Spain: The government is claiming none of its auctions will fail after it signs a Troika MoU

The latest information out of Europe comes via the Financial Times where Miles Johnson writes that the Spanish are geared up to sign a Memorandum of Understanding with the Troika. Other countries are holding things up, according to this story. And when those issues sort themselves out, the MoU is a go. But no bailout will be needed, because Spain believes just signing the MoU will be enough to cause markets to lower Spain’s rates, the story says. I don’t find this entirely credible.

The logic behind the Spanish government’s view is this:

• We are ready to go now as soon as other issues in other countries are worked through
• When we do this ‘bailout’, it won’t really be a problem because we will just sign a Memorandum of Understanding, having already done the heavy lifting as to conditions that such an MoU would impose
• Moreover it won’t even be a bailout because the mere act of Spain’s signing up for the program will make rates come in and stay there. It will be like an “atomic bomb”

I get the logic but I think the claims are dubious.

As I have outlined it, the OMT program is supposed to see the sovereigns acting in a normal fashion on the funding front. The bailout only kicks in when the European Stability Mechanism is forced to buy bonds at a failed auction, where demand does not meet supply. And the ECB is supposed to buy bonds in the secondary market to both lower the price of bonds and to re-assure market participants that they ‘will be made whole’ so to speak.

What the Spanish government are now saying is that none of its auctions will fail, meaning it will not have to draw on the ESM “credit line”. They believe the threat that the ECB would do so and an MoU in place would be sufficient to keep bond yields low. The Spaniards point to the effect merely announcing the OMT has had on bond yields as testament to how effective signing an Mou would be. Right now, the government is no hurry to sign a Troika deal because the OMT announcement has given them time. They are going to wait and see how this plays out before they go further.

My view is that the Spanish government have three problems that will cause yields to spike and force the ECB’s hand. First, the Spaniards’ austerity plans will cause them to miss their deficit targets as austerity will lower domestic demand and tax receipts. We have seen this effect in 2012 where the Spanish government wildly overestimated its ability to cut the deficit. Second, the government is still on the hook for local government bailouts. The local governments are shut out of bond markets and this is likely to remain so for some time. Now the Spanish central government is bailing them out. They will have to continue doing so to avoid a regional government default. And that adds to the sovereign’s debt burdens. Third, the banks will need a lot more capital. The Oliver Wyman report was not credible and is just a started for the amount of capital that Spanish banks will need in order to repair their balance sheets

All of this says to me that markets will want and need reassurance that the ECB stands at the ready. I believe that yields will rise as the Spanish economy continues to remain soft and as the contingent liabilities crystallize. Nevertheless, the logic the Spaniards are using makes sense. And it shows how powerful a weapon unlimited central bank liquidity is.