Daily Archives: April 30, 2012

Spain is rapidly approaching a liquidity impasse. Markets are nervous because it’s not clear how the government will finance its budget deficit and the rollover of its maturing bonds. Spain’s budget deficit now stands at 5 per cent of its gross domestic product and the bonds maturing in 2012 equal an additional 15 per cent of GDP. The IMF expects these large deficits and refinancing needs to continue for several years.

To meet its financing needs, the Spanish government needs the confidence of foreign and domestic investors. Those private investors must believe that Spain has a credible programme to eliminate the annual fiscal deficits and a back-up plan to deal with the maturing debt if there is a shortfall of buyers. If investors know there is such a plan that could be triggered in an emergency, it might never be needed. The Spanish government should quickly reduce its near-term fiscal deficits and develop an operational plan to deal with its needs in following years.

Spain’s commercial banks have little remaining lending capacity, the result of their previous purchases of Spanish government bonds and of their losses on real estate loans. The Bank of Spain lacks the money-creating ability of the US Federal Reserve and the Bank of England to buy government bonds. And the European Central Bank is explicitly precluded from financing fiscal deficits of member governments.

The Spanish government must therefore depend on foreign and domestic investors who are now reluctant to lend to a government that may be insolvent. The challenge is to rebuild their confidence.

Although eliminating annual budget deficits is politically difficult, Italy has recently shown that it can be done by a combination of reforms to spending (particularly pension reforms) and strengthening tax collections.  The IMF now forecasts that Italy will have a cyclically adjusted budget deficit this year of less than 0.5 per cent of its GDP and cyclically adjusted budget surpluses starting in 2013.

Like Italy, Spain should also be able to find the spending cuts and revenue gains, since Spanish government spending now exceeds 45 percent of GDP. The relative budget autonomy of the Spanish regions should be allowed to continue only if (as with the states in the US) they are required to limit their operating outlays to the funds that they receive from the central government and from their own taxes.

Even with tough political action, it will take years to achieve a balanced budget. That means there will continue to be budget deficits that need financing and therefore a possible delay in persuading investors to roll over existing debt as it matures. Building investor confidence during this process requires a plan to avoid a Greek-style default.

One part of such a plan is to negotiate access to the European Stability Mechanism, the €700bn fund created to protect member governments from default. But if the refinancing shortfall from private sources is very large, Spain will need to supplement the funds from the ESM.

Raising those additional funds by increasing taxes would push the Spanish economy into a deeper recession and would weaken the supply-side incentives needed to stimulate long-term growth.  Although some of the increased supply of lending might be achieved by changing the required asset holdings of the Spanish banks, the current condition of those banks leaves very little scope for such additional lending.

An alternative emergency approach would be to mandate, on a temporary basis, bond purchases by Spanish households and businesses.  Here’s how such a plan might be implemented.

The Spanish government could use the income tax system to levy a temporary “lending surcharge” on individual incomes. In exchange for those surcharge payments, the households would receive an interest-bearing government bond with a maturity of five to 10 years.  A similar surcharge could be levied on businesses based on corporate profits or the businesses’ value added.

Having this back-up plan in place to fill any shortfall in Spain’s finances could give private sector investors the reassurance they need to provide the funds that are needed.  With private sector confidence that a default would be avoided, it should not even be necessary to draw on the ESM or to levy the surcharge on households and businesses. The Spanish government should therefore move quickly to enact such a plan before it is overcome by its current liquidity problems.

Standard and Poor’s' multi-notch downgrade of Spain’s sovereign credit rating was largely shrugged off by markets. That is the good news. The bad news is that S&P’s reasoning speaks to dynamics on the ground that are likely to worsen if a more balanced Spanish policy mix is not accompanied by targeted external support.

In slashing Spain’s credit rating to BBB+ and retaining a negative outlook, S&P cited its forecast that the Spanish economy would contract by 1.5 per cent in 2012 (rather than expand as previously anticipated), the budget deficit would exceed 6 per cent of gross domestic product (compared to a government deficit target of 5.3 per cent), and the country’s debt-to GDP would rise steadily to almost 90 per cent by 2015. And all this in the context of recent government data that show that one in every four Spaniards is unemployed (with the youth unemployment rate alarmingly exceeding 50 per cent).

This difficult reality explains why Spain is experiencing the worrisome combination of high borrowing costs, a slowly shrinking bank deposit base, capital outflows, and an increasingly binding internal credit crunch. This is a scary combination. It systematically withdraws oxygen from a real economy that is already struggling mightily; and it worsens in to a vicious cycle unless pronounced progress is made in three critical areas.

First, Spanish policy needs to do a better job in convincing citizens that medium-term economic stability is both feasible and probable. To do so, it must act through both the numerator and denominator of debt sustainability; and, in particular, by striking a better balance between deficit containment (numerator) and growth (denominator).

Too much of the burden is being placed on budget austerity and not enough on structural reforms that enhance Spain’s growth and job creation in a sustainable manner. As such, there are doubts about the durability and effectiveness of Spain’s adjustment efforts.

Second, Spain needs to reduce worries about the potential impact on government finances of contingent liabilities that reside in its banks and on account of its real estate bubble. At a minimum, this requires further progress in consolidating the banking system, in allocating loan losses, and in convincing institutions to be much more aggressive in raising new capital from the private sector.

The greater the timidity of these actions, the larger the concerns that Spain’s funding needs will overwhelm the markets’ appetite to provide voluntary financing at reasonable terms. It is thus paramount for Spain to do more to reassure the world that its budgetary financing gap will not be crushed by the assumption of liabilities from other sectors of the economy

Third, Europe needs to be more willing and able to support Spanish adjustment efforts. As currently set up, European mechanisms for exceptional financing assistance are overly binary – either way too little assistance or, at the other end, a full blown rescue package that brings with it the risks of collateral damage and unintended consequences.

Existing procedures make it difficult for Spain, if not impossible, to receive targeted official financing without also signaling that it is becoming a ward of the European state. As such, rather than complement a market-financed adjustment program, recourse to European emergency funding could result in Spain foregoing virtually all access to private financing (as is the case today for Greece, Ireland and Portugal).

What is at stake here goes well beyond the wellbeing of 46m Spanish citizens. The country’s health is also central to the proper functioning of a vital European unity project that is already under pressure due to economic and financial dislocations elsewhere, as well as political uncertainties that are sure to continue increasing.

Spain does not have the public debt problems of Greece, nor its administrative dysfunction. Moreover, its government has not followed Ireland in assuming on its balance sheet the liabilities of an irresponsible segment of the private sector. But all this could prove irrelevant in avoiding a full-blown crisis if the country’s mounting difficulties are not tackled in a more balanced fashion by the government and, at the same time, supported by European partners in a more targeted fashion.

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