Spain’s economy can be fixed but needs credible recapitalisation plan

Asset managers are keeping Spain and its economy under careful observation, following domino effects on the economy of the country caused by the government’s decision to agree on a €19bn recapitalisation of Spanish troubled lender Bankia.

The government’s mishandling of the recapitalisation process, coupled with concerns over spillover effects from Greece, have pushed Spain’s 10-year yields up to 6.5% and the spread with Germany above 500bp.

While the consensus view remains that Spain’s economy is fixable, a credible recapitalisation of the industry will be a necessary, though not sufficient, condition to stabilise markets, according to Darren Williams, senior European economist at AllianceBernstein.

A mechanism for the recapitalisation process is at the moment a source of controversy, and according to to AB credit research its cost could reach €100bn, or 10% of the GDP of the country.

“Spain was always going to be a key battleground in the sovereign-debt crisis. At €1.1trn, Spain accounts for 11% of euro-area economic output, and is almost twice as big as Greece, Portugal and Ireland combined. More pertinently, it has total banking assets of €3.7trn. That’s why Spain has often been called ‘too big to fail and too big to rescue’,” Williams says.

On Spain, investors have two immediate concerns.

The first is related to the plausibility of the fiscal adjustment. In other words, the government would have to impose austerity measures on an economy with no monetary or exchange-rate flexibility. 

“The second relates to its banks. Along with Ireland, Spain experienced a huge boom in money, credit and asset prices in the early years of monetary union. Unfortunately, the bust phase of the cycle has left much of its banking system in tatters. Unlike Ireland, the Spanish government has been very slow to do deal with this,” the economist adds.

According to Williams, a credible recapitalisation would help neutralise one important source of market concern and volatility.

“The question is whether this recapitalisation will be supplied directly or indirectly by the EFSF/ESM. Spain could attempt to recapitalize the banks itself but that would not be regarded as credible. For markets, a direct recapitalization would clearly be the best outcome as it would help loosen the link between the sovereign and the banks. It would also represent an important step towards debt mutualisation,” he adds.

Tristan Cooper, sovereign credit analyst at Fidelity Worldwide Investment, confirms that the willingness to support Spain is there.

“The difficulty is designing a method that can satisfy both Germany and the market. Germany’s desire to preserve sovereign accountability clashes with the market’s wish for contingent liability relief,” he says.

A support package that adds debt to the sovereign balance sheet or shifts contingent liabilities from one place to another will fall short in the eyes of bond investors.

“Although sick banks are Spain’s most acute ailment, there are more chronic ones. These include the highest unemployment and the third widest fiscal deficit in Europe in the context of a deep recession. Markets would react positively to an adequate bank recapitalisation solution. But a structural change in investor sentiment requires the prospect of a sustainable economic recovery and a credible plan for achieving it,” he says.



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