All Hail Mario Draghi: The Spanish Bank Run is Over for Now

The Spanish bank run caused by redenomination risk is over. And Spanish bond yields are now back to around the 5% level today. Apparently, the ECB’s monetisation scheme has worked – and without Spain’s having entered a Troika program yet too. That tells you how important currency sovereignty is. Let me spell out what’s happening here and why with a few thoughts on how things will proceed going forward.

First, on the bank run front, Spain’s central bank, the Bank of Spain, reported today that deposits from families and businesses in Spanish banks increased by 16 billion euros in November 2012 (link in Spanish). This was the largest increase in Spanish deposits in two years. So this is a very big deal. If you recall, just this August, Sober Look was highlighting for us that Spanish banks were completely funded via the ECB as deposits were leaving in droves. I called this a bank run, one due entirely to so-called redenomination risk i.e. the potential that Spain could have to exit the euro zone. I predicted monetisation – as I had done in my 2012 beginning of year post:

“My view is that Spain is in a death spiral and it is dragging Italy in tow. What happens now in Spain will also happen in Italy. It would be foolhardy to try and ring fence Spain without addressing the problems in Italy, a much bigger economy. I have been saying for some time that there is no escape from a sovereign bailout for Spain and the follow on monetisation or default. The question is how. What exactly will be the mechanism to effect a Spanish sovereign bailout? Spain is too big for a normal bailout as is Italy.

“And so we are likely seeing the end of European bailouts and the beginning of monetisation.”

And that’s what we got with the OMT. The question then was and still is what would happen next. My view is that Spain is still in trouble.

This crisis is driven by the need of politicians in core euro zone countries to demonstrate that there will be strings attached to any bailout funds used for the periphery. In Germany in particular, the middle class has had a difficult decade with stagnant pay and cuts to the social safety net ostensibly to boost Germany’s external competitiveness. This has worked in giving Germany a hand up in export markets but it has caused the economy to be excessively dependent on export demand as internal demand has stagnated along with wages.  Any economist would tell you that the benefit of trade is the lower cost imports and the cost is the foregone consumption of domestically-produced goods.  The Germans are therefore locked into an industrial policy geared toward maximising the costs of free trade and minimising the benefits.

This dynamic is driving German domestic politics so that ordinary Germans want to see the same sacrifices made in Spain, Greece, Italy and Portugal that the Germans themselves have already made. Clearly, however, this would suppress demand in those countries in the same way demand has been suppressed in Germany by this mercantilist turn, ricocheting back onto the Germans as exports to the euro zone stall. In a nutshell, the Europeans are committed to a deflationary economic policy path for political reasons as much as anything else. And this policy path will continue for some time to come.

At the beginning of December, Spanish Prime Minister Mariano Rajoy said point blank that it would be hard for Spain to meet its deficit target as we knew it would be from the start. Austerity is deflationary and that reduces economic output growth, decreasing tax revenue. Why then should we believe the Spanish could meet the 2013 deficit target? At this juncture, we should not. And so I believe Spain, with its huge commitments to its banks and its regional governments will be forced into a program. In my view, the OMT’s success will eventually have to be met by actual monetisation rather than just the threat of such.

This is not a certainty by any means. The fact that Spain’s yields are so low tells you that the OMT has been a success so far, especially given the fact that Spain has adamantly resisted a national government bailout program. Spain has two potential paths it could go. It could either sink into a debt deflationary spiral and become the next Greece. Or Spain could wade trough crushing austerity and improve enough to become the next Ireland. While neither scenario is exactly palatable, the Irish do have the potential to start issuing bonds to public markets and exiting the Troika program, aided by minimal assistance from an OMT-style program if necessary. Spain has cut its deficit somewhat. It has turned a current account deficit into a surplus. Bank deposits are flowing back in. Bad debts are being pushed off bank books. And bond yields are declining. Going forward, the real problems will be the continued decline of house prices and their impact on the banks and as a consequence on the Spanish government in their need to provide the banks with capital. This scenario means recession and will therefore mean large deficits and increased public debt. How long Spain ‘can get away with it’ is anyone’s guess.

For now, things have stabilised. But I expect the situation to get worse again. And the trigger the next time may be the regions as opposed to the banks because the regional governments are still locked out of the debt markets and beholden to the national government for funding. They have been pushing the national government to formally apply for an OMT-style bailout. This year, the funding needs for the banks and the regions will continue to be met by the central government. At some point, however, the Spanish government will be unable to fund both itself and the regions and the banks and that is when it will make a request to the Troika for a bailout. I expect it to happen sometime this year.