UPDATE (13/04/2012): While the overall tone of this post holds, in the view of its author, there are some errors that were identified an addressed in a followup post. You are highly recommended to read these. The relevant sections are highlighted and linked to that correction. Thank you very much and sorry for your trouble.
Unfortunately, I have been very silent over the last two weeks. While this seemed reasonable given the temporary end to the Greek sovereign debt Odyssey, one unintended consequence was that I missed the markets’ shift in speculative attention towards Spain. In the lines below I go through what happened and why it did.
What has happened? – Failed auctions since March 20, 2012
While Spanish yields are below their 5 year peak, they have nonetheless risen in the last week. Despite the fact that the rise is not very large, its persistence has proven difficult to cope with.
The cause of this rise in Spanish bond yields after a considerably consistent fall since the end of 2011, can be found in two failed sovereign bill auctions conducted on Wednesday March 20. On that day, Spain was faced with the embarrassing situation of not being able to raise as much money in 12 month and 18 month bills (€ 3,547.70 Mn and € 1,410.50 Mn “adjudicated”, respectively) as it demanded ( € 7,575.08 Mn and € 4,123.08 Mn “solicited”, respectively).
This remains a problem, as the latest bill auction, which took place on March 27, 2012 resulted in yet more financing difficulties.
Finally, the 28% increasing in funding costs faced by Spain in today’s (April 4, 2012) bond auction continues to frighten analysts. Of course the identification of the direct causation brings about the need to explain its own direct causes, i.e.: the deeper, root, causes of the problem.
Root Causes of the Spanish Problem
When sovereigns engage in debt auctions they enter the liquidity market, where they demand cash in exchange for a debt contract. The supply is provided by banks and other financial institutions. As the figure below shows, there are three possible explanation for the problem that Spain is suffering: (A) and increase in the governments demand for cash, caused by an increase in deficits; (B) a contraction in the supply of cash, caused by a fall liquidity shock to the banking sector and or (C) a desiquilibrium in the liquidity market because the price is set below the market clearing level. (Note that here supply is provided by the banks, not the central bank and as such is not vertical).
Liquidity Supply Shock – In the following lines I consider two different measures of liquidity in the Spanish financial sector: interbanking rates, the size of the aggregate financial balance sheet, the use of marginal lending and deposit facilities by Spanish banks, and the share of the LTRO allocated to Spain. Clearly, all are imperfect and incomplete measures of liquidity, but they do provide some very interesting insights.
- Interbanking rates (kindly distributed by the EBF), be them EUREPO or EURIBOR, all point to a differentiated situation, with the infamous Cajas (“CECA”) experiencing higher rates. Overall, however, the rates are relatively low, in comparison to where they have been historically. As such, while there is a lot of talk of the risk of Spanish banks, this is not priced at incredibly high levels.
- The balance sheet of Spanish financial institutions, as provided by the Bank of Spain, seems to have stagnated since 2011Q3. This would imply a more limited scope for leveraging which can limit the scale of liquidity growth in the economy.
- A quick look at the recourse to the
Marginal lending and to the Deposit facilitiesthrough the Bank of Spain shows that there is still a substantial addiction to the safety provided by monetary authorities, which is likely to be artificially pushing the previously mentioned interbanking rates down. Although this might have severe implications for the long term stability of the Spanish financial sector, as a policy tool it is completely adequate in the adjustment that takes place after a shock. More importantly, it is not too bad when compared with the overall use of the same tools for the EMU as a whole.
- Finally, FT Alphaville reports that after Italy, Spain was the largest receiver of the 3 year LTROs conducted by the ECB
In conclusion to the supply side analysis, there is some evidence of a slow down in the potential for leverage growth. However, the relatively moderate interbanking rates, the relatively low level of deposits with the BoS, seem to point to a less problematic context. However, it is likely that the funding gap was (at least partially) filled by the LTROs. To that effect, it is likely to have (at least temporarily) dealt with some of the liquidity shortfall in Spain. Clearly Spanish banks are not very healthy, but whether at this precise moment they are much more strapped for cash than their European neighbours is not at all certain. Moreover, it also seems to not be going through its most difficult period in financing. Therefore, I am not convinced that the present troubles of Spain have a “supply of liquidity” origin.
Liquidity Demand Shock – I believe it is much more likely that the recent announcements of increased Spanish deficit targets, from 4.4 % GDP to a 5.8% of GDP, are the true cause behind the problem financing problems of the sovereign. Clearly, either of the targets seems unrealistic in light of the forecasts available, but the unilateralism of Rajoy’s government signals an unproductive uncooperative attitude that leaves room for a lot of politically driven turbulence. As banks anticipate an increase in the demand for liquidity, and with the government fixing the price, supply cannot meet demand resulting in the under-supply of liquidity.
Is it worth all the noise?
At 4.319% the coupon on Spanish 10 year debt is still cheaper than its Italian homonym, which everyone is praising. The same insight can be extended to yields. While the media and officials are in a frenzy about Spain, no one has noticed that most Italian yields are higher than their Spanish equivalents. The figure below provides a comparison of Spanish and Italian sovereign bond yields by maturity as of 09:08 on Monday, April 2.
Surely, if this level of yields is “dangerous” for Spain it is similarly “dangerous” for Italy. Of course neither the yields nor the coupons are actually close to the dangerous level of 7%.
In the preceding lines I have argued that the liquidity problem facing Spain seems to be mostly driven by recent shocks in liquidity demand rather than to the supply. More importantly, I argued that Spain is not in a particularly bad position, particularly compared to Italy. I conclude, below, by arguing that in the end it doesn’t matter. While countries might be under the illusion that they can pursue unilateral policies, the absence of an independent national central bank exposes them to the demands of the ECB, who will always win the ensuing games of chicken. In sum, there’s no need to worry because after some struggle the ECB will always come to the rescue.
Mr Rajoy ,as a true newly elected official, has begun his term on the wrong foot, by “unilaterally” changing the targets for the Spanish deficit, thus drawing “unfortunate attention to a fundamental weakness in the EU’s new rules to reinforce fiscal discipline: their pettiness”. Clearly, Spanish banks are not in good shape. But this is not new. Spanish banks have been in bad shape for at least 3 or 4 years. So may be it’s time to calm down and stop exaggerating the market’s reaction to Spain.
This is particularly important because both Spain and Italy are too big to fail. The ECB has treated them in a very different way than the other peripheral (small) countries. If Mr Rajoy continues to pursue this PR line, turbulence is likely to rear its head, and again we’ll have ourselves a little Game of Chicken between the ECB and a/the member state/s. This we know always ends in favour of the desired goals of the ECB rather than the member state, because a single country cannot credibly threaten the ECB.