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Why Would Anyone Buy a Spanish Bond? Part 2

by John Rubino on May 20, 2011 · 15 comments

Spain has so far managed to avoid being sucked into the Eurozone periphery financial abyss. But that might be about to change. This week protesters rallied against the relatively modest cuts in government spending implemented so far. And upcoming elections are a nearly-certain source of more instability:

Spain Vote Threatens to Uncover Debt

As Socialists Risk Losing Key Areas, Economists Fear ‘Hidden’ Bills

MADRID—Weekend elections that threaten to drive Spain’s ruling Socialist party from power in several regions and cities also promise a potentially nasty surprise: the revelation of piles of undisclosed debt in local governments that could undercut the country’s drive to avoid an international bailout.

Five months ago, a government change in Spain’s Catalonia region revealed a budget deficit more than twice as big as previously reported. Now, a growing chorus of economists, local politicians and business leaders say that new governments are likely to discover, as Catalonia did, piles of “hidden debt” owed to health clinics and other suppliers.

Economists, analysts and anecdotal reports from companies that supply local governments suggest there is widespread, unrecorded debt among once-free-spending local governments. Some companies are complaining that fiscally frail administrations are pressuring them to do business off the books and not immediately bill for goods and services, said Fernando Eguidazu, vice president of the Circulo de Empresarios business lobby group in Madrid.

Such bills could add tens of billions of euros to the official debt figures reported by local and regional governments. If such skeletons come out of the closet in coming weeks, Spain’s cost of funding could continue to rise—throwing the country back into the limelight after it has struggled to demonstrate it doesn’t need to be bailed out like Greece, Ireland and Portugal.

“Investors are worried about the regions, given that there has been a precedent in Spain and other countries of debt not being recorded properly,” said Luigi Speranza, a BNP Paribas economist.

Sunday’s elections, which will be held in 13 of the country’s 17 regions and its more than 8,000 municipalities, threaten to be hard on Prime Minister José Luis Rodriguez Zapatero’s Socialists. Polls show Socialist-led governments could be unseated in Castilla-La Mancha, the Balearic Islands, Asturias and Extremadura regions. Undermined by a 21% unemployment rate and a perceived slowness in reacting to the country’s economic crisis, the Socialists could also lose control of the municipal governments of Barcelona and Seville, the country’s second- and third-largest cities.

The social fallout from the poor economic conditions is evident in Spain this week as waves of protests swept the country. Young people took to main squares in Madrid, Barcelona and Valencia on Thursday to protest unemployment among those in their 20s and 30s, which has reached 50% in some areas, and the government’s austerity program. Demonstrators are hoping their ranks will swell over the weekend as people head to the polls.

Nearly a year ahead of March 2012 Spanish national elections, a poll last month by the state-owned Center of Sociological Investigations, or CIS, forecast the opposition Popular Party could capture 43.8% of the vote, while the Socialists could get 33.4%.In the 2008 elections, the Socialists won 43.6% of the vote, compared with 40.1% for the conservative PP.

Some thoughts:

Spain has three problems, each of which is manageable in isolation. But they’re all coming to a head at the same time and threatening to combine into something serious. They are:

  • The next-domino syndrome. Greece is clearly going to default in the not too distant future, which will cause 1) the other bailed-out Eurozone countries to demand better terms for their own debt repayment, and 2) analysts and money managers to speculate even more intensely about who is next. Spain is an obvious candidate.
  • The fear that this weekend’s elections will uncover a bunch of off-balance sheet debt is well-founded. Many US states and cities are hiding their true pension obligations, so it should come as no surprise that their Spanish counterparts are running similar scams. The incentive to spend on constituents and use accounting tricks to hide the resulting debt has apparently become overwhelming, so we should expect to find lots of skeleton-filled closets in coming years.
  • Spain’s voters are already rebelling against the current austerity program — which sliced a measly two percent of GDP from public spending. With another six percentage points to go just to reach the Eurozone’s mandated deficit threshold, the next round of cuts might turn unrest into regime change.

Meanwhile, Spain’s credit rating is Aa2 (Moody’s third-highest) and its 10-year bonds yield 5.2%. Which takes us back to the question that has been nagging euro-skeptics for over a year: Why would anyone buy a Spanish bond? Is it reasonable to lend money for ten years at such a low rate to a country facing this much uncertainty — in a currency bloc that’s under this much stress?

Think it through: If the stronger economies bail out the weaker ones on terms that allow the weaker governments to remain in place, then the balance sheets of the stronger countries become so junk-laden that they’re no longer AAA credits. But if the Eurozone insists on austerity to bring peripheral countries back into fiscal balance, voters will simply say no, resulting in Greek-style crises being repeated four or five more times. Either way, the euro is tarnished by instability, and investors who lock themselves into a ten-year euro income stream will be sweating for a long, long time.

Two final notes:

  • First, why pick on Spain when so many European countries have budget issues? Because Spain is the firewall. The Eurozone could bail out Greece and Portugal without missing a beat, but Spain is too big to fail. Either it gets its financial house in order very soon, or the Eurozone’s problems grow by an order of magnitude.
  • Second, a very reasonable complaint about US-based criticism of the Eurozone is that it’s motivated by a desire for the euro to fail and the dollar or pound to succeed by default. So let’s address that here: The dollar and pound are in worse shape than the euro because the Fed and Bank of England are blatantly, systematically destroying their currencies in order to prop up a banking system/welfare state/military industrial complex that could never survive in a sound money environment, while the European Central Bank is at least trying to maintain the euro’s value. As a result, long term US Treasury bonds are horrendous investments — probably worse than the average euro-denominated sovereign bond.
    But in the search for the catalyst that finally pushes the dollar over the edge, Europe’s problems are interesting. The final stage of a currency collapse is more about confidence than supply and demand. When a society loses faith in its currency, it abandons it. Prices in that currency soar and savings evaporate. So as we inflate away the dollar, the key question is: what brings us to this tipping point? It might be the US just finally spinning out of control, or it might be an event in Japan, Europe, or the Middle East that calls the whole concept of fiat currency into question. Whatever it is, it’s coming. For better or worse, we live in an interconnected world.


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  • Agent P

    John –

    Any idea of how the combined GDP’s of Ireland, Portugal, Greece, Spain and Italy stack up against the combined GDP from the rest of the Euro-bloc countries? Axel Merck was commenting the other day on FSN that they comprised something like 5%. Is that true?

    The other Euro-bloc countries might not mind sticking together, sans the aforementioned lesser output ones. If the Euro really starts to tank, removing a necrotizing limb/s might be the prescription of necessity for the Euro.

    • paper is poverty

      Based on Wiki data for the EU ( http://bit.ly/67Y51T ) Italy contributes more like 13% of EU GDP and Spain about 9%. Much more than Greece, Ireland, and Portugal, all at 2% or less.

      I’ve been surprised that not many people are talking about Italy’s dependence on Libyan oil. They used to get over 20% of their imported oil from Libya (376,000 bpd) and some part of that is now offline. They can get it from elsewhere, but if some of their refineries were built for Libyan crude (supposedly some of the sweetest / lightest), can they refine heavier crude? Even if they can, it’s got to be more expensive to get crude from elsewhere. So what are the economic effects? I can’t tell if they’re minor or just not on people’s radar. But if Italy starts to falter it’s even worse news– its economy is over 3/4 the size of France’s. Still, it’s a dark horse, well behind Spain in the race to disaster.

  • DW

    agent P – I am convinced that this is what germany’s long term aim is. if you can actually call it an aim. in the wider context of government germany “gets it” more than others, due to their experiences of hyper inflation within living memory, and are relatively smart (hence why they still have a technology driven manufacturing base, and stomached decreasing wages for the sake of productivity). they surely must know that the PIGS wont be able to stomach the necessary austerity for long

    however they might be being too ambitous in this regard. a realignment of the eurozone will be far from orderly…

  • sly1

    Sovereign Debt Terrorism Strikes Back… Bonds cause more destruction than 1000 pound Daisy Cutters! Welcome to the Financial Terrordome!

  • Frank

    Germany and the Scandinavian countries (and Scotland) are in secret talks to form a “Northern Euro.”
    Poor England! They won’t have Scotland’s oil profits to seize, anymore. ‘Course, we may see a Battle of Bannockburn II. Scots will win that one.

    • Are Riksaasen

      If “Scandinavian Countries” would be Norway, Sweden and Denmark, as the common perception is, none of them ever joined the Euro. They each still has their own sovereign currencies. They had a monetary union of sorts from 1875 until 1914. I very much doubt this rumor.

  • Kees Bruin

    Compliments from a Dutch reader. You’re spot on as regards the essential problem of the Euro, which was clear from the start of the common currency, namely that the whole “one size fits all” principle does not work.
    And now the northern countries are bailing out the southern ones, which – of course – can only go on for so long. The people in the southern countries are protesting against the austerity measures forced upon them, and the people in the northern countries are increasingly getting fed up with having to pay for the problems of the southern countries. And all of that for the benefit of the Euro and the banks. No wonder that anti-Euro sentiment is gathering steam. People are waking up to the fact that the EU-project is a very bad idea.
    I wonder how this all will end, but it can’t be a happy ending.

    Kees Bruin
    The Netherlands

  • Bruce C.

    Why would anyone buy a Spanish bond? For the same reason(s) that one would buy a US Treasury bond. A faith that the status quo will be maintained, that Spain (like the US) is “too big to fail” and will be propped up by every means possible. There is also a lot of money that has to go somewhere, and which may be mandated in some way due to outdated rules (think pensions, mutual funds, etc.), not to mention the huge foreign exchange reserves that are trying to diversify out of the dollar. Cynical traders might hope to gain on rallies as yet another false positive is engineered, and shorted when rates fall. (There’s plenty of room for that game since 5.2% is barely the historical average for US Treasuries.) Moving down the crazy list a few more spots, one could just decide to embrace insanity and invest completely opposite to one’s best analysis, understanding, and intuition. Those are the best reasons that I can come up with but I still wouldn’t do it, and for moral reasons as much as financial ones.

    And I hope to God that we aren’t talking about finding “skeleton-filled closets” in a few years. If so just shoot me now. This Eurozone breakdown circus is absolutely brutal. It’s like watching a re-run of an unending soap opera.

    In the meantime, however, the dollar and Treasuries may become even more popular as European-style denial and evasion gives way to glimpses of reality, and that could lend political support for continued deficit spending in the US. Thus most countries are still willing to buy Treasuries because they think they’re the safest option, ironically. And the trouble for “visionaries” like China is that if they sell their Treasuries they end up with more dollars. Ay-ya-ya!

  • hollow man

    Why would anyone buy a US investment of any type from the goverment. A president and congress who are to busy caring about their own pocketes to care about their own children much less the rest of the world. A moral hazard has been perpatrated upon the world. The US has been the designer of its own demise.

  • Bruce C.

    Come to think of it, I read an article a few days ago in which some converted analyst confessed to having been wrong about the effectiveness of the TARP bailouts. She cited things like once Congress was faced with a “real crisis” (i.e., the stock market falling drastically within a few days) that they managed to put politics aside and actually did something that worked. She said that Europe could learn a thing or two about how that situation was handled. Although she implied something else, it occurred to me that one thing the US did was to hide the immediate consequences from the citizenry. Europe, by contrast, is insisting upon immediate austerity in return for bailout loans, which even the most disengaged can associate. Maybe the US methodology is the better plan initially, but it also indicates what is coming down the pike for US citizens. The “genius” of the Obama administration has been to enact legislation that won’t go into effect until 2014 or so, when it will be impossible to reverse and the dire effects much easier to blame on other things.

  • Jason Emery

    I believe China started buying Spanish Bonds. If they are using a portion of their huge stash of US Treasury bonds for the purchase funds, they are basically getting the Spanish Bonds for free.

    Surely the Chinese know that their US Treasury bonds are basically worthless. Any attempt by them to sell a sizeable portion of them would tank the treasury market and push the price against themselves.

    The status quo is working in China’s favor, for now. They have grown their economy to the world’s 2nd largest, and are now a global power. I believe they are accumulating a lot of gold and silver for future reference, as well.

  • Brad Thrasher

    John Rubino is once again ahead of the curve as European debt worries rattle markets today. Ironically the USD, representing the world’s largest debtor nation, is rising as investors look for a safe haven. Fricken amazing.

  • sly1

    Another reason why you cannot have a “one size fits all currency” for europe. All economies are local, bad news for the EURO!

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