Why Spain may be More Worrisome than Italy

At the end of last year, Italian 10-year yields were more than 200 bp on top of Spain. The spread has narrowed in recent days, but is still well beyond the euro era average of about 10 bp and the late 2008 extreme near 65 bp. There is more room for Italy to outperform Spain.

By Marc Chandler

Most market participants are more concerned about Italy’s debt burden than Spain’s. Since July ’11, Italy’s benchmark 10-year yield has risen through Spain’s. In August ’11 the price of Italy’s 5-year CDS surpassed Spain’s. The rating agencies agree and all three of the main agencies give Spain a higher credit rating than Italy.

There there are several reasons why Spain may ultimately be more worrisome than Italy. Spain, unlike Italy, has a housing and real estate bubble. The full magnitude of the cost of this is still unclear. Investors and policy makers have a greater sense of Italy’s financial burdens than Spain’s.

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In the middle of December, for example, the Bank of Spain indicated that bad loans in the Spanish banking system were 7.4% of all loans. This is a 17-year high and is still rising. Property price and house prices do not appear to have bottomed and the deterioration of the economy, which likely contracted in H2 11 and appears poised to contract in the H1 12, warns of the downside risks.

The government fund for bank restructuring (FROB) has already injected 30 bln euros into the banks. The EBA says Spanish banks need to raise another 26 bln in capital in H1 12. Spain’s new Economics Minister has indicated that Spanish banks may put aside another 50 bln euros (~4% of GDP) aside for provisions for bad property loans.

Investors’ focus has been on the challenges that Italy’s largest banks face in raising capital. They have yet to turn the attention to Spanish banks capital needs. In Q4 11, the largest Spanish banks indicated they could meet a could part of the EBA’s identified needs by simply adjusting their risk asset models.

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The linkages between the private sector (banks) and public sector (sovereign) are a subject of great interest, as Ireland’s experience, among others, has shown. At the very end of last year, the new government in Spain revealed that the 2011 budget shortfall would be 8% (and an official suggest maybe even a bit more)of GDP rather than the 6% target of the prior government and the EC forecast of 6.6%. The target for 2012 is 4.4%.

In order to achieve it, PM Rajoy unveiled a 15 bln euro tax and savings plan–roughly 40% tax increase and 60% spending cuts on December 30. Rajoy still will need another 30-40 bln euro in savings to reach the fiscal target assuming the government’s GDP forecasts are not undershot.

Spain’s autonomous regions are a major challenge for the country’s overall deficit and debt levels. In the first three quarters of 2011, the regional debt rose 22% from the year earlier period. This does not include the debt of the municipalities, which estimates put near 3-3.5% of GDP.

The Valencia region was in the news this week as it had delayed 123 mln euro payment to a German bank. The Wall Street Journal reported that the payment was finally made because the central government convinced an unspecified bank to make a bridge loan to the region. In December the region’s debt rating was cut below investment grade by Moody’s following a failed bond auction. This region appear to be to Spain’s housing market bubble what Las Vegas was to the US housing bubble.

Italy also has some municipal government debt issues, but again, without the bubble, they seem to be more of a known quantity.

It is true that Rajoy’s Popular Party dominates a majority of the regions. Some think this may make it easing to rein in the regional spending, but as often is the case, disputes within parties can be more vicious than between parties. The Andalusia region holds an election in March.

The technocratic government in Italy under Monti seems more in a position to implement structural reforms than in Spain. Italy’s capital markets are deeper and there has not been the surge in debt as there has been in Spain. The average maturity of Italy’s debt is around 7 years, which means it can sustain higher yields than other countries, including Spain. In addition, given the linkages between the public and private debt, it is noteworthy that when combined, Italy has among the lowest debt in Europe. Moreover, more of Italy’s debt is owned domestically than Spain’s.

At the end of last year, Italian 10-year yields were more than 200 bp on top of Spain. The spread has narrowed in recent days, but is still well beyond the euro era average of about 10 bp and the late 2008 extreme near 65 bp. There is more room for Italy to outperform Spain.

Lastly, although yesterday’s rumors that Spain was considering asking for international assistance were quickly denied, it seems more conceivable that Spain rather than Italy receives assistance. Spain’s economy is about 70% of the size of Italy’s and its debt (or simply a bank recap scheme) seems more affordable for the IMF/EFSF than securing a multi-year assistance program for Italy.

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7 Comments
  1. Anonymous says

    Spain will be a much bigger problem than Italy. Italy’s debt was predominantly self financed. Unlike Spain it did not have a big property bubble. The Spanish bubble has been deflating for a number of years, even before the crisis. It has a lot further to fall and credit write-downs have been minimal overall. Spain will have another problem to contend with in future. Its big banks will get even bigger as they swallow up the smaller banks that are crushed by losses. This will inevitably mean that Spain could end up with too big to save banks. 

    1. Oz says

      While I agree that Spain is a major problem likely to get worse, I still believe Italy is likely to be a real problem sooner.  Debt is already 120% of GDP.  The official government estimate is that Italy GDP will contract 4% this year. Despite austerity, we can thus expect they will run a budget deficit this year.  Add on top additional borrowing to pay their interest bill on existing debt.  Mathematically, their debt is going to blow up.  Throw on top of that, they may be faced with the need to bail out their banks just like Spain faces. 

      I believe its only a matter of time before the bond market really catches onto this and the lack of any credible facility to bail them out.  What a toxic thing the Euro is – people finally understand how important having your very own currency is…

      1. Anonymous says

        Italy’s banks are probably in a lot better shape than Spain’s. They do not have the property losses of Spain to start with, and they have decent deposits. I will agree that Italy and Spain will both blow up at some point with current policy. Italy might have had a deficit but it was financed by savers. With the new panic created by markets it might become a self fulfilling outcome that Italy fails to refinance its debts because it has scared away its domestic investor. With austerity making things actually worse then a default actually increases in probability. That will destroy Italy’s banks not their bad lending. 

        Spain is the other way around. Its government debts were manageable but the banks were collapsing and ultimately they are trying to avoid taking on the debts of the banks. They are allowing the big banks to swallow up all the small caja’s and that will create systemic problems in future and probably not that far out into the future. 

        Either way I think that the current policy by both Italy and Spain is disastrous. 

        1. Oz says

          Yep – fair points.

          Its a sad state of affairs when we’re debating which large European sovereign nation is likely to blow up first…

          1. Anonymous says

            Yes no disagreement there. 

  2. Aitor Calero García says

    What could be a solution for Spain and/or Italy? A bailout by the ECB? Even though, I know that this is very unlikely

    1. Anonymous says

      It depends how it is done. A straight forward bailout would be a disaster. It would effectively transfer the debts of the private sector on the public balance sheet and effectively destroy the country as a trading partner for decades.

      My solution is to allow the banks to collapse. Block any takeovers of banks as this will just increase systemic risk. As each bank collapses create new banks with to create a new banking system without the liabilities. Each new bank must operate under new rules of fiscal strength to eliminate future problems. That avoids state entrapment and forces counter-parties to take losses. Long term we need to end cross border activities by banks. Without that there would have been no contagion. Iceland had the right idea shame that governments have not realised this yet. 

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