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Testing market patience

Spain has become the major concern for investors over recent weeks. Attention is particularly focused on whether – or more realistically when – Spanish Prime Minister Mariano Rajoy will make an official request for a bailout plan. With the country crippled by a deep recession and a large deficit, in addition to political turmoil and social discontent, Spain is likely to have to seek rescue aid imminently.

There are now signs that investors are becoming anxious with Spain’s procrastination
- Karl Falzon

At the time of writing, an economic update had just been released. Gross Domestic Pro-duct decreased by 0.3 per cent during the third quarter of 2012. The deficit for this year is likely to miss the 6.3 per cent target. Unemployment is at 25 per cent, the highest ever for post-Franco Spain. Meanwhile inflation is rising, up 3.5 per cent from a year ago, driven by value-added tax increases that are part of the austerity programme. The state may need to compensate pensioners for the higher inflation, which, in turn, will adversely impact the budget deficit.

Given the dire situation, expectations were for Spain to trigger a bailout some weeks ago. Instead, the country hesitated while benefiting from the improved investor sentiment that lowered its borrowing costs. Since the end of July, when Mario Draghi began providing an insight into the ECB’s efforts to deal with the debt crisis, the yield on 10-year Spanish sovereign bonds has dropped by more than two per cent from a peak of 7.75 per cent. The CDS of Spain, which provides an indicative measure of credit risk perception towards the country, has decreased by more than 300bps.

However, since the borrowing costs of Spanish debt have decreased because of expect-ations that Spain will be bailed out, there are now signs that investors are becoming anxious with the country’s procrastin-ation. Rajoy reiterated this week that he will ask for aid when he thinks “it is good for the general interest of Spain to ask for it”.

Recent discussions between Spain and the EU have centred on likely demands by inter-national lenders as part of a potential aid programme. The idea was to put these in place before an official request for aid is made. Rajoy is trying to have a number of measures approved before engaging in a programme and thus risking facing EU demands for even tougher policies. This is understood within the context of how the European Stability Mechanism and the Outright Monetary Transactions programmes will work.

The ECB’s bond-buying programme will be available only if the recipient country adheres to the conditionality imposed on it. Also, some analysts note that there could be a strategic ration-ale in this delay (from Rajoy’s perspective). Requesting aid later and when deeper in crisis has in some previous cases resulted in softer conditions – particularly when contagion was an issue.

Progress in the restructuring of the Spanish banks is seen as a fundamental pillar of any resolution to Spain’s problems. A condition of the €100 billion bail-out of Spanish banks agreed to in early summer was the creation of a special institution to absorb the weakest assets of the industry. The objective is to clean up bank balance sheets and to help banks start lending again.

An asset management agency, Sociedad de Gestión de Activos Procedentes de la Reestructuración Bancaria, is now being set up to act as this ‘bad bank’. According to Spanish officials, up to €60 billion of severely distressed real-estate assets will be placed into this facility by the nation’s lenders. There are indic-ations that the average discount at which assets will be acquired by SAREB will be about 63 per cent.

Ideally, transfer prices will be low enough to eventually attract private investors, but not so low as to amplify bank losses. In fact, according to Bloomberg, the state would like to keep its stake in SAREB to below 50 per cent to avoid including it in national accounts. More generally, there is also some lack of clarity on how this agreed bank bailout will relate to the overall rescue programme tied to the ESM. For example, at some point Spanish officials showed interest in using part of the cash from the bank bailout to buy sovereign debt. As expected, this was faced by German concern.

On a positive note, there was an encouraging reaction for Spain’s longer-term proposed reforms. S&P noted that the recently-passed National Reform Programme will ultimately improve economic fundament-als. But the current overriding risk is that hesitation to access an official aid programme will lead to further deterioration in economic and financial fundamentals.

Curmi & Partners Ltd are members of the Malta Stock Exchange and licensed by the MFSA to conduct investment services business. This article is the author’s objective and independ-ent opinion. It is based on public information and should not be viewed as investment advice in any manner. The value of investments may fall as well as rise and past performance is no guarantee of future performance.

Mr Falzon is a credit analyst at Curmi and Partners Ltd.

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