Daniel Lacalle

Austerity sucks, but default sucks even more: Spain’s risky bet on sovereign bonds

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This article was published in El Confidencial on January 2013.

“Governments truly believe in a better future, that’s why they have spent it already”

The reserve fund of the Social Security in Spain is already up to 90% ‘invested’ in sovereign debt and some argue that it is a good idea to concentrate the vast majority of the resources of these entities on one instrument. Prudent risk management and asset allocation rules are ignored.

Some defend that the use of state pension funds and social security to buy domestic bonds is ‘normal’. Yet in the EU’s most intervened state, France, the maximum that the Social Security has invested in national sovereign debt is 44% and the average in the euro zone is 25%.

It is the perennial problem of our country, ignoring the risk of accumulation and concentration. Any family, any manager knows that putting all eggs in one basket is not the most appropriate thing to do for prudent investment. “But, why? it is going very well!” … Like the housing bubble. Until it stops doing so and citizens suffer the collapse. As a gambler in his last bet, all or nothing, to perpetuate the system.

“Rug” entities to hide debt

However, the process of hiding debt under all possible “rugs” -pensions, insurance companies, nationalized banks, Social Security- means that the exposure of citizens to “Spain political risk” is huge. On the other hand, Spanish private companies are issuing debt at rates well below that of the state, with real international demand that exceeds five to six times the offer because, despite all their past mistakes, the companies have done and are doing their homework.

De-capitalize through accumulation

There is no “risk-free asset”. When one buys bonds, interest rates and coupons are not the only variable to watch. The possibility that the principal collapses is as important as yield. One has to measure the issuer’s repayment capacity or supply-saturation if the State issues more than the market can absorb.

A bond can be less volatile than the stock market, but it is not without risk. Yet in Spain it is common to hear “bonds are very attractive because they give a 4% or 5% interest,” ignoring the risk in the underlying principal. Why do you think that there are bonds with higher rates than others? Because of the generosity of the issuer?

If the bonds purchased fell by 30%, for example, savers have less money despite the coupons. It might sound obvious, but if you have all your savings in one product and it collapses, capital vanishes.

If you decide that the product is attractive, investing is perfectly legitimate. If the investment is imposed, hiding debt under the “rug entities” is to sell you high risk at low return. In Japan for example, according to Goldman, less than 20% of the population know that they have all their money in government bonds, for example.

Collective action clauses (CAC): the risk is on you

We talked for months of CACs in the Greek crisis. If 66% of sovereign debt holders “accept” a haircut and re-structuring, the conditions are automatically forced on all other bondholders. This applies to bonds issued by the State since January.

What happens when 80-90% of the debt is absorbed by local “rug entities”? That small investors have no say, as all those entities will “accept” the haircut and activists have no option to defend their rights, while citizens have no idea that almost all their pensions and Social Security are invested in sovereign debt. Isn’t it quite convenient that the market regulator, CNMV, does not require reporting excess limits in sovereign debt holdings since last summer?.

My friends tell me that these clauses are “normal”, imposed by the EU, and that the Treasury would not enforce them … If all goes well.

In Spain we continue to confuse debt accumulation and low cost, with low risk. And it is a huge mistake. I recommend you read the excellent post from Jesus Sanchez-Quinones in Spanish in Cotizalia.

In 2013, the Spanish State will have additional net financing needs of 71 billion euro, according to the Treasury. Around 230bn euro of total bond issuances. In fact, Spain will be the fourth largest issuer of debt in developed countries, more than 21% of its GDP, after Japan, the US and Italy.

The pros and cons of accumulating and hiding our own debt are:

  • Hiding ourselves from external debt financing, is a sly attempt to reduce the cost, because our managers would lower the interest rate they are willing “to accept”. Our risk always seems smaller to our own eyes.
  • Assuming our own debt is a way to “finance our future”, or rather mortgage our grandchildren to pay our current expenses. We gamble our future on one card.
  • If we go into default, we suffer it on our own, but risk does not necessarily spread to other countries. So we can call  it “orderly restructuring”, which sounds very fashionable. It is the “internal default” I mentioned in my article ” The day after the bailout. “
  • We lower the cost of debt to finance the State to “invest”. That’s paying twice, in taxes and donation of savings. It would be nice if the money was not thrown to finance cronyism, current expenses and government plans that generate negative returns since 2004, or disguise the last batch of political appointments as “health and education expenses”.
  • To maintain a low cost and reduce the risk of default internal, we must trust that Spain will reduce the absolute level of debt, wealth increases, taxpaying population grows and we see GDP rise more than 2% annually. Or we condemn ourselves to bailouts in exchange for very painful conditions. But if there is a risk that these forecasts are not met, and then it is an extremely risky bet. When industrial production slumped 7% in November those risks are not small…
  • The periods of low interest rates should be used to reduce debt, not increase it, even if it is “less than last year” because the shocks come afterwards and then we say that the markets are attacking Spain.
  • The accumulation of sovereign debt concentrated in domestic hands, even if it is at low rates, does not improve growth or reduce the need for cuts. All the stimulus plans we have seen generate more debt and more risk, so low cost cannot be a panacea to open the checkbook to the next useless infrastructure project.
  • Assuming that debt does not matter if the cost is low is a big mistake. It generates enormous and unforeseen shocks that happen increasingly often and more aggressively  “Creating” employment through government programs of more debt and kicking the can forward does not help, because it subsidizes jobs, does not create them, prevents the clean-up of a low productivity system and curtails the opportunities for the private sector. And the total cost is much higher than the short-term placebo effect, as we have seen again and again but refuse to accept.
  • The opening of credit is absorbed by government in the “crowding out” we are seeing every day. And with the accumulation of public risk in banks (see my article “The State attacks us”) and savings plans, shocks as those seen recently are repeated, because it does not cleans a system that consumes resources to pay for current expenses.

Moreover, the problem comes when”rug entities” need to sell their bonds as the Spanish Social Security, for example, carries a deficit but it cannot reduce its sovereign debt portfolio, because the State continues to issue more and “needs” them to keep buying , not selling. So “profit taking” is an impossibility while the snowball of debt grows. But even if they could, who would buy at this price? ‘Another “rug entity”? The ECB through a painful bailout?.

This is the problem of the “great opportunities” that some point to me. “The State is selling ‘expensive’ Bunds to buy cheap Spanish debt, making a bundle”. Sure, except that they cannot sell, hence profits are just accounting, and accumulation increases the risk enormously.
The deficit of Spain will likely reach another 5.8% in 2013 after having exceeded 7% in 2012. This means that even after tax increases and cuts, current expenses remain stubbornly high.Real austerity now. Private sector, now.

When we see that even if taxes went up by 40%, Spain would not cover the excesses of debt, this is clearly not a revenue problem. It is a spending problem.

If, despite the fall in bond yields and tax increases, the deficit remains rampant and public expenses -less cost of debt and social items- fall less than 10%, it is clear that the so-called austerity, which is to maintain political spending cutting investment, is imperceptible. Yet I fear that taxes will go up again to cover the 13.5 and 15 billion of additional adjustments needed in 2013 and 2014 respectively to reach the 4.5% deficit agreed with the European Union, even assuming that Spain meet the targets announced in 2012.
The solution to these risks is obvious. Apply strict codes of risk management and public investment. Hammurabi Law written in stone, as Nassim Taleb said and my friend Carlos Cuesta from Mirabaud reminds me.
Stop mortgaging the future. Start cutting political spending, and end unnecessary bailouts. Adjust expenses to income-not vice versa-. Lower taxes and free up financial resources to create consumption, employment and wealth, not to subsidize them with borrowed money.After the unsustainable accumulation of debt, even at low cost, there is only one outcome: default, recession and cuts.

I always say it, austerity sucks, but default sucks even more, for many generations.

3 Respuestas a Austerity sucks, but default sucks even more: Spain’s risky bet on sovereign bonds

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  3. Anonymous 12 febrero, 2013 a 10:30 am

    Solutions are already. Austerity sucks.


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