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Spain's Dangerous Waiting Game

Spain's Dangerous Waiting Game Morningstar

The Spanish government (with an assist from the rest of Europe) has spent the last few weeks denying it is on the verge of asking for a bailout or even that the country needs a bailout at all. Given the underlying problems in the Spanish economy, the only way this could be at all credible is if the continent were on the verge of a surge of economic growth.

As the International Monetary Fund pointed out this past week in its updated economic outlook, that is extraordinary unlikely. In fact, the IMF now sees an "alarmingly high" risk of a global slowdown in 2013. By holding out on accepting the help of the European Union, and by extension the European Central Bank (ECB), Spain is playing with fire and hoping the market's patience doesn't run out. It likely isn't a risk worth taking.

Spain's Tribulations


Spain's economy is in real trouble. The IMF expects gross domestic product to contract by 1.5% and 1.3% in 2012 and 2013, respectively, assuming everything goes to plan and there are no external shocks. Growth could be much worse. Unemployment looks set to remain stratospheric at more than 25%. The country is trying to bring budget deficits under control, but it keeps missing targets as revenue falls short of expectations and cuts are harder to execute than expected. The housing market remains deeply troubled. Banks are going to need a huge amount of capital to stay afloat. Political protests and talk of regional secession are becoming the norm rather than the exception. The only plausible way out of this mess is going to be through a lifeline from the rest of Europe.

This is not to say that Spain is a lost cause. The country's debt/GDP ratio remains under 100% (though that number will likely rise quickly if bank bailouts are placed on the Spanish sovereign balance sheets). Plus, the adjustments the country needs to make are much less severe than, say, those that Greece has to undertake.

But Spain is not out of the woods yet, either. Given the issues facing the country, Spain is not going to have a primary budget surplus anytime soon, even in the rosiest projections. That means the country will need access to the bond market to both refinance existing debt and to finance new spending. If yields on Spanish debt are elevated, then debt service becomes very expensive and makes the fiscal problem even worse. This can quickly create a vicious cycle, sending rates even higher and making it that much more challenging for the country to refinance its debt load.

The bond market is only going to be open if investors feel like there is a credible plan to fix the economy and that there is going to be a long-term political will to implement that plan. It is going to be near impossible to make that commitment credible without the explicit backing of the rest of the European community, particularly Germany. There are just too many chances for things to go wrong, too much uncertainty surrounding how the bank recapitalization are going to work, and too much that could potentially go wrong elsewhere in Europe.

Confidence Needed


Despite the seeming necessity of the aid, the Spanish government has been extremely hesitant to formally ask for help, and the rest of Europe seems content to let the Spanish leaders wait. The reasons are likely more political than economic. The money will almost certainly come with strings attached, which is never going to be popular to the Spanish electorate. And on the creditor side, the German people aren't exactly chomping at the bit to help rescue yet another nation. By holding out, political leaders are betting that they can kick this can well in to 2013 and delay the political pain. This strategy carries tremendous risks.

The only reason they are able to wait is because yields on Spanish debt have come off their crisis highs to elevated, but somewhat manageable, levels. The 10-year Spanish yield is sitting around 5.6% at the moment, below the 6.0% level that is generally considered unsustainable. But this yield is not lower because investors have had a sudden burst of confidence about Spain; it is lower because of the European Central Bank. In September the ECB rolled out a programme that would allow for the unlimited buying of sovereign debt (known as Outright Monetary Transactions, or OMT) in order to keep borrowing costs low. The catch was that OMT would only be used for countries that have accepted a bailout.

Because Spain hasn't asked for the money yet, let alone received it, the programme hasn't spent a single euro. The bond yields have declined in anticipation of the programme coming into force because very few investors want to bet against Spanish bonds knowing that at some point the central bank is going to come in and pump an unlimited amount of money into the market regardless of fundamentals. Spain and the rest of Europe's ability to keep putting off the bailout is predicated on the fact that the bond market believes a bailout is coming eventually.

Is the Wait Worth the Risk?


The question is, what happens if the rescue suddenly seems in jeopardy? Applying for the bailout is not as easy as picking up the phone. The rest of the eurozone has to approve it, a process that could take some time and is fraught with potential political land mines. It's not hard to envision a scenario where, due to the upcoming German elections or domestic Spanish problems, suddenly Spain's request looks shaky. This could quickly send borrowing costs through the roof and reignite worries about the soundness of the euro. As we've seen before, that worry could then spread to other indebted nations such as Italy.

It's not clear whether the current bailout mechanism will act quickly enough to stop the bleeding should an event like that occur. Europe could lose the hard-fought gains it has made in convincing investors that it is serious about tackling its sovereign debt issues.

Leaving this tail risk out there is a dangerous gamble. The bailouts aren't likely to get more popular as the months go on. There doesn't seem to be a huge upside to waiting, and the downside appears to be much greater. Spain is going to need the cash, so ripping off the Band-Aid now before there is a crisis seems like the prudent way to go. Trying to get it done when the sky is falling is not going to inspire confidence.

Waiting may very well turn out to be fine. But given how many things have gone wrong during the course of the European debt crisis, it seems like a much better choice to be safe rather than sorry.

This article was originally published on Morningstar under the title: Spain's Dangerous Waiting Game

Tags: central banks , ECB , European Central Bank , European Monetary Union , eurozone , financial crisis , sovereign debt , Spain
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