Spanish Bonds – Austerity, Spending, Honesty, and Reality
Austerity will not work. While it is prudent to cut some frivolous programs and will be important to cut future programs that were too generous, there is little that can be cut today that won’t actually hurt the economy and make the situation worse. The big savings are in retirement benefit cuts, but those will take years to impact the annual deficit or to trim the debt burden. There will be some programs that could be cut today that won’t hurt the economy as the spending was largely frivolous or based on favouritism, but that is a small portion of current spending. Too many potential cuts would actually be a drag on the economy and make a bad situation worse.
If austerity doesn’t work, is spending the solution? To be honest, spending is what created the massive debts in the first place. There is little evidence that spending helps a debt problem. The American economy has grown in the past few years, but the debt has ballooned and many question if the increased debt burden was worth the limited growth. It is hard to target growth with spending – if it was easy, we wouldn’t have a global economy in the doldrums. Good targeted spending can help, but it isn’t a longer term solution, especially once a country has already lost the faith of the bond market.
And no matter what the politicians tell you, Spain has lost the faith of the bond market. Of the €100 billion of debt Spain has issued in the past 5 months, 40% of it has been t-bills. These are protected by various treaties and even Greece was able to issue t-bills at less than 5% throughout the entire crisis. The LTRO program has helped bonds with maturities of less than 3 years, trade well, but that is artificial. Looking at longer dated bonds, we are seeing weakness. Away from rumors of the ECB buying Spanish bonds late last week, there has been almost no support. The credit markets are less liquid than people understand and have a tendency of long drawn out periods of modest improvement followed by dramatic and quick sell-offs. I believe the improvement from December is now over, and we are at the cusp of another potential sell-off, and after the experience of Greece, even ECB purchases have limited effect as real bond buyers understand that the ECB is subordinating other holders, and the potential for retroactive rule changes to be invoked that hurt bondholders is another fear that will limit who participates in the market on any weakness.
So what can Spain do? The first step is to do an honest assessment of the real debt burden of Spain. Spain has guaranteed too much debt – for banks and for regions. Spain has committed a lot of money to the ECB and EU. Headline Spanish debt is “only” €711 billion, but some estimates of all the guarantees and commitments that Spain has made, put the potential debt burden as high as €1.7 trillion. Neither is right, but as stress on the system increases, investors will focus on the worst case. Spain needs to come clean on what it has guaranteed. Those entities that don’t really need the guarantee should release the country from it. All the banks that issued bonds with government guarantees so they could get cheap ECB funding are a prime example of guarantees that should be cancelled. Commitments to EFSF which is likely to lose money on many of its loans (recent ones to Greece in particular) are a hidden exposure that should be clarified, or maybe even see Spain “step out”. Why is it risking money that it cannot afford to lose?
Once the actual debt and real obligations of Spain are known, they need to restructure the debt. If austerity doesn’t work, and spending has limited value, debt restructuring is the only way to get the debt under control and allow the policies of spending and austerity to work over time. Let the banks and insurance companies, particularly foreign ones take their losses and shift some of the burden of too much debt to the places that can afford the losses, and off the shoulders of the citizens. Unemployment is too high, and hurting yourself to pay bank creditors is a foolish policy. It may seem bad to default or restructure, but the stigma won’t last (Russia and South Korea are market “darlings” and both returned from defaults and near defaults far faster than people outside of the markets would have ever suspected).
So restructure, get a sustainable debt load, focus spending on growth, and use austerity to ensure the debt problem doesn’t resurface. This is the best way forward for Spain, and the stigma of default (or PSI) will disappear more quickly than anyone will tell you, and Spain can once again have an economy to be proud of.