof two

thirdsNPLforthesector;50%lossgivendefaultmeansagranddeleveragingofaround267billionor25%ofGDP.

Thishasbegunbut,asinmostcountries,willbeaprolongedprocess,andagaininonewayoranotherbemanifest

inahighercorporatesavingsrate.

Althoughmanymortgageshaveverylongdurationsandthelowrateenvironmentallowszombieloanstopersist,

eventuallymuchofthedeleveragingwillhappenthroughdefaults,foreclosures,debtequityswapsorshortsales

to distressed investors, governmentrun bad banks or asset management agencies like Irelands NAMA.

Deleveragingthrough

rising

asset

values

and

steady

repayment

of

amortizing

principal

is

a

pipe

dream.

IfSpainhadamoderatecurrentaccountdeficit,allthissaving(sadlygeneratedinpartthroughunemploymentand

bankruptcy)wouldswingthetradebalanceintosurplus.Buttheeconomywasso imbalancedanduncompetitive

duringtheboomtimesthatthecurrentaccountdeficitwas10%,andisnowstillcloseto4%ofGDP.Thismightbe

tolerable,butinlightoflargecapitaloutflows,thefinancinggapwillcontinuetoresultinafastincreaseinexternal

indebtedness.Austeritywillhelpdecreasethecurrentaccountdeficitstill further,butbycripplingtheeconomy

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

1.8

2.0

Dec99 Mar01 Jun02 Sep03 Dec04 Mar06 Jun07 Sep08 Dec09 Mar11

Spain

UK

US

France

Italy

Japan

Germany


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will damage household wealth and corporate ability to service debt still further: That road leads nowhere but

towardSpainbecominganotherbailoutvictim.

Figure11:NFNDebt/GrossOperatingSurplus

Source:Haver,RGEestimates

Figure12:Overall,theSpanishCorporateSectorDebtDoesNotAppearExcessive

Source:Haver,RGE,nationalcentralbanks

0

2

4

6

8

10

12

14


Spain

UK

France

Italy

Germany

0

100

200

300

400

500

600


Non

FinancialCorporateDebt

to

GDP(%)

Portugal

Italy

Ireland

Greece

Spain

Germany

Japan

UK

US


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ScenariosforSpain

It isextremelyunlikelySpaincouldundergo theprimaryandcurrentaccountbalanceadjustmentsnecessary to

placeitselfonacleartrajectorytowardpublicandexternaldebtsustainability,againstthisbackdropofsignificant

deleveraging ineverypartof theprivateand public sectors. In lightof Spains substantialvulnerabilities, itwill

prove extremely difficult for the government to handle the situation without some form of external financial

assistance.Below,weanalyzethevariousoptionsforSpainoverthenext18months.

Scenario TheMiracle(15%) TooLittle,TooLate(60%) TheStoryofIcarus(25%)

Triggers

Politicalpressurefromtroika.

Depositsbleedfromfinancial

sector,collateraldwindles.

SpaindowngradedtotripleB.

Othercorecountriesunable

tomeettheirtargets.

France,ItalyandECBgain

momentumwithprogrowth

rhetoric.

Politicalpressurefromtroika.

Depositsbleedfromfinancial

sector,collateraldwindles.

SpaindowngradedtotripleB.

Deepeningrecession,missed

fiscaltargets.

UncertaintyofFrench/

GermanleadershipinEZ.

Severerecessionandpoor

reformimplementationdestroy

confidence.

Policy

Response

Proactivebank

recapitalization.

Bankrecapitalizationtoo

lateandtoosmall.

SMP/EFSF/ESMintervention,

liquidityprovision.

ShiftinEZpolicytoward

growth.

ReactivationofSMP,capped

purchases.

EU/IMFfirewallusedfordebt

restructuringsandsomeEZ

exits.

Moreaggressiveintervention

byECB,e.g.QEandCE.

Limitedbondbuyingby

EFSF/ESM.

Endgame

Spaindoesnotrequireatroika

program

and

avoids

a

debt

restructuring.Signalingof

coordinatedactionsupports

fundingaccessandfocuson

growthratherthanausterity

seesrecessionbottomoutin

2012.

Spainlikelyrestructuresdebt,

butmayremaininEZ.Concerns

overhugefiscaladjustment,

lackof

growth

initiatives

and

hugeexternaldebtburdenshut

sovereignsandbanksoutof

fundingmarkets.Spain

requeststroikaprogramItaly

likelyfollowssuit.Economy

strugglesforyearsamid

deflationanddeleveraging.

Delayallowscontagionto

spreadtothecoreEZdespite

liquidityprovision.TheEUIMF

firewalldoes

not

stretch

far

enoughtobailoutallthe

countriesinneedofofficial

supportandisinsteadusedto

recapbanksfollowingdebt

restructurings(includingin

Spain)andsomeEZexitsas

earlyas2013.

Baseline Scenario: 65%Too Little, Too Late: Banking Sector Package Fails to Restore Confidence, Sovereign

BailoutPackageRequired

Ourbaseline

scenario

involves

a

number

of

different

potential

triggers

prompting

Spain

to

recapitalize

its

banks,

eitherusing itsownfinancesormore likelyrequestingfinancingfromtheEFSF/ESMforthispurpose.Thiswill

address uncertainty in the banking sector but, in the absence of growth, Spains fiscal dynamics will remain a

significantconcernforinvestorstoo.TheSpanishsovereigncouldlosemarketaccessasearlyas2013andrequest

financingfromtheEUIMFfirewall.AlthoughthatwillhelptodelayadebtrestructuringforSpain,itwillprobably

notsucceedinavoidingone.


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A bailout package seems inevitable for Spain, but we expect both the government and EZ policy makers to

continuetopursueapolicyofbuyingtime.ThegovernmenthasstrongincentivestopostponeaskingitsEZpeers

for financialassistance foras longaspossible.PrimeMinisterRajoysgovernment,whichcame intopowerbya

landslidevictory less than sixmonthsago, is facing littlepoliticalpressureat the national level to throw in the

towelalready.Althoughthegovernmentsapprovalratingshavestartedtodeclinesharply(unsurprisinggiventhe

announcement

of

a

tough

austerity

budget

and

painful

structural

reforms

at

a

time

when

unemployment

has

hit

a

record high), Rajoy can still count on his strong parliamentary majority to push through his reform program.

Furthermore,theSpanishgovernmenthasprefundedabouthalfofitsmedium andlongtermdebtredemptions

for2012,helpedbytheECBstwothreeyearLTROs.Asaresult,ithassomebreathingspaceandisunlikelytohave

toaskforexternalfinancialassistanceforthesovereignin2012.

EZ policy makers also have little incentive to push the Spanish government toward a fully fledged bailout

immediatelyas they did in the case of Irelandgiven that the financing needs of Spains sovereign are

significantly higher than the financial support already extended to the three smaller periphery countries.

Furthermore,abailoutforSpainwould likelyresult inabailoutforEuropesthirdlargesteconomy,Italy,aswell.

ThefatesofSpainand Italyremain inextricablytied,asreflected intheupwardtrend inbothSpanishandItalian

bondyields inearlyApril.The firewalltheEUand IMFhavebuilttosupportweakerEZcountrieswillrunoutof

fundingquicklyifbothSpainandItalyrequirebailoutsfortheirbankingsectorsandsovereigns.

WhenWilltheMusicStop?Postponing a bailout for Spain will only work if, in the meantime, market sentiment toward Spain improves

considerably. Given the ECBs recent rhetoric indicating reticence to further relax monetary policy or conduct

additional longerdurationLTROs, it isdifficulttoseewhatcouldserveasapositivetrigger forthis.Currently, it

seemstheSpanishgovernmentwillbeunabletoregainmarketconfidence,nomatterwhatitdoes.InearlyApril,

Spanishgovernmentbondyieldsbegantocreepupafterthegovernmentpushedbackonitsfiscaltargets.Rajoys

administrationannouncedanadditional12billion insavings ithaddiscovered in thebudget inthehopes that

investorswouldbecalmed.Instead,investorsfrettedovertheimpactofevenmoreausterityongrowth,andbond

yieldscontinued

their

upward

march.

If

the

government

pushes

back

on

its

fiscal

targets,

it

is

deemed

irresponsible.

Ifitannouncesmeasurestoensureitachievesthesetargets,themarketsworryaboutSpainsgrowthprospects.

Furthermore, there are a few potential triggers for investor worry up ahead. In May, the Spanish regions will

presenttheir2012budgetsandweexpectseveraltofailtohonorthedeficittargetssetbythecentralgovernment.

This,combinedwithadeepeningeconomicrecession,indicatethatthegeneralgovernmentbudgetdeficittargets

of5.3% in 2012 and3.0% in2013will be widelymissed. Inaddition,aFrancoisHollande victory in theFrench

presidential election could see increased quarreling among EZ policy makers over his demand that the fiscal

compactberenegotiated.

AnotherkeypotentialtriggerforabailoutinSpainisthebankingsector.Bankscanfinanceanydomesticsovereign

bondwithECBrepofinance,buttheirappetitetodoso intheabsenceofmoralsuasion isafunctionof investor

sentimentand,moreimportantly,thehaircuttheECBimposesonthecollateral.Puttingasideinvestorsentiment

(giventhatbankscanfundthemselvesattheECBanddonotfeeltheneedtoraiseequityinthecapitalmarkets),

thehaircuteffectivelydrivesbanksdecisions.Atthemoment,wethinkthehaircutisintherangeof0.52.5%;but

a tripleB ratingacrossthe ratingagencieswould increase thisby5percentagepoints.Thus,bankswillneedto

deployothersourcesofunencumberedassetsorcash tooffset thehaircut.Thisprospectbecomes increasingly

unattractiveasbanksrunoutofcentralbankeligiblecollateralandashaircutsrise.Wethinkbankshave limited

appetite to support all but the shortest tenor instruments issued by the Spanish sovereign, but this too may


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changeshouldallratingagenciesdowngradeSpaintotripleBasthevaluationhaircutonbillswouldjumpto5.5%.

Thus,adowngradecouldsignalamajorshiftinthefortunesofthesovereign.

ButperhapstheSpanishbankshavesignificantexcesscapitalborrowed inthethreeyearLTROtoputtousefor

further sovereign debt purchases, which could support auctions. Yet, here too we are doubtful; in fact, at the

currentrateofdepositwithdrawals,theremainingLTROmoneymaynotmeetbankrefinancingneedsfortherest

of2012(circa54billion).6ThepotentialsupportthatSpanishbankscanprovidetotheirdomesticsovereignsare

effectivelyafunctionoftheiroutflowsdebtanddepositredemptionsandtheirinflowscentralbankand

private fundingandthe rollofforwriteoffofbank loans (deleveraging).Asshown inFigure14,we thinka fair

portionofECBfinance(here,thethreeyearLTROfunding)hasbeenusedtofinanceroughly100billionofdeposit

withdrawals, inadditiontofinancingroughly83billionofsovereigndebtpurchases.Some60billion80billion

remains,whichwouldbeinlinewiththespikeintheuseofthedepositfacility,asreportedbytheBankofSpain.

Bluntlyput,then,themusiccouldstopwhenSpain isatripleBcreditorwhenbankcollateralbuffersrundry; in

thelattercase,banksbetterhopethepaceofdepositwithdrawalsdonotpickup.

Figure13:MarginalECBBorrowingSupportsSovereigns,ButMoreDepositFlight(,billions)

Source:Haver,BancodeEspaa,RGEestimates

Note:CumulativechangesinaggregatedbankbalancesheetsinceNovember2011

PackagefortheBanksFirst,ButNotEnoughInaccordancewithEZpolicyresponsesthroughoutthecrisis,weexpectabailoutforSpaintocometoolateand/or

tobe inadequatelysized.Rather thangoing fora fullfledgedbailout forbothSpanishbanksand thesovereign,

bothSpainandthetroikaare likelytoopt forabankingsectorsupportpackage first.Therearetwooptions for

recapitalizingSpanish

banks:

The

recapitalization

funds

can

come

from

the

Spanish

government

or

from

the

EU

bailoutfunds(EFSFandESM).Ideally inourview,theEFSForESMcouldprovidetheSpanishbankswithadirect

capital injectionsothat theSpanishsovereigndoesnothaveto lumpthe recapitalizationcostsonto itsbalance

sheet.Thecorecountries,particularlyGermany,remainvehementlyopposedtothisideawhichwouldrequirea

6Excludingretainedissuance,residualmaturitiesfor2012(MaytoDecember)and2013forprivateSpanishbanksareroughly

54billionand77billion(source:Dealogic).Aswiththecaseofthebanklossestimates,wefocuson issuancefordomestic

operationsandignorefundingofforeignsubsidiaries,whichweassumeareselffinanced.

400

300

200

100

0

100

200

300

400

Nov11 Dec11 Jan12 Feb12 Mar12

BillionsofEuros

OtherAssets

DomesticAssets

ForeignAssets

Sovereigndebt

OtherLiabilities

DomesticDeposits

ForeignDeposits

ECBBorrowing


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treatychangeonthegroundsthatitwouldbeverydifficulttoimposeconditionalityinexchangeforthecapital

injectionsandtoforcethesovereigntoimplementstructuralreforms.Muchmorelikely,therefore,wewillseethe

Spanish government recapitalize the banks, either directly or by first borrowing the funds from the EFSF/ESM.

Although Spains debt ratioat least the official oneremains relatively low in the crosscountry comparison,

markets may decide to shun its government bonds, concerned that efforts aimed at backstopping the banking

sector

are

too

much

to

handle

for

the

Spanish

sovereign,

thereby

pushing

the

sovereign

into

a

full

fledged

troika

program.ToaddresstheriskoftheSpanishsovereignlosingmarketaccess,theEFSFand/ortheECBwilllikelystart

buyingSpanishgovernmentbondstokeepalidonbondyields.

Withno initiativeattheEZ levelparticularly incorecountriesto implementgrowthboostingmeasures,Spain

canonlytrytoreassurethemarketsthat itscommitmenttofiscalausterityremainsstrongandcarryonwiththe

announcedstructuralreforms.Thecontinuous insistencebyEZpolicymakersonthehardlineausterityapproach

and the meeting of previously agreed deficit targets in 201213 will push the Spanish economy further into

recession, which will fuel concerns about the sovereigns capacity to rein in its public finances, even following

attemptstodrawalineunderthebankingsector.DespiteadditionalECBliquiditymeasuresandSpanishsovereign

debtpurchasesbytheECB/EFSF,Spainwillbeshutoutofmarketscompletelyasearlyaslate2012andwillhaveto

apply for a troika program. We assume that once the Spanish government is forced into a bailout, the Italian

governmentwillfollowsuitshortlythereafter.

If the Spanish sovereign recapitalizes Spains banks directly without the use of the EUIMF firewall, then the

firewallcouldsupporttheSpanishandItaliansovereignsuntilearly2015.IfSpainuses100billion250billionof

EFSF/ESMmoneytorecapitalizeitsbanks,roughly572billion725billionwillremainintheEUIMFfirewall(Figure

15).ThefirewallwouldthereforeonlyhaveenoughgunpowderinittosupporttheSpanishandItaliansovereigns

until,atbest,theendof2014.WedonotthinkSpainandItalywillmanageto implementthestructuralreforms

necessary to restore market access by late 2014 or early 2015, and consequently expect a sovereign debt

restructuringinbothcountriesasearlyas2015.

Figure14:EUIMFFirewallvs.FinancingCostsforthePIIGS(,billions)

EUIMFFirewallLendingCapacity

EUbailoutmechanism(EFSF/ESM):Freshlendingavailable 500

IMFbilateralloans 323

TotalcumulativeEUIMFfirewall 823

SpanishBankingSectorRecapitalizationby: DeductionEUIMFFirewallCapacityPost

Recapitalization

a)Borrowing100billionfromEFSF/ESMtorecapbanks 100 723

b)Borrowing250billionfromEFSF/ESMtorecapbanks 250 573

c)Recappingbankswithnationalfunds 0 823

PIIGSSovereign

Financing

Needs

2012*

2013

2014

2015

2016

Greece,PortugalandIreland 142 81 76 65 70

ItalyandSpain 557 348 295 330 280

Totalneedsperannum 699 430 371 395 350

TotalcumulativePIIGSfinancingneeds 430 800 1,195 1,545

Source:EFSF,ESM,IMF,RGEestimates

*WeassumethatItalyandSpainwillnotbeforcedtorequestofficialfinancingbefore2013


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UpsideScenario:15%TheMiracle:BankingSectorPackageHelpstoRestoreConfidence,FullFledgedBailout

Averted

Inourupsidescenario,aproactiveSpanishbankrecapitalizationwouldbeaccompaniedbyapolicyshiftattheEU

level to focus on growth rather than austerity, further liquidity measures by the ECB and government bond

purchasesbytheECBand/orEFSF.Consequently,abankrecapitalizationwouldhelptorestoreinvestorconfidence

inSpain,andafullblownbailoutforthesovereignwouldbeavoided.

Inthisscenario,as inourbasecasescenario,weexpecttheSpanishbankingsectorwillberecapitalized in2012.

ThiswouldaddressonepieceofthepuzzleinSpaintheuncertaintyovertheholeintheSpanishbankingsector

thatiscorrosiveformarketconfidencebutwouldalsoaddtothesovereigndebtburden.

TorestoreSpaintofiscalsustainability,animprovementinSpanishgrowthprospectsiskey.Inthemediumtolong

term,thiscanbeachievedby implementingstructuralreformstoopenup laborandproductmarketsandboost

Spains competitiveness. However, in the short term, such structural reforms serve to undermine,not support,

growth. To restore growth to Spain more quickly, EZ policy leaders will need to shift their focus away from

austerityandfiscalresponsibility.Althoughthisisnotourbasecasescenario,thiscouldoccurifFrancoisHollande

winsand

continues

his

pro

growth

rhetoric,

which

has

also

been

adopted

by

Prime

Minister

Mario

Monti

in

Italy

andtheECBshead,MarioDraghi.Asevensomeofthecorecountrieshavedifficultymeetingtheirfiscaltargets,

Germanyisincreasinglybecomingisolatedinitsinsistenceonfrontloadedausterity.

InshiftingtheEZpolicyresponseawayfromausteritytowardgrowth,theEuropeanCommissioncouldgrantSpain

at leastonemoreyeartoreachthe3%budgetdeficittargetagreed.ForgrowthtoreturntoSpain intheshort

term,wewouldalsoneedtoseesignificantquantitativeandcrediteasingfromtheECB,adepreciationoftheeuro

toparitywiththeU.S.dollarandfiscalstimulusprovidedbythecore.Additionally,investmentinitiativesfromthe

EuropeanInvestmentBankcouldhelptostimulategrowthintheEZsweakermembers.

Thesovereigncouldregainmarketconfidenceandavoidabailoutforthestatebydrawingalineunderthebanking

sectorandseeinggrowthreturn,toputSpainonapathtowardpublicandexternaldebtsustainability.

Downside Scenario: 25%The Story of Icarus: Extend and Pretend Is the Name of the Game Until it All Falls

Apart

Inourdownsidescenario,theSpanishgovernmentwould resistabailout foras longaspossible,andcontagion

wouldtakethecrisiswellbeyondSpain,toItalyandsomeofthecorecountries.

In the meantime, with consumer and business confidence plummeting, Spains economic performance would

deterioratesharply,exacerbatingthesovereignsfiscalchallenges.Foreigninvestorswouldseektoquicklycuttheir

exposure,andthehighercapitaloutflowswouldneedtobeoffsetbymoreECBfinancingandabailoutpackage.

Withthegovernmentwaitingaslongaspossibletodrawalineunderitsbankingsectorandgrowthprospectsgrim,

contagionwouldswiftlyhitnotonlyItaly,butothervulnerablecorecountriesaswell,suchasFrance,Belgiumand

theNetherlands.TheEUIMFfirewallwouldneedtosupporttheseeconomiestooand,consequently,theamount

oftimeitcouldbuyfortheimplementationofstructuralreformswouldbemuchshorter.EZpolicymakerswould

lookatthesheermagnitudeofthefinancialresourcesrequiredtosavethecommoncurrencyandrealizethattheir

plantobailoutcountriestobuytimeisdeadinthewater,beforeithadevenstarted.

Atthispoint,EZpolicymakerscouldchoosetotakesomeofthestepsnecessarytomovetowardsafiscalunion,

withtheECBsteppinginasalenderoflastresortforsovereigns.Theendresultcouldthereforelookmorelikeour


20/20

ECONOMICRESEARCH 20

Page|

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upsidescenario.Inourview,amuchmorelikelyresultwouldbethat,ratherthanthrowmoregoodmoneyafter

bad,EZ leaderswouldchoose touse theEUIMF firewall tosupportanorderlysovereigndebt restructuring for

severalcountries,includingSpain,andtofacilitatetheexitofsomeEZcountriesasearlyas2013.

Conclusion:SpainOnlyGetsOneRolloftheDice

Theadjustments

that

Spain

would

have

to

make

to

its

primary

and

current

account

balances

to

put

itself

on

a

path

towardfiscalandexternaldebtsustainabilityarenotonlyunrealistic,butwouldalsobeselfdefeating,significantly

undermininggrowth.Theeconomyfacessignificant"balancesheet"headwinds,with largebankrecapitalizations

andsignificanthouseholdandcorporatedeleveraging.Withoutanominaldevaluation,immensecapitalflightfrom

willneedtobeoffsetbyexternalfinancialassistance.Wehaveseenthismoviebefore,butSpainandtheEUelite

seem determined to pursue the internal devaluation course. The austerityrecession negative feedback loop in

Spain isreminiscentofwhathasfedyearsofeconomiccontraction inGreeceandPortugal.Thecorrosivenessof

bankingsectoruncertaintyforinvestorconfidenceinSpainremindsusofIrelandsroundsofbankrecapitalizations

in2009and2010.

Althoughtherehasbeensomechange inthecrisisresponseattheEU levelparticularlyonthepartoftheECB,

which

has

stepped

in

not

only

with

the

SMP,

but

with

two

three

year

LTROs

in

late

2011/early

2012there

has

not

beenenoughofashiftforustobelievethatSpainwillendupanydifferentlyfromtheseothercountries:Inneed

of a bailout program and, in the absence of growth, eventually requiring a debt restructuring. The biggest

difference between Spain and the current bailout countries is size. Second bailouts are possible for Greece,

PortugalandIreland,buttherecanonlybeonerollofthediceforSpain.Abailoutpackagecanbuysometimefor

Spain,butthatwillonlyhelpifthetimeisusedtogenerateeconomicgrowth.Witheconomicindicatorsshowing

Spainisshrinkingfurtherintorecession,suchareversalineconomicperformancewouldrequireasignificantshift

inpolicyattheEUlevel.TheonlywayfortheretobeahappyendinginSpainisifactionistakenswiftlyinBrussels,

FrankfurtandotherEuropeancapitals.

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Spain Scenarios- Bring on the Bailout

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