We are now in another existential crisis for the euro zone with yields on sovereign debt from Spain and Italy spiking well over 6%. We have been here before, most recently in November. Then, it was Italy in Spain’s position as the lead problem. Now it is Spain’s turn on the hot seat. Yields for ten-year bonds in Spain have spiked to a record 541 basis points over equivalent bonds in Germany. Spanish ten-year debt now yields 6.65% after spiking to 6.703%. We are dangerously close to the 7% mark that has meant the point of no return in Greece, Portugal and Ireland. I expect a policy response from Europe within days now, not weeks or months. The focus on Spain is deceiving. Spain and Italy are now coupled. Any crisis policy move that hits Spain must hit Italy too or we will be back to square one in short order.
The question is what the response will be. Ambrose Evans-Pritchard does a good job of outlining the key policy response possibilities in a recent post at the Telegraph.
- Spanish bank bailout via the EFSF/ESM and IMF facilities that Greece, Portugal and Ireland are using
- EU-wide bank recapitalisation scheme via the same EFSF/ESM facility
- ECB rate cap for Spain and Italy at 300 basis points above Bunds
I have mentioned all of these possibilities in the past. During the Italian crisis I voiced support for a temporary rate ceiling for Italy and Spain as the easiest, longest lasting and least costly policy response because:
the only reason not to buy Italian debt at 2 or 300 basis points over Bunds, or Greek debt at 3 or 400 basis points over Bunds is because those governments are not credibly backstopped by the ECB.
I haven’t heard any discussion of this since that time except via the Ambrose Evans-Pritchard article. What I have heard is a lot of discussion about bank recapitalisation. And the question now is whether the recap is EU-wide or just for Spain. The sticking point is the stigma for Spain and the mutualisation for Germany according to the Telegraph.
The ECB is pushing Spain to accept a loan package from the EU bail-out fund (EFSF), the proper body for fiscal rescues. Mr Rajoy has refused vehemently. Any recourse to the EFSF is viewed with horror in Madrid, entailing an unacceptable loss of sovereignty.
The result is paralysis as both sides refuse to shift ground. Mr Rajoy is clinging to hope that the EU will take care of Spain’s banks through an EMU-wide recapitalization plan. This would avoid stigma and draconian conditions.
Brussels floated the idea on Wednesday for a eurozone “bank union” and use of the European Stability Mechanism — which has not yet been ratified by most states — to rescue banks and sever the dangerous nexus between crippled lenders and crippled states.
The proposals were shot down instantly by Berlin. Such plans amount to debt-mutualization, a form of back-door eurobonds. German opposition is “well known”, said the Kanzleramt.
Sources in Berlin say Germany wants Spain to tap the International Monetary Fund — as well as the EU — to spread the rescue burden to the US, China, Japan, Britain and others.
I don’t see an EU-wide recap as mutualisation whatsoever. But that’s where we are now on what happens next. In all likelihood, we will get a recap, the question is whether it’s for Spain alone or for the EU as a whole. Spanish finance Minister de Guindos is headed to Berlin now to discuss this matter.
As a final point, I should note that the Rajoy government in Spain have cocked this up completely. Two Spanish language articles I read at the weekend pointed to what their approach has been and why the bank nationalisation scheme has been such a failure. First in this article at ABC (El BCE rechaza el plan del Gobierno para sanear Bankia – ABC.es), the Spanish press reported that the ECB has rejected the Bankia rescue plan. Spain wanted to use sovereign collateral that ends up getting pledged to the ECB as a way of recapping the bank through the ECB on the sly. Second, Rebelión en el Banco de España from El Pais demonstrates that the Spanish government is trying to blame the Bank of Spain and the previous socialist government for the Spanish bank problem. Doing this allows them to absolve themselves of blame. But it has fatally undermined confidence in the entire Spanish banking system. Now no one believes the Bank of Spain’s reports about any of these institutions. Spain is well and truly screwed. I didn’t think for a minute Spain could get out of this without some sort of bailout. But the way Rajoy has done this has brought the entire banking system into disrepute and Spain’s goose is now cooked.
As with the Italian crisis, the potential for a policy mistake – in which neither side gives in – is large. What European policy makers fail to understand is that their extend and pretend policies are making each successive wave of this crisis worse. Ever more countries are in bailout mode and more will follow until we get a real solution or a euro breakup.