Moody's Keeps Spain At Investment Grade

Two weeks ago I commented on Moody’s rating on Spain, which was on review for downgrade:
“My guess is that the rating will go to Ba2 with a negative outlook. In my opinion, while Spain will be helped in the short-term by the eurozone’s “crisis-management framework”, it is doomed in the end to default and redenomination, as long as the ECB sticks to its price-stability suicide pact.”
(Spain On The Brink Of A Downgrade To Junk, Oct. 2nd, 2012)

My prediction was incorrect. Yesterday Moody’s confirmed Spain’s rating of  Baa3 in advance of Spain’s planned EUR 4.5B bond sale on Thursday. The rationale for the rating confirmation can be capsulized as follows:
“Moody's believes that the combination of euro area and ECB support and the Spanish government's own efforts should allow the government to maintain capital market access at reasonable rates, providing it with the time it needs to stabilise public debt over the next few years. Ultimately, the Spanish government's ability to refinance maturing debt will depend on the credibility of its efforts to reduce its large fiscal deficit and reverse the rising public debt trajectory.”

The core element of Moody’s decision is that the ECB’s bond-buying program will enable Spain to maintain access to the private debt market as it slowly gets its fiscal house in order. Over time, Moody’s expects Spain to stabilize its debt trajectory and thus make it once again a creditworthy borrower on its own. Moody’s also believes that the ongoing bank recapitalization program will restore confidence in the banking system, presumably curbing deposit outflow. The risks cited by Moody’s are a lower growth outlook, a Greek exit, and insufficient ECB bond purchases to bring down yields.

As I indicated above, I take a more negative view than does Moody’s. This is because I see no hope for a stabilization of Spain’s debt trajectory as long as there is no nominal economic growth in Spain and the eurozone. It is very hard to grow government revenue in a zero nominal growth environment. In the recessionary world in which Spain lives, it is painful to raise government revenue while cutting social spending.

Moody’s is certainly right to say that the preservation of Spain’s market access “will depend on the credibility of its efforts to reduce its large fiscal deficit”. I am in no position to judge the resolve of the Rajoy regime in implementing austerity. Presumably they will have no choice, given the conditionality of the aid program. But I can say that imposing austerity on Spain in the midst of a recession will be deeply unpopular and not without controversy. Spain is not Finland.

What to expect going forward? Spain will next have to apply for aid from the Eurogroup and agree the terms. Then, the parliaments of Spain, Germany and Finland must approve the deal. (Yes, Finland too.) That needs to happen over the next month or so. If the bailout deal goes through, then the onus will be on Mr. Draghi to do “whatever it takes” to bring down Spanish yields. Rajoy has asked for a ceiling of a 2% spread over Bunds, versus the current 4%. That seems like a reasonable request to me. There is nothing to prevent the ECB from making it happen.