Catalonia: bailout and junk bond
This article was published in El Confidencial on September 1st 2012
“When you blame others, you give up your power to change”
“A sense of entitlement is a cancerous thought process that is void of gratitude and can be deadly to relationships, businesses, and even nations.” Steve Maraboli
On Friday, Standard & Poor’s downgraded the rating of Catalonia to junk after the region made a bailout request to the Spanish central government of €5bn. S&P warned in its report of the “economic and credit deterioration of the region,” and added that “the region’s request to modify key institutional and financial aspects of its relationship with the central government raises uncertainties that we deem incompatible with an investment-grade rating.”
The report also warns that “Catalonia continues to show a poor individual credit profile, with a deteriorating liquidity position dependent on the support of the central government to repay its debt.”
The bailout of Catalonia has generated much controversy in the market, but it’s worth saying that my comments in this article are applicable to most of the regions in Spain.
Despite the huge amount of communication efforts towards investors conducted by the different regions, all with ‘more GDP than Luxembourg and less debt than Japan,’ all considering themselves entitled to borrow indefinitely, the fact is that regions have no access to capital markets. And this shows how, all across Europe, countries and regions continue to believe that credit is free, investor money is unlimited and deserved without questions. And there is no unlimited capital.
The excellent presentation to investors that the Catalan government, theGeneralitat, made in 2011, very complete and detailed, shows some of the common problems that Spain and the regions face, and the reason why investor confidence and interest are still low.
. Estimates that were very optimistic: “Our revenues cannot fall.” “In 2012, with very conservative estimates, revenues will increase by 10.5 percent.”
. A debt maturity schedule that implies annual needs of €3bn added to the current financing needs of nearly €9bn. Added to that, the habit of financing current expenditures with long term debt and weakening future revenues, as Catalonia has received advances on transfers of more than €10bn until June 2012 – advances spent today that will not be collected later.
. The average maturity of the Catalan debt is six years. More than 71 percent of its debt matures between two and five years. I always tell my readers of the importance of not accumulating short-term maturities in good times as risks accelerate exponentially in times of recession. Accumulation of maturities well above marginal institutional demand is a problem throughout the European periphery coming from the misperception that “there is plenty of available demand” in the credit market for all, when the United States and major countries account for nearly all of the debt market capacity.
. Expectations of international funding sources were not met and have only been partially covered by local retail investors.
The real problem, however – the reason why investors do not rush to buy Catalan bonds that give a return of nearly 12 percent in 2016 – is that it has been proven since 2004 that any increase in revenues is engulfed by the regional administration and as such, the risk of default is higher than implied by companies and the region’s financier, the Spanish central government or Germany.
I heard this a few times from colleague credit investors: “a country that doubles its expenses in four years while its revenues fall, either has oil, or gold, or it does not have my money.”
The 10-year-Catalonia bond has a risk premium –spread– to Spain of almost 600 basis points and 1,100 basis points over Germany. This difference is not because of Catalonia’s dependency on Spain, or the alleged fiscal deficit. It is caused by the massive deterioration of expenditure and revenues, and the accumulation of debt maturities far beyond institutional demand. And it is important to say this, Catalonia is one of the regions with better credit structure. So, imagine the rest.
In fact, if investors perceived the massive spread between Spain and Catalan bonds as unjustified by the fundamentals, they would take the arbitrage opportunity and load up in Catalan bonds. Any credit arb hedge fund would buy them in size. But they don’t.
Now the blame game heats up. Spain blames Germany, Catalonia blames Madrid, Andalusia blames the banks, etc. Meanwhile, with on-going downward revisions of the gross domestic product and failures in budget implementation, governments continue to believe in the mantra of eternal credit ‘because we deserve it,’ sinking the ship with the crew and passengers inside.
In the Spanish regions and the central government, each euro received of additional income, either through taxes or transfers and structural funds since 2004, has become inexorably a euro and ten cents of debt. Looking at the Spanish regions, all the money received has been spent, but all of them have expanded primary deficit as well. In 1993, the regions managed 20.1 percent of the country’s budget, today they manage nearly 60 percent, yet all of them spend far beyond their means and income, regardless of their business and economic differences. Here in Spain there is no poor state. No Alabama. We are the United States where everyone is Washington or California.
This leads us to a comment made by my esteemed Xavier Sala i Martin, Spanish-American economist at Columbia University, who says that the problem of access to debt markets for companies is mainly because they are Spanish, and that if Catalonia were an independent country “it would be considered one of the world’s healthiest economies and financial markets would rush to lend it money.”
In this post, I am joined by my fixed income colleague to give readers an idea of how the debt markets work, because it is false that the main indicators to buy bonds are just debt to GDP and deficit, and I remember the comments from one of the British investors when the premier of the Generalitat made the presentation of its bonds in London. “If Catalonia was an independent country it would have the same access to credit as Andorra,” he said.
But even more surprising to me, as an investor in equities and bonds, is to read that “financial markets would rush to lend money” to an independent Catalonia. That is not true, as we have seen from country after country that declared themselves independent, from Yugoslavia to the former Soviet Union. Either they have abundant energy commodities or credit evaporates until they have gained years of experience as independent states. Estonia, the example for independence movements, only saw some modest short-term credit because Germany broke the treaty rules and recognized the country quickly. Even with that, credit was modest and GDP collapsed by 14 percent in 2009 and 9 percent in 2010.
When investing in bonds – debt to GDP, which is an indicator, inflated precisely by government spending and real estate bubbles – is irrelevant. What matters is the institutional credibility, the acceleration of expenditure against income, the quality and predictability of that income, the weight of public spending, monetary stability and the primary deficit or surplus.
We assume that Catalonia has institutional credibility, but:
. An independent Catalonia would be an economy that depends by 57 percent on Spain for its “exports.” In fact, since the trade balance with “non-Spanish” countries is negative (Catalonia imports more than it exports), Catalonia’s exposure to “Spain” would remain the same if not higher, particularly on the risk of the bonds of the alleged independent Catalonia. The cost of belonging to the EU, however, which Catalonia does not pay today as a region, would expand its deficit. Add to this that an independent Catalonia would have to absorb 18 percent of Spain’s national debt on the way out, and Catalonia would have debt to GDP higher than 100 percent. In a Spanish recession, the independent Catalonia bonds would also aggressively discount that same recession.
That’s why, despite the huge attractions and exceptional positive elements of Catalonia – dynamic, open economy – the investors perceive as the biggest problem the structure of a state that swallows any extra income received as it has done since 1996, making the solvency and liquidity ratios very tight, and this will continue to impact their access to credit. In fact, it is precisely the liquidity ratio, even assuming the previously mentioned tax deficits, which scares investors. Because the deterioration of income – with the deindustrialization of the region into more competitive and less bureaucratic countries, like Morocco – is accompanied by expenditures which can only rise, and do not take into account that the economy of Catalonia is very cyclical.
We end with a note on the “negative impact of being Spanish” to finance large companies. Sala i Martin says that ”the reason (for not having access to credit) has nothing to do with the sector in which they operate or the state of their economic health. The reason is simply that they are Spanish companies.”
First, we have seen debt issues, divestitures and hybrid access by several of these companies (Gas Natural, BBVA, Telefonica and other Spanish companies have issued €7.05bn in bonds with over 10 times demand in 2012), and all are trading at less risk of default than Spain or Catalonia. What we have said in this column many times is the real problem. The average debt of the Ibex is very high relative to its peers due to the orgy of strategic acquisitions at crazy multiples, but we have seen companies do an exercise that neither regions nor the central government have done. Prudence. Aggressively reducing costs, cutting unnecessary investments, cutting dividends, funding themselves long term since 2007 to avoid the “credit crunch.” That is, the opposite of what the governments have done. Companies have been preserving cash generation as an essential policy against an uncertain future, both in its core business as in its “growth markets.”
Surprisingly, Sala i Martin takes as an example of the ‘bad influence of the Spanish state’ three companies with almost monopolistic businesses in national services, telephone, natural gas, and construction-concessions. Great companies which have financed their international expansion with a lot of debt that they have been able to accumulate thanks to very high returns generated in Spain, which allowed them to enjoy better growth than their peers in the past, with full access to borrowing that could not have been there without the support of those domestic revenues and without a Spanish government that supported high risk cost strategic adventures.
No company is Spanish only for the good times and not for the bad times. These large companies, which enjoy a very comfortable monopolistic position in our country, do not suffer lack of credit “for being Spanish.” This is like saying that France Telecom, Veolia, EDP, Telecom Italia or Areva suffer lack of access to credit for being French, Portuguese or Italian rather than their strategic mistakes of expansion with debt.
Catalonia is wonderful and deserves all the good things that can happen there and more, and it is worth a bailout, or twenty, if needed. Spain has regions-nations – whatever you want to call them – with wonderful, huge possibilities. The problem was, and remains, having an unsustainable structure of administrations that absorb any extra income they get. Everyone has the right to claim independence for romantic reasons, or whatever, but we cannot say that the markets would be jumping to provide credit. In five years we would see Barcelona wanting to cut ties with Lleida or Madrid with Guadalajara, until the final implosion of a country with a level of public spending crowding out the real economy that looks like Argentina.
In Spain today, there is a golden opportunity to change, and to unite the country in the solution, not separate ourselves in the debacle. But let’s not blame the other. The solution is in our hands.
On fiscal deficits. here is the contrarian view to Catalonia’s government one.