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The Unrescued


The Unrescued

Over the weekend, EU Finance Ministers agreed to extend up to 100 billion euros ($125 billion) in support of the crumbling Spanish banks. Spanish President Mariano Rajoy crowed that his government had obtained everything they had asked for without any concessions on the part of Spain – in other words, Spain remained “unrescued”. This was just prior to his flying to Poland for a football match.


/ˈrɛskyu/  [res-kyoo] verb, res·cued, res·cu·ing, noun verb (used with object)

1. To free or deliver from confinement, violence, danger, or evil.


There is no doubt that, stricto sensu, Spain was rescued. This measure proved necessary for a number of reasons:

  • A still unknown number of Spanish banks require large injections of equity to meet capital requirements in the face of large and increasing exposure to non-performing real estate assets[1];
  • Raising fresh equity on the IBEX stock exchange was out of the question[2];
  • Spanish banks are essentially locked out of wholesale debt markets, making new debt issues unlikely unless they come from the ECB;
  • The Spanish sovereign is also up against the wall – with bond prices climbing to historic and unsustainable level, the government lacked the ability to issue the additional 10% of GDP in new debt equivalent to 100 billion euros;
  • And the ECB has shown a remarkable lack of interest in purchasing more Spanish debt. Perhaps Mr. Draghi has simply run out of patience;
  • With Greeks returning to the polls next weekend, Brussels feared massive contagion in the event of a Syriza victory and decided to act preventatively;

Mr. Rajoy’s claim of “no rescue for Spain” refers to the fact that there were no formal strings attached to the bailout package from Brussels. This is strictly true – though Finland continues to push for collateral on their portion of the loan[3] – but surely disingenuous: Brussels (and Berlin) will assuredly have a large say and long look on how the money is spent[4].

Mr. Rajoy also argues that the “credit facility” is for the Spanish financial sector only rather than for the Spanish sovereign. True, but again disingenuous. The Spanish government guarantees Spanish deposits and would be forced to intervene in the event of further insolvency events such as Bankia’s in order to prevent a catastrophic meltdown of the financial sector. Since the government lacks the means to do so without bankrupting itself, the bank bailout is merely a pre-emptive bailout of the sovereign.

Markets see it that way as well. We’ve all seen the cycle of “crisis-> ‘definitive’ solution –> euphoria -> deception” play out over the past two years as Europe has lurched from one cliffhanger to another. Usually, the “euphoria” period lasts at least a couple of weeks (though the cycle has been shortening alarmingly since March). This time, the “euphoria” lasted barely 3 hours, as markets rapidly lost ground on Monday and Spanish bonds continued their inexorable grind towards unsustainability.


That was Tuesday. Today, the 10-year Spanish bond has risen even further to 6.75. Credit default swaps on 5-year Spanish bonds briefly rose above 600 bps for the first time[5] – it was at 500 bps two months ago[6]. Investors fear a self-fulfilling prophecy, and rightly so. This dynamic was repeated in Greece and Portugal, there is no reason to think Spain will be different. Europe has thrown Spain a lifejacket made of lead.

This reflects a number of factors:

  • The bailout money may not be enough. No one will really know for sure until the independent auditors finish their work. It is not certain how the 100 billion euro figure was arrived at – other than that it is a nice round number – but it probably doesn’t take into account the further fall in housing prices as well as the increase in non-performing loans across the financial products due to the ongoing deep recession. Investors are right to worry that this looks scarily reminiscent of the stuttering approach applied to Greece, and that it represents “Spanish Bail-out: Tranche 1”;
  • The bailout money subordinates private bondholders. As in the case of the Greek “haircut” the ECB and EFSF loans were treated differently and more favorably than PSI’s[7]. Thus, the risk of every investor in Spanish bonds in the event of a credit event has now significantly increased – Europe will claw back the loan before any private investors see a cent;
  • The bailout significantly increases the risk of a Spanish sovereign rescue. Precisely because private investors will view their Spanish bond invests as subordinated, they will either demand substantially increased returns or else shun the bonds entirely. This was the beginning of the death spiral for Greece and Portugal. With the Spanish government unable to fund itself, or only at exorbitant rates, it will be forced to seek a true rescue package. JP Morgan estimates this to run to 350 billion euros[8].

In a further response to the bailout, Moody’s downgraded Spanish debt three notches to Baa3 – one notch above junk status[9] – with a negative outlook over the next three months. This move was justified by the argument that the bailout  pushed Spain’s public debt above 90% and this “official” figure does not include government’s contingent liabilities or regional debt. Spanish and European officials will no doubt excoriate Moody’s decision and reflect yet again on the Anglo-Saxon plot angle: but the ratings agency is merely reflecting a reality that markets and investors have already recognized by fleeing the Iberian nation’s debt.

There is also a fundamental doubt and mistrust of the capacity of the Spanish government to respond adequately. This is something that both the Partido Popular and the Partido Socialista, and the Spanish public at large, utterly fail to realize or comprehend. They are continually shocked that Spain could be unfavorably compared to less developed nations – Chile, for example. When Mariano Rajoy texted Luis de Guindos during the bailout negotiations saying, “Hold out for more. We are not Uganda,”[10] he was not only stating an obvious fact and making a clear threat to his European partners, he was expressing an underlying Spanish assumption of superiority to what he obviously considered a “banana republic”. When Santiago Jiménez, a Spanish representative of the Ugandan Embassy in Paris retorted, “We have not required a rescue, nor asked for IMF aid,” he was more accurately reflecting investor sentiment.[11]

Perhaps Mr. Rajoy should have reflected on Albert Camus before making his unfortunate and ill-received remark. “L’Afrique commence aux Pyrénées.”[12]

The knee-jerk mendacity of both the Zapatero and Rajoy governments has done incalculable damage to Spain’s international reputation. Both administrations have lied so often and so routinely on the country’s situation that one is forced to conclude that they must really believe what they are saying. What do outsiders see when they look at Spain?

  • The Zapatero government must have known that the Bankia books were being cooked while that entity was being constituted from the various sickly savings banks. It was easier to turn a blind eye however and “hope for the best” in order to avoid the very bailout that has now been forced on Rajoy;
  • The Zapatero government also knew that rampant regional spending would make it impossible to achieve the 2011 deficit target, yet they issued no warning and made no publically visible effort to rein in the regions until springing the surprise on Europe and the world that the Spanish deficit would be 8% of GDP rather than 6%;
  • The Rajoy government then made no effort to negotiate with European partners on a new, achievable deficit target for 2012, but rather unilaterally decreed that it would be revised upwards to 5.8%. This untimely display of sovereignty and individualism did not sit well with Brussels or with investors;
  • The “independent” governor of the Bank of Spain resigned one month before the end of his term and in the middle of the Bankia scandal while the regulatory failures of his institution were being openly decried. In any serious country, the governor would have been hauled before an investigative committee in the legislature and put under the harrow – but Miguel Ángel Fernandez Ordoñez departed quietly without public declarations or legislative explanations[13];
  • The Rajoy government continued the Zapatero policy of claiming that the financial sector was perfectly solvent right up until the day that Bankia cried uncle and asked for €4 billion in public assistance. Even more unbelievably, the administration went on to declare that no further public money would be given to the banks, just prior to pledging an additional €19 billion in aid, then did it again just prior to asking Europe for €100 billion. Is it any wonder that Mr. Rajoy’s government is viewed as, at best, out of touch with reality or grossly incompetent[14], as is far more likely?
  • The day the rescue package is announced, Mr. Rajoy made only a brief public statement, in his haste to arrive in Poland in time for the Euro 2012 match between Spain and Italy;
  • Meanwhile, the head of the Supreme Tribunal is being investigated on corruption charges (misuse of public funds) and strikes in the mining region of Asturias have turned into violent clashes with the police. The country looks to be falling apart at the seams.


Even the Spanish electorate is slowly coming to understand this perception. What the implications are for Mr. Rajoy’s government are not yet clear: with a majority in Parliament and a long term yet to run, he is clearly hoping to weather the storm short-term and counts on short memories in four years’ time. On the other hand, should he prove increasingly to be the problem and not the solution, Europe may be tempted to “pull a Berlusconi” on Mr. Rajoy and insist on a technocratic government as a condition for the coming bailout of the sovereign. This would lead to an extremely ugly showdown.

Yet Germany may no longer care. An article in Spiegel Online[15] fulminated against French, Spanish and Greek “blackmail”, excoriating the cynical politics of “supposed friends” in Paris, Madrid and Athens who talk of Europe only when they need to tap German finances. The author, Mr. Fleischhauer, decries Eurobonds as another thinly veiled attempt to tap the savings of hard-working Germans so that French socialists can retire at 60. He then labels as “political simpletons” those who hold out a romantic hope that national interests will fade into the background of a united Europe. If Mr. Fleischhauer represents more than a minority view in Germany, then the end is near.

The Pernicious Dynamic

The “pre-emptive” Spanish bailout, far from containing contagion risks, seems to have poured gasoline over the fire. The Italian Treasury auctioned notes on Tuesday. Rome was forced to pay 3.972% for the one year issues, an increase of 70% from the 2.34% paid just one month ago.[16]

Europe’s financial and sovereign crises have merged. Underlying it all, the pernicious dynamic of goods and capital flows remains unaddressed by any but a few economists, who might as well be crying in the wilderness. The original intent of the founders of the European Union and of the single currency was a zone for free flows of capital, goods and labor – as in the United States – which would create “convergence” of the national economies: they would become much more alike in their fiscal and social policies.

What has become evident in the crisis is the existence of two, non-convergent areas within Europe. “Core Europe” includes the goods and capital export nations like hypercompetitive Germany, the Netherlands, Austria, France, Belgium, Finland and (outside the euro) Sweden. Increasingly, “Core Europe” is just Germany. Then there is “Peripheral Europe”: those nations that import goods and capital and export services – mainly tourism. Guess who they are.


The size of the arrows is not accidental. The “Periphery” goods and services consumed by “Core Europeans” do not offset the imports of industrial goods, leaving the “Periphery” with a perpetual trade deficit and current account imbalance. The repatriation of profits and repayment of loans do not offset the continued borrowing from the “Core” to finance consumption and balance the current account, leading to escalating public and private indebtedness, as well as increasing financial exposure of the “Core” banks to “Peripheral” default risk. I have deliberately left out a third dynamic with “Emerging” Europe in the former Warsaw Pact nations, which is different and not entirely related.

This dynamic exists in every currency union. It exists in the United States. It exists in the United Kingdom. Usually, it balances out through massive transfer payments to and from a central government authority; or else by sustained migration of labor from uncompetitive to competitive areas. Both are in operation in the European Union. Transfer payments through agricultural subsidies and infrastructure development funds are not large enough, however, to balance the account. Labor migration exists, but cultural and linguistic barriers mean that the impact is less than that of more homogenous nation-states like the US.

The German answer to this quandary is to promote increased competitiveness from the “Periphery”. Traditionally, this has been done through periodic currency devaluations. In the single currency union, it can only be achieved through wage devaluations and long-term productivity enhancing investments in education, retraining, R&D, etc… Beyond the obvious difficulty of increasing funding for education and R&D when budgets are being slashed to the bone, the more fundamental problem is that “Core Europe” is engaged in precisely the same exercise:


Italy and Spain, whose unit labor costs had increased rapidly during the “good years”, have been attempting to readjust to increase competitiveness since 2009 (both by -4.6% from 2009 to 2010). But costs in France, Germany and the Netherlands have fallen by just as much or more (-5.4%, -8.1% and -7.7% respectively). [17]

What this graphic shows is that “Periphery Europe” will never become competitive against “Core Europe”. It is a great illusion, a pipe dream sold to “Periphery” citizens to justify the massive pain being inflicted on them. Germans are not going to radically change their national economic model by engaging in wage inflation having spent the better part of two decades perfecting it. Markets understand this, which is why temporary solutions and patches that don’t address the dynamic are being more heavily penalized.

There are only two possible ways to break the “Pernicious Dynamic”: full federal union through a constitutional convention and progressive transfer of sovereignty, or an “amicable” break-up of the currency union along the fault lines. The latter option would still require a loss of sovereignty among the remaining euro nations, in order to protect what remains of the currency union, but Germany is more likely to agree to such a step with “responsible” governments like the Netherlands, Austria and Finland.

The “option” of doing nothing and muddling along will only increase costs and losses to all parties and eventually default into a euro break-up. A messy break-up, however, would almost certainly preclude the possibility of saving even a “Core Euro” from destruction.

Whichever road is taken, Europeans – or should I say Germans, French, Italians, Spaniards, etc…? – are rapidly running out of time, money and options.

Sources and Notes:

[1] The first set of reports on the Spanish financial sector by independent auditors Roland Berger and Oliver Wyman are not due to be completed until around 21 June;
[2] The IBEX 35, the key Spanish stock market index, has lost more than 60% of its peak value since 2008, making fresh equity issues of doubtful viability.
[3] Vita, Kaspar, “Finland Wants Collateral For Spanish Bank Aid From EFSF,” Bloomberg, 09 June 2012
[4] L.A./EFE, “Merkel asegura que el rescate a los bancos españoles ‘por supuesto’ que conlleva ‘condicionalidad’,” El Plural, 12 June 2012 (Spanish only)
[5] Levine, Deborah, “Spanish bond yields, insurance hit records,” MarketWatch, 12 June 2012
[6] Bloomberg
[7] Private Sector Investors. Technically, the EFSF does not automatically benefit from seniority, unlike IMF or ECB funds; however, this consideration was ignored in the Greek case. Furthermore, the EFSF will be rolled into the permanent European Stability Mechanism (ESM) in July, whose loans will be given senior treatment.
[8] Foxman, Simone, “JP Morgan: A Spanish Bailout Would Cost €350 Billion,” Business Insider, 30 May 2012. JP Morgan arrives at this estimate by calculating €75 billion for the recapitalization of Spanish banks and the remainder to fund the Spanish sovereign through 2014. I am left to wonder if this includes the cost of funding Spain’s regions and public corporations as well.
[9] Lopez, Luciana and Bases, Daniel, “Moody’s slashes Spain debt ratings three notches,” Reuters, 13 June 2012.  The negative outlook is a clear warning that junk status is almost inevitable. S&P has Spanish bonds at BBB plus, which is three notches above junk; while Fitch’s has the sovereign at BBB, two notches above junk status.
[10] García-Abadillo, Casimiro, “El SMS de Rajoy a Guindos Qué Marcó La Cita Clave Para La Economía Española,” El Mundo, 11 June 2012 (Spanish only)
[11] “Uganda responde: “A nosotros no nos han tenido que rescatar ni hemos pedido un préstamos de 100.000 millones,” Qué.es, 11 June 2012
[12] Albert Camus, December 1959
[13] Comfort, Nicholas and Weisbach, Annette, “European Bank Shares Drop as Spanish Lender Concern Deepens,” Bloomberg, 30 May 2012
[14] Mario Draghi, head of the ECB, certainly implies this when he stated that the Bankia bailout was handled in the worst possible way.
[15] Fleischhauer, Jan, “Playing Until the Germans Lose Their Nerve,” Spiegel Online, 8 June 2012
[16] On 11 May 2012. “Spanish, Italian yields spike,” MarketWatch, 12 June 2012
[17] Unit Labor Costs in Local Currency, International Comparisons, Federal Reserve Bank of St. Louis (FRED)

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