Wednesday, October 10, 2012

S&P Takes Spain To The Brink Of Junk

S&P downgraded Spain today from BBB+ to BBB-, joining Moody’s at the bottom of investment grade, along with a negative outlook (obligatory these days).

Their summary rationale for the downgrade is as follows:

“(1) The deepening economic recession is limiting the Spanish government's
policy options. (2) Rising unemployment and spending constraints are likely to intensify social discontent and contribute to friction between Spain's central and regional governments. (3) Doubts over some eurozone governments' commitment to mutualizing the costs of Spain's bank recapitalization are, in our view, a destabilizing factor for the country's credit outlook.”

S&P is arguing that GDP will continue to decline; that the country’s governability is becoming ever more difficult; and that there is no assurance that the Eurogroup has the willingness or the ability to restore market confidence in the creditworthiness of the Kingdom or its banks.
S&P is particularly peeved that Europe reneged on its promise to provide ESM money to recapitalize Spanish banks. S&P must now add the cost of the bailout to Spain’s debt ratios.

S&P’s overall view is consistent with Moody’s and with my own, except that I am much more pessimistic. I do not view Spanish government bonds as an  investment suitable for widows and orphans, due to its many speculative elements. Spain belongs squarely in the Ba/BB category, because no matter what happens next, it won’t  transform Spain into a stable, investment-grade credit. And Spain will go to junk over the next month or two, you can count on it.

What is of interest in S&P’s extended rationale is the emphasis it places on governability, which is certainly warranted. As in both Greece and Italy, the government does not command the parliament, and cannot simply push through its agenda. The Rajoy government appears to be weak, and to be playing to the gallery rather than dealing with a national crisis. One can see Rajoy as being canny in refusing a bailout until it meets all of his (reasonable) demands, but that doesn’t make him a powerful leader in Spain. Time will tell on that score.

With regard to the inopportune resurgence of aspirations for regional independence, here’s what S&P has to say:
“With local elections approaching and many regional governments facing
significant financial difficulties, tensions between the central and regional
governments are rising, leading to substantially diluted policy outcomes.
These rising domestic constraints are, in our view, likely to limit the
central government's policy options.”

It is ironic that the regions are simultaneously demanding bailouts and independence, which takes the hispanic equivalent of chutzpah. This, as S&P observes, complicates the political challenge of uniting the nation behind an austerity program acceptable to the IMF.

S&P also expresses concern about the breakdown of the credit process in Spain due to bank deleveraging, with the price of credit for corporates becoming prohibitive, and the availability of credit for SMEs disappearing. As we know, when credit flows remain blocked, the heart stops beating.

S&P gives Rajoy no credit for his policy of refusing to apply to the Eurogroup until he knows what he’s going to get and what he has to do to get it. They say:
“We view the Spanish government's hesitation to agree to a formal assistance program that would likely significantly lower the sovereign's commercial financing costs via purchases by the ESME and ECB as potentially raising the downside risks to Spain's rating.”

I don’t agree with that sentiment. In my view, Rajoy is smart not to make Ireland’s mistake by agreeing to drink poison in exchange for life-support. He needs a free bailout of his banks, an ECB deposit guarantee, unlimited ECB purchases of  government bonds, and reflation. If all he is offered is pocket change, he should hold out until he gets what he needs, and I applaud that. That is the only way for Spain to avoid eventual default.

There is no evidence in S&P’s commentary or Moody’s that they fully understand the hopelessness of the PIIGS’s outlook as long as price stability remains ECB policy. No amount of austerity and bailouts can restore economic growth. As long as the denominator in D/GDP is declining, the only way to stabilize the ratio is to impose losses on bondholders. That is much more costly than 5% inflation.

S&P and Moody’s are correct in observing that Spain’s credit is deteriorating. What they don’t grasp is that, under present circumstances, there is no way to avoid creditor losses. It’s already happened in Greece which was, of course, “unthinkable” until it happened.

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