|
Value has recently returned to Spanish bonds, the result of a disinflation policy which has begun to bear fruit and a European-wide convergence process which is making rapid advances as the all-important date of January 1, 1999 approaches. Spanish yields may fall to as low as 8% to 8.25% at 10 years as a result of this process in 1996, representing a narrowing of the yield spread over Germany towards 200bp this year and 150bp next. What is important is that this conclusion is not dependent on the limiting assumption of Spain joining Emu as early as 1999. EMU in 1999 Looks Ambitious for Spain Spain will most likely be excluded from the first round of Emu. Its public deficit is still some way from the 3% of GDP target and, perhaps more of a problem in Spain’s case, its public debt is not only above 60% of GDP (65.1% currently, see chart 2), but is still rising. Even inflation, at 3.4% vastly improved from the 5.2% registered 12 months ago, nonetheless would still leave Spain outside of Emu on inflation grounds. But in terms of finding value in Spanish fixed-income securities, this is probably of little importance. The forward curves currently price in a convergence process which stops dead in its tracks after 1999. There is no limiting assumption of monetary union underpinning the prices of Spanish assets. Therefore, room for disappointment if Spain does not make it into Emu at the start is limited. And yet Spanish policy and politics remain clearly oriented to the Maastricht goal. This policy priority shows every indication of surviving the passage of power from Felipe Gonzalez’s Socialists to a right-dominated government under the leadership of José María Aznar. The political determination to achieve monetary union, even at the expense of a growth cycle shortened by the necessary fiscal and monetary rigour, means that Spain’s participation in a single currency should be viewed largely as a question of time. A New Look ERM In the meantime, the Spanish convergence programme will be smoothed by the participation of the Spanish peseta in a revamped exchange rate mechanism (ERM) after 1999. Potential participants in the Euro currency consider the avoidance of competitive devaluation by the non-Euro currencies to be a priority in the post-Emu world. One means of discouraging such damaging devaluations would be for Euro members to offer an insurance policy to the high yielders, taking the form of unlimited and guaranteed bilateral currency support, excercisable only in the case of a currency crisis. The premium paid on such an insurance policy by countries such as Spain would be the renouncement of devaluation. The degree of exchange rate cover received would depend on an assessment of the depreciation risk for the Spanish peseta and each of the non-Euro currencies. This would determine the size of the new fixed, but revisable, ERM fluctuation bands. The Spanish peseta has already demonstrated its ability to maintain a tight trading range around Deutschmark within the current ERM framework. In the worst-case scenario, where Spain fails to join Emu in the initial phase, its ERM central rate is unlikely to be very different from its central rate today. Recent pressures on the Peseta/Deutschmark exchange rate have been to the downside not the upside and the peseta remains some 4% undervalued relative to purchasing power parity. There is strong justification for the maximum permissible fluctuation of the peseta to remain 15% from now until Spain is finally ready to join the Euro. Limited currency risk will narrow yield spread to target 150bp If the exchange risk for Deutschmark/Peseta were to be bilaterally guaranteed at a maximum of 15%, fair value Spanish yields at 10 years should be no higher than 150bp above Bunds. This compares with 290bp currently. This conclusion holds true independently of the size of the short-term inflation differential between the two countries, since the impact of higher inflation on currency movements would henceforth be restricted in this system. But the importance of the above conclusion stretches beyond the potential capital gains which would therefore be on offer in long-dated peseta-denominated assets. It would feed back into the whole economic convergence process. Convergence Becomes More Credible By reducing the yield spread of Spain over hard-core Europe, the cost of servicing outstanding Spanish public sector debt would fall significantly. Interest charge cuts of over 0.5% on the totality of Spanish debt, the consequence of a limited Deutschmark/Peseta risk, would immediately reduce Spain’s deficit/GDP ratio by some 0.3%. This would simultaneously give credibility to the eventual attainment of the Maastricht deficit criterion and facilitate the stabilization of debt/GDP. As credibility in the Spanish fiscal convergence programme grew, additional capital flows would then be attracted into peseta assets and a virtuous circle of lower yields, greater economic convergence and therefore greater monetary convergence would be set in motion. Such a virtuous circle could render Spanish participation in Emu a reality after only a short delay. Inflation Oriented Down Underpinning this process of exchange rate stability and fiscal and monetary convergence is an inflation trend which remains oriented downwards. Subdued final demand, and the need to maintain competitiveness in the face of a strong peseta, places a cap on the extent of consumer price increases. Cost pressures are also subsiding, the result of diminishing capacity utilization and important structural adjustments such as the ending of many public service monopolies and widescale privatizations. Labour reforms enacted in 1994 have also enabled unit labour costs to sharply contract, by some 3.5% in real terms over the past two years. With growth now slowing towards 2% in 1996 and spare capacity increasing, the government target of 3.5% inflation through 1996 looks increasingly realistic. This favourable inflation trend should gradually narrow the differential with Germany and the rest of the hard core towards 1.5% by early 1997. Spain would then satisfy not only the exchange rate requirement for participation in the single currency, but also the inflation requirement. The attainment of the Maastricht yield target, average European hard-core yields plus a maximum of 200bp, should then follow naturally. Conclusion Spain’s participation in the single currency can by no means be guaranteed for 1999. The dynamics of its debt and deficits suggest that a little more time may be necessary to fully achieve stabilization of public finances. But with the help of lower yields, as a result of both limited exchange rate risk which is bilaterally guaranteed by the members of the new Euro and a convergent inflation trend, debt stabilization could be achieved with only a short delay after the start of Maastricht phase 3. The convergence of Spanish long-term yields on the European hard-core could be very rapid through this process. We have forecast a 10-year yield spread of 150bp for early 1997. The risk is that this target will be achieved more quickly than even we are forecasting. The European bond specialistsBrussels André Habay 322 505 9284Copenhagen Merete Hyldmar 45 33 77 88 01 Madrid Patrick Daries 341 432 7808 Milan Andrea Cecchini 392 72 303 354 Paris Bertrand Sauzey 331 53 76 50 00 Stockholm Anders Wilson 468 454 5909 |
