Tuesday, September 18, 2012

Spain Remains A Basket Case

Aside from the Greek circus, Spain is now the cockpit of the eurozone government debt crisis. How does Spain look as she confronts the need for a big bailout?

For the sake of this discussion, let’s agree that the ratio of government debt to GDP is a good measure of sovereign risk. Both government debt and GDP are nominal figures; no complicated constant dollar calculations are required. Government debt grows at the rate of beginning period debt plus the current year’s fiscal deficit in current dollars. For the D/GDP ratio to stabilize, nominal GDP must grow at the same rate as the deficit as a percent of GDP. Not rocket science.

Let’s take a look at Spain’s numbers.

Spain’s nominal GDP (EUR B), as calculated by the OECD, has been pretty flat:
2006: 986
2007: 1,053  (+7%)
2008: 1,088  (+3%)
2009: 1,048  (-4%)
2010: 1,048  (+0%)
2011: 1,063   (+1%)

Spain’s general government fiscal deficit as a % of GDP as calculated by Moody’s has been high:
2007 (+1.9%)
2008 (-4.5%)
2009 (-11.2%)
2010 (-9.3%)
2011 (-8.9%)
2012 (-6.6%) est.

Spain’s central government debt (EUR B), as reported by the Tesoro Publico, has grown rapidly:
2007 307B
2008 358 (+17%)
2009 475 (+33%)
2010 540 (+14%)
2011 592 (+10%)
2012 605 (July) (+2%)

Spain’s general government debt to GDP ratio (%) as calculated by the Fed has risen by 250%:
2007 36%
2008 40% (+4%)
2009 54% (+14%)
2010 61%  (+7%)
2011 69%  (+8%)
2012 91% (proj.) (+22%)

That is what the ECB is facing, as it seeks to facilitate Spain’s effort to become a creditworthy sovereign issuer. Spain’s numbers are all going in the wrong direction. The ECB can help to refinance Spain’s maturing debt at affordable rates (if it tries hard enough). But it can do nothing about Spain’s large fiscal deficit, which only the government (with the Troika’s help) can fix. And the ECB has announced no plans to raise the eurozone’s rate of inflation or the rate of nominal GDP growth. The outlook is grim.

Looking forward, Spain’s nominal GDP growth outlook is at best modest (zero?), while its fiscal deficit is unlikely to get much below 5-6% of GDP, despite whatever cuts Spain eventually agrees to. Thus, the medium-term outlook for Spain’s debt ratio is a steady annual increase, in the direction of higher credit risk, lower credit ratings, and higher bond spreads. Spain will remain a deteriorating credit until its budget comes into a sustainable balance and its GDP starts to grow in a sustainable way. Neither are likely without much higher inflation in the eurozone (which had been experiencing deflation until recently).

Moody’s currently rates Spain at the bottom of investment grade (Baa3), with the rating under review for possible further downgrade (to junk). In a recent comment on the continuing review for downgrade (expected to end soon), Moody’s sounded pessimistic in observing that:
“official support beyond banking recapitalisation but short of a full package may also pressure the rating below investment-grade if (1) the combined measures were unlikely to succeed in maintaining ample market access; or (2) if these measures were effectively providing the bulk of the Spanish government's funding needs through crisis-management tools such as the European Financial Stability Facility and ESM, and European Central Bank actions that provide liquidity to government debt markets. Short of the accompanying fiscal and structural reforms being successful, full return to market access at the end of these initiatives may prove very difficult, raising the risk of private sector participation in a debt relief effort before more official support is provided.”

That sounds to me that Moody’s will either downgrade Spain or extend further its review (begun three months ago). Most likely they will take the rating to Ba2/negative outlook (which won't lower bond yields).

My overall conclusion is that while the OMT can help to overcome the market’s reluctance to buy Spanish debt, it can’t fix Spain debt trajectory. That can only be done by politically unpalatable austerity combined with massive unsterilized QE by the ECB. By sterilizing the OMT program, the ECB has condemned Spain to a future of zero growth, weak government revenue, and rising debt ratios. Let us hope that Bernanke’s QE3+ will succeed, and provide a model for the ECB before it is too late.

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