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Recipe for a Spanish Comeback

Global Economy, On the cover, Sin categoría, Spain

(This article was published in The Wall Street Journal on June 26th, 2012 copyright WSJ)

The recent pullback in Spanish bond yields has been heralded locally as almost a victory. But if so, it’s probably a pyrrhic victory, as Spain’s 10-year sovereign bond yield still stands at 6.5%, and five-year credit default swaps remain at historic highs of 563 basis points. Meanwhile, the question in investors’ minds is the same: How will Spain repay its public debts, which have more than doubled since early 2008 to 72% of GDP as of the first quarter of 2012?
Before Spaniards elected the Rajoy government last year, the previous government had denied the crisis for years and failed to act swiftly upon it, leading foreign investors to avoid the country’s bonds. Spanish public debt owned by non-residents has fallen to 37.3% today from 54.5% in 2010. The real figure is even lower, as a significant portion of that 37.3% represents debt bought by the European Central Bank.
The slump in international demand has been mostly offset by bond buying by domestic institutions, including the Spanish social-security and public-pension funds, and mostly from Spanish banks. These Spanish banks now loading up on sovereign bonds are the same ones that have used €288 billion of the ECB’s discount-lending facility so far this year. This is a truly dangerous move, as the vicious circle of risk-contagion between bank balance sheets and sovereign risk affects every asset class. This has also created a credit crunch for the real economy, particularly unhelpful in a country in which small and medium-sized businesses generate 70% of value added and almost 80% of employment.

According to Spanish Finance Minister Luis de Guindos, investors are not taking Spain’s “growth potential” into account. There is truth in that assessment, but Spanish authorities seem resigned to the notion that they can do no more to actualize this “potential.” I believe there is a lot more they could do.Given its potential, Spain can do better, it can do more and it can do it now.

Spain has failed to restore investor confidence in its ability to repay its debts predominantly because the reforms pushed by the Rajoy government so far have focused mostly on revenues, namely tax increases, while the government’s bloated administration and massive subsidy culture remain in place. As such, the economy deteriorates and taxes go up, while debt continues to grow.
Spain seems stubbornly intent on restoring tax revenues that were the product of a giant real-estate bubble, and those will not return easily. Tax collections per capita increased almost 40% between 2003 and 2008 due to the housing bubble, driving a similar increase in government spending. Spain created a public sector perfectly suited for an economy that would grow 2% per year forever. It didn’t. Once the bubble burst, those revenues disappeared but the spending stayed. That funding gap, which took Spain to an 8.9% deficit in 2011 from a 2% surplus in 2007, can not be tackled through taxes, but only through cuts in spending.
When discussing possible cuts to Spanish public spending, one always hears that every reduction is only a drop in the ocean. True, but a million “drops” would add up quickly in a country with 17 regional administrations, thousands of loss-making public enterprises, tens of billions in subsidies, and a complex web of regional and national regulatory bodies.
The Spanish economy, centered on services, industry, tourism and construction, is strongly cyclical. As such, the burden of the state and the maximum debt it can sustain need to be smaller than its less cyclical peers. Spain could restore confidence and reduce its bond yields by achieving this through a four-step, zero-cost program focused on:
1. Structural public-administration reforms: Eliminating duplicative public administrations, chiefly in regional, island and county councils, could save up to €20 billion, according to Spain’s Circle of Entrepreneurs think-tank and the Conservative Party. Additionally, selling off Spain’s dozens of public television and radio networks, and ridding taxpayers of thousands of loss-making companies owned by regional governments, could save €10 billion.
2. Tax Reform: Increasing Spain’s standard value-added tax rate to 20% from 18%, while reducing the employer portion of social-security taxes by 3.5 percentage points, could boost GDP by between 1-1.3% without any decrease in government revenue, according to a recent study by domestic banks. Spain scores 69.1 out of 100 in the Heritage Foundation’s Index of Economic Freedom, significantly below its peers. It needs a long-term sustainable plan of tax incentives for new businesses, and a unified system of regulation instead of the current patchwork of rules, to allow small and medium-sized businesses to grow into large corporations.
3. Cut subsidies by half: Spain spends more than 2% of its GDP per year on corporate subsidies and grants (not including its aid to banks). So far these have only been lightly trimmed throughout the crisis. The subsidy culture keeps zombie businesses in place and puts up a barrier to the development of more productive enterprises. End it.
4. Attract capital: Spain’s private-equity funding of companies is below 0.1% of GDP, according to the national stock-exchange regulator. This is partly due to regulatory instability, along with its protectionist regulation of foreign capital, as any fund that has tried to open an office there knows. By opening its doors to foreign investment, Spain could erase the view that all major deals there must happen between friends and behind closed doors, thus improving its public image in financial markets.

Sovereign-bond investors are by definition the most risk-averse of the world’s financiers. Markets want clarity, sustainability and no surprises. Spain needs to prove to them that it can not only meet its current economic estimates, but beat them. The country has done it many times in the past, and it still possesses all that “potential” that Mr. de Guindos talked about. Spain can do better, it can do more and it can do it now.copyright The Wall Street Journal. Published with permission.

How to Save the Spanish Banking System

Global Economy, On the cover, Sin categoría, Spain
(This article was published in Cotizalia on June 23rd, 2012)

The big news of the week was the presentation of the independent assessment of capital needs of Spanish banks. It is interesting, but on Tuesday I was at a dinner with several managers and analysts of the financial sector, and all of them were spot on about the figure that would be published: A maximum of 60 billion euro.”A solvent banking system” read one of the local press headlines. The ones that have proven to be solvent are the usual suspects: Santander, BBVA, etc… And a positive surprise in Sabadell, which came off better than expected by the market. The savings banks have proven again to be the main problem, because a financial hole of tens billions is frightening.

What angers me is that this tremendously harmful process of “pretend and extend” the problem has led to cast doubt on the solvency of some banks that never should have been doubted. Not all the savings banks are a problem either. It should be noted that Caixabank, made the transition from savings bank to commercial bank and proved to be better-prepared within the national economic disaster.

It is worth to note that at least for the first time, the Government has sought to manage expectations. Hence, the chain of events: 1) The IMF says that the capital needs of banks are 40 billion euro. 2) The State requests a loan of 100 billion euro, and 3) independent consultants put capital needs between 15 and 62 billion, depending on macroeconomic conditions. All happy, instead of changing numbers every three months.

However, if we go into detail, this is another “stress test” I am afraid that leaves more questions than answers.

All prior stress tests have started from the premise that they were very conservative, but the market misses ​​a genuine exercise in “cleaning up the closet.” Let us not forget that all entities that have gone bankrupt – Dexia-, or have been intervened, passed the “stress tests” with flying colours. And do not forget that in 2006 one of the consultants, Oliver Wyman, said that Anglo Irish Bank was the best bank in the world . And it went bust.

Everyone can make mistakes, of course, but what is important to note is that these reports are neither aggressive nor conservative in their estimates. That is the premise from which we must start the analysis.

spanish banks I

The Positives:

Spain is the only country that has made ​​the exercise of bringing independent consultants. It is an important exercise in transparency.

. Now no one doubts that losses in the “adverse” scenario would reach about 250 billion euro, with recapitalization needs of 51-62 billion. And forget about the other scenarios. The independent reports themselves provide many clues and reasons to consider that the “base” scenario is the least relevant, starting with bank profits estimates, GDP growth and estimate of fall in home prices.

. If recapitalization needs remain in the medium scenario, the State would not use much of the 100 Billion loan granted by Europe, reducing the negative impact.

. Listed banks are saying they would not need to access the loan and provisions will be made ​​against their results. Let us see if I banks make the necessary capital increases, as Italian banks did.

. The Government itself, as part of the committee preparing the basis of the report, has allowed some macroeconomic estimates for the base and adverse scenarios that in many other countries would have not been allowed.

The criticisms:

– The consultants have not analysed corporate risk, liquidity, and sovereign risk. There is no review or analysis of the substantial portfolio of sovereign bonds, or the DTA (deferred tax assets), or industrial holdings losses, when latent losses are very important, estimated at 20 billion euros, according to Merrill Lynch. This is very important because in some cases more than 70% of the core capitalization ratio (CT1, Tier 1) is made of government bonds.

– The acceptable solvency ratios are calculated at very low levels: They use an acceptable ratio of core capital (CT1) of only 6% in the adverse scenario, while 9% is used in the base scenario. If the economy is going to deteriorate further, would financial institutions be allowed to reduce their capital ratio from 9 to 6%? This difference alone can enlarge the capital needs by 50 billion euros, according to BNP or Credit Suisse.

– The estimated “new profit generation ability” clearly seems benign for the banks, at approximately 64 billion of profits in the adverse scenario. It seems at least optimistic, since the entire sector generated 100

billion in the last three years. If the economy collapses it is very difficult to estimate this level of profits as “conservative.”

Spanish banks IIHow to save the system from another “stress test” in a year:

I have participated in the documentary, “Fraud.Why the great recession” , which outlines some of the essential measures to prevent further financial shocks from a liberal perspective. It is worth listening to some of these ideas and leave behind the old arguments of “that’s impossible” or “it has never been done” to find sustainable solutions.Using core capital ratios of 6% or 9% is simply putting patches. Banks cannot be so thinly capitalized and risk going bankrupt with any small change in the markets. Banks must be capitalized at least 25%, and ideally build a cash to deposits reserve ratio that gets as close as 100% as possible.

The risk spiral “sovereign debt-bank balance sheet” should be cut. They cannot keep gorging on Treasuries, because when bond yields rise it impacts the credit quality of the bank through the cumulative risk in the sovereign portfolio.

The spiral of corporate risk should be limited and provisioned at market prices. Industrial stakes, with millions in latent losses, should be reviewed and banks should get rid of those that are not profitable.

In the absence of wild credit to feed the bubble that created the Spanish network of industrial holdings, the cycle of “debt rises -> GDP falls -> stock market falls -> industrial stakes stocks fall -> quality of bank assets deteriorates -> bank stocks fall -> loans to the real economy fall -> debt rises -> GDP falls -> start again” is repeated over and over again.

Don’t bail out banks. The bail-in alternative we always mention is the logical one. Bailing out banks perpetuates the incentive to lend recklessly, to continue to take risk “suggested” by politicians and fail again. Use the EU loans to guarantee bank deposits and liquidate the insolvent ones or we will have another round of “bailouts” in a year.

Leave any intermediate solutions. There are no partial provisions for zombie loans. Provisioning “part” of Non Performing Loans does not cut the risk. It perpetuates it. And old school bankers know it.

Finally, conduct a continuing review of the loan portfolio by independent entities and increase international transactions.

If the entities base their risk analysis less on PowerPoint, and less on optimistic own research, banks will see the beginning of the solution and the return to a banking model that has made some of our institutions and managers global models. Do not forget that the solution is not so crazy, because we have it in the past.

You can’t get Blood from a Stone

Global Economy, On the cover, Sin categoría,

In the hope that someone in the EU reads it:I: Inflation is a tax. Create inflation when salaries are stale and spending will collapse

II: Printing money is stealing funds from savings and from efficient companies to give it to inefficient and indebted governments.

III: Trying to increase tax revenues to bubble-period figures is impossible. Those revenues disappear when the bubble bursts. You have to bring spending to pre-bubble levels.

IV: Increasing spending and debt means passing the bill or the consequences of a default to our children.

V: Offsetting private investments with government spending assumes that politicians are better managers and investors than private entrepreneurs.

VI: More taxes, less growth, less revenues. Same spending, more deficit. More debt, bigger hole.VII: Increasing debt today is to assume that we deserve to spend today the expected productivity and efficiencies of the future.

VIII: If our policy is that countries don’t have to worry about debt because governments don’t need to pay it we shouldn’t be surprised with increased cost of borrowing.

IX: Increasing public spending today assumes that the same governments that made spending mistakes in the past will now change their way and do it well.

X: If a country’s debt is “low” and its cost “manageable” yet demand for its bonds is collapsing and costs soaring, the debt is neither low nor manageable.

 

The Euro House of Cards and the Greek Temporary Relief

Global Economy, On the cover, Sin categoría,

After a week of maximum tension in Europe driven by the Greek elections, Spanish and Italian bond yields, and Cyprus, another one that needs a bailout, things seem to be stabilizing. As suspected, New Democracy -the conservatives- have won in Greece but they will need to form a coalition in the next 3 days. Germany have already suggested this may allow some loosening of program terms but Eurozone bond yields remain at historical highs and the challenges remain. Yet Greece solves nothing. At the close of this post (Monday 18th) Spain 10 year soared to 7.00%, a spread to the Bund of 553bps.The solution to the debt crisis in Europe is evident. No more reckless spending, reduce debt and avoid forcing monetary expansion measures. After consuming billions of dollars in expansionary policies without success, Europe should stop and think that the damage is greater than the benefit. All these mechanisms have proven ineffective . We have seen five consecutive years of stimulus plans in Europe, a total of $2.63 trillion, with no evidence of success. Providing liquidity and financial relief must be temporary measures, not structural. To demand half a trillion in new stimulus each year is madness.

The solution is fiscal prudence, halting the spiral of political spending, cleaning banks’ balance sheets-preferably paid by shareholders and bondholders-, attracting capital and eliminating unproductive subsidies.

The European House of Cards

The European crisis continues and this page ” The European Super Highway of Debt “ shows visually the size of the house of cards. More debt is not going to help.

In the European credit market we have seen this week a few interesting things:

  • Despite the austerity measures, Spanish public debt has grown 5.39% in the first quarter to 774.5 billion euros, 72.1% of GDP. Reforms must continue, but much faster.
  • The Spanish risk premium to the Bund stands at 553 basis points . Why? Because debt and financing costs would soar if the country was to use the loan of 100 billion to recapitalize the troubled banks, making it more difficult to repay that debt. The key issue to tackle is that international investors are selling government bonds, leading to the Spanish banks having to buy more public debt. Almost 67% of the country’s debt is now in national hands.
  • The credit default swaps (CDS) in France and Germany are up almost 12% in a month, showing that the crisis is still spreading. All CDS, including Germany’s, have risen on the risk of another stimulus plan/shot of debt. This is what happens when one breaks the principle of responsibility of creditors. Structurally rescuing banks and countries endangers the whole system.
  • The International Monetary Fund on Friday urged Europe to help Ireland refinance its crippling bank bailout and consider taking equity in state-owned banks to help Dublin return to bond markets and avoid a second bailout next year.
  • We are told again and again that the ECB and Germany do not support peripherals . However, the numbers say otherwise. The Bundesbank has lent to the periphery of Europe 699 billion euro since January within the Target scheme II, equivalent to almost 25% of the GDP of Germany. Spanish banks have asked the ECB for a further 7.4 billion euros, making a total of 288 billion so far.
  • While Europe, the ECB, EFSF or ESM, provides support, the countries contributing funds to these institutions are almost all highly indebted and are funded in many cases at much higher rates. Il Corriere della Sera echoed the irony that Italy will contribute 19 billion euro to the 100bn loan to Spain, lending it at a 3.3% rate when Italy has to borrow in the markets at 6%.

Look at the chart below. Over 85% of the money that is contributed to the European stability fund is provided by heavily indebted countries and their contribution is not capital. It is debt.

The Greek Relief

In all this week heading into the Greek elections we have read comments that central banks “maybe” “may” “study” the “possibility” of a concerted action to support the economy. Failed before? Try and try again.

Greece shows us the fragility of Europe’s policy of “debt with more debt.” Greece is not the problem, it is part of it, but it can cause a big financial turmoil given the web of cross-country loans.For starters, Greece will need a new additional injection of 15 billion within weeks. Remember in April 2010 when former Spanish president said that the country would gain about 110 million euros a year -yes, a year-with the loan to Greece? Now, neither loan nor gain. A donation.

To put it simply:

New Democracy winning, with a coalition of pro-Europe parties, solves nothing. It is ironic to see the markets rejoice at the fact that the same party that lied about the countries’ finances is now winning. Greece will probably renegotiate the terms of the bailout, yet require a package of “growth”- ie debt- for infrastructure projects financed by the EIB. Funded is probably too big a word, because it is highly unlikely that the loan will be repaid. The “cost” of this option is estimated at 50 to 60 billion Euro in a period of 18 months. JP Morgan estimates only €15bn of €410bn total “aid” to Greece went into economy – rest to creditors, yet the financial hole of lending to Greece has only grown.

The reality is that no matter who ends in government, in Greece what has won is the scheme of a hypertrophied state, political spending and cronyism between government and financial institutions. And that additional debt will be funded by a Euro-zone with fewer resources and increasingly isolated from international markets.

The giant financial web, the house of cards of the Euro-zone, is the reason why every time there is an announcement of intervention the placebo effect lasts a few hours an bond yields explode higher. The  house of cards of debt is the root of the problem and only tackling it would be the beginning of the solution

At the close of this article, there is speculation again with the possibility of a massive shot of liquidity (LTRO) from the European Central Bank, but this has a considerable risk. Banks use most of that liquidity to buy sovereign debt, creating a vicious circle. On the one hand, liquidity does not reach the real economy, lending to households and businesses continues to fall, and on the other hand, it doubles the risk. The bank balance sheet risk and the public debt risk together. This is because banks have ​​it more difficult to attract funding as their sovereign bond portfolio gets larger and riskier, impairing financial entities’ balance sheets.

The stubbornness of the European Union to solve a debt problem with more debt only increases the fragility of this house of cards. Fortunately, now there is no turning back because the creditworthiness and the credibility damage is already done. Now, the entire European Union must address the shortcomings of its foundation and find a real fiscal union and implement credible fiscal prudence. Only then, and not before, will Europe see international capital returning and see sustainable economic growth.

You can watch my interview in Al Jazeera on the Spanish crisis here
http://www.aljazeera.com/programmes/insidestory/2012/06/20126126534386935.html