Time to get real?

May 30, 2012

Spain’s plans to revive Bankia with state money and sort out its regions’ finances have well and truly unnerved the markets. It seems that Plan A — to inject state bonds straight into the stricken bank so that it could offer them to the ECB as collateral in return for cash — was roundly rejectd by the European Central Bank, so Madrid rapidly produced a second plan which will involve the government raising yet more money on the bond market, not helpful to its drive to cut debt.

That leaves the impression that Spain is making up policy on the hoof, not something likely to endear it to the markets. That’s particularly unfortunate since it has actually done an awful lot on the austerity and structural reform front over the past two years. But not enough.

It’s not all one-way traffic. Madrid is pressing its insistence that the ECB should be the institution to deliver a decisive message to the markets that the euro is here to stay – presumably by reviving its bond-buying programme (highly unlikely at this stage).

Spain’s big plus was that it had issued well over half its 2012 debt needs in the first five months of the year but with some of the Bankia recapitalization set to fall on the state and its indebted regions having to refinance far, far more debt than had been anticipated that advantage has been eroded. The government is set to impose a new mechanism on Friday to provide funds to the regions with strict strings attached.

For the next couple of month things aren’t too acute but the country faces hefty refunding humps in August and October which could prove difficult. It will want borrowing costs to be significantly lower by then which will require measures to foster investor confidence.

There has been talk among EU officials of giving Spain an extra year to get its budget deficit down to 3 percent of GDP if it presented a credible 3-4 year plan of fiscal adjustment, which would give important leeway. It is currently tasked with lopping about 6 percentage points off the deficit in two year; most economists say anything more than 2 points a year chokes the economy. Something may be afoot.  A government source told us last night that Spain would put forward a three-year plan to control central government spending in the months to come.

We may also get  hints of movement in that direction from Brussels with the European Commission putting forward its policy recommendations for all EU states. That could be the point at which it admits what everybody is saying: that Spain and others will be unable to meet the budget cuts demanded of them. It does not automatically flow that high debtor members will be given longer to meet their fiscal targets but it will certainly fuel the debate. It should be noted, though, that the noises from Berlin are not supportive.

The late June EU summit is shaping up to be a pivotal one, not least because it will  follow the Greek election re-run. The latest polls confirmed the findings of a clutch over the weekend – pro-bailout New Democracy holds a narrow lead over radical leftist SYRIZA which would rip up Athens’ aid programme. The winner gets an extra 50 parliamentary seats so if the former prevails there is a good chance it could cobble together a pro-bailout coalition with the former ruling party PASOK. However, few expect them to have a sufficiently robust mandate to create a sustainable, stable government. It would, however, at least kick the can down the road (apologies for the much over-used cliché).

Italy will sell six billion euros or more of five- and 10-year bonds in what looks like a demanding auction given prevailing market conditions. Domestic buyers are expected to deliver the goods but five-year yields are expected to climb sharply from the last equivalent auction, hurdling the 5 percent mark. Not surprisingly, Italian bonds have outperformed Spain’s in recent weeks. 10-year yields are a touch below 6 percent whereas Spain’s are around 6.5.

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