Spain’s Woes Continue – FSG Analyst Insights

Interview with Matt Lasov, Head of EMEA Research for Frontier Strategy Group

Politically, there is zero will to allow Spain to default but markets have moved faster than politicians every step of the way. It’s very difficult to view European politicians as credible at this point, the markets certainly do not. Remember, default is always a political decision (or in this case indecision). There are policy tools available to fix this crisis, debt monetization for example. The challenge is in getting 17 eurozone governments to agree when they are beholden to domestic voters, though they share a supranational currency. As of now there is no path to solve this fundamental challenge in a timely manner.

Here’s what we know about Spain – and why we think risks are very high:

The story for Spain is bust banks and a dose of social unrest

CDS spreads show 40% chance of default, up from 30%

Youth unemployment at 50% with zero public benefits (there is no available cash for extended unemployment etc…) is a recipe for disaster

12-month yields at 5% and 10-yr at 7% is not sustainable from a funding point of view – borrowing at these rates only compounds the debt crisis.

With high borrowing costs and the 100bn euro loan, Spain’s government debt to GDP jumped to 90%, it was at 60% last year. The credit crisis was effectively transferred from Spain’s banks to its government – a government that lacks cash and the typical policy toolkit – ie printing money, devaluation.

Spain’s bond purchases are fully subscribed but there is zero foreign participation which will be necessary to bring in rates. The only buyers are Spain’s bust banks which are now reliant on government funding. This is a less-than-virtuous circle that cannot last.

Various eurozone bailout funds have the cash to string Greece along, but not Spain/Italy. A true bank recapitalization would overwhelm the size of current facilities.

Timing:

We’ll know more about the willingness of policy makers to credibly solve the problem by June 30th. At that point the European summit will have ended, the G-20 will be over, and Greece will hopefully have been extended. The pendulum will have hopefully swung from harsh austerity to the balanced deleveraging approach.

If things have not made progress by June 30th, we will need to talk about broader eurozone contingency planning. Policy makers are running out of chances and markets don’t give mulligans.

Meanwhile in Greece:

Looks like a weak coalition of pro-Europe parties will govern Greece.

Greek parties have told the Greek people that they will modify bailout terms but simultaneously told European leaders they would not ask for this.

Driven by the cycle of austerity, social pressures in Greece are too high to bear and coalition parties realize they will need to soften austerity if they are to stay in power for any period of time.

This coalition will not be long lasting. Aside from historic domestic political competition between the parties, the coalition’s legitimacy now depends completely on Europe’s willingness to modify loans. Germany has not indicated it is willing to do this in a meaningful way.

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