Thursday 31 May 2012 8:12 pm

Spain can’t save all of its banks without sinking

ANYONE struggling to understand what former Spanish Prime Minister Felipe Gonzalez meant when he said his country was facing “total emergency” should take a drive through the suburbs of any medium-sized Spanish town. Lines of empty and half-built houses show exactly why the country’s banks are on their knees and why, sooner or later, Madrid will have to go cap-in-hand to Brussels. Bankia, Spain’s number three lender, has admitted it will need €23.5bn (£18.8bn) to recapitalise, and the sector’s shortfall will probably be well over €100bn over the next three years. After the European Central Bank’s (ECB) refusal to refinance Bankia, Madrid’s time is running short. The country’s finances are falling into a vortex of slumping tax returns and spiralling debt service costs – up 32 per cent in the year to date – and it is effectively frozen out of debt markets, with 10-year bond yields approaching 7 per cent. The rising debt burden on Spain’s shrinking economic base is creating a feedback loop that, once trapped within, can be almost impossible to escape. Savers are getting nervous, withdrawing €31.5bn from Spanish bank accounts in April. Given the growing risks to financial stability, Spain may hold out hope of the ECB blinking first and riding to Spain’s, and the banks’, rescue. That is unlikely. The central bank is already uncomfortable with buying more sovereign debt and effectively providing fiscal aid through the back door. Frankfurt may conclude that, if it sits on the sidelines and refuses to buy Spanish bonds in any great quantity, it can force Spain into asking for a bailout from European peers and the International Monetary Fund. The European Stability Mechanism (ESM) would probably need to dish out around €350bn over the next two years for Spain to recapitalise its banks and roll over debt obligations. For now, Spain is likely to baulk at such a loss of sovereignty, even if the pill is sugared with a softer line from Brussels on economic reform. The European Commission lent a hand yesterday, giving Spain an extra year to slash its deficit. That is unlikely to suffice, given such intense pressure from markets, and Madrid is still likely to have to go to the ESM within weeks of the bailout fund coming on stream in July. At this point, having recognised its perilous plight, Spain may then see the folly in trying to support all its banks. As Ireland showed, it could lead to a massive over-extension of Spain’s finances and plunge it into a vicious cycle of austerity. That would further ramp up Spain’s horrific levels of unemployment, increase insolvency and hit the banks with more bad loans. At that point we’d not only have to worry about €184bn of problematic loans to Spain’s builders, but the country’s entire €1.7 trillion domestic loan book. Madrid should allow for an orderly unwinding of its weakest banks and leave bondholders to assume losses and focus its efforts instead on recapitalising its strongest banks. If it ducks them, the pain of austerity will have been for very little gain. Harvinder Sian is co-head of research at RBS.

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