The Rack Turns

by Andrew Stuttaford

Via Ambrose Evans-Pritchard in the Daily Telegraph:

Spanish premier Mariano Rajoy has given a fateful hostage to fortune. He told the nation that there will no EU rescue of Spain’s banking system, even as `Black Monday’ brought a further crash in bank shares and the IBEX index dropped to nine-year lows.

So where will he find the money to finance his €23.5bn bail-out of Bankia, a bank deemed healthy just weeks ago? The Fund for Orderly Bank Restructuring (FROB) has €5.3bn, and other banks to worry about. It would be ruinous to tap the bond markets. Spanish 10-year yields are already at danger levels of 6.4pc. The spread over German Bunds has reached a post-EMU high of 514 basis points.

Capital flight has cut foreign holdings of Spanish debt from 50pc to 37pc since January. Spain’s banks — including Bankia — have been propping up the state with €316bn borrowed from the European Central Bank. Now the state is propping up banks. The incestuous nexus is surreal…

Mr Rajoy is sticking doggedly to his line that Spain is a collateral casualty of mess elsewhere in Europe. “There are major doubts over the euro zone and that makes the risk premium for some countries very high,” he said.

He wants mobilisation of the EU bail-out fund to recapitalise weak banks across Euroland, lessening the stigma for states in crisis. This amounts to EU debt-pooling — a variant of eurobonds — and has been vetoed by Germany.

…Whether Mr Rajoy can keep his pledge depends on the ferocity of Spain’s double-dip recession. Credit has contracted for eighteen months. Madrid expects the economy to shrink by 1.7pc this year but it could be worse as Mr Rajoy tries to slash the budget deficit from 8.9pc to 5.3pc of GDP in a single year.

Barclays Capital says Spain’s housing crash is only half way through. Home prices will have to fall another 20pc to clear an overhang of one million excess properties. That will bleed banks to death.

The Centre for European Policy Studies puts likely write-offs at €270bn. Much of the loss would land on the state, as in Ireland. The risk is that Spain’s public debt will surge above 100pc of GDP.

Mr Rajoy has called on the ECB [European Central Bank] to soak up Spanish bonds and cap yields at a viable cost. Yet such action by the ECB subordinates other creditors, a sore subject since ECB bond purchases in Greece concentrated pain for private holders, They lost 75pc.

Piecemeal purchases of Spanish bonds might backfire badly at this stage. Such ECB intervention can only work if conducted according to the Powell Doctrine in Iraq: with crushing force. That would require Berlin’s blessing. It is not forthcoming.