Spain non-bank bailout: when, how and why


Euromoney Skew, Sid Verma
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Rather than Spain requesting a full troika bailout markets reckon Spain will tap the enhanced conditions credit line (ECCL), which would unlock European Central Bank (ECB) sovereign-debt financing and offers fewer conditions.

Rumours are swirling over that vexing issue for the eurozone: when Spain will request a bailout – for non-bank financing – and the likely mechanism.

On late Monday, wire reports suggested Spain would request a bailout by the end of the week, while other reports indicate German chancellor Angela Merkel is pushing back amid bailout fatigue, since the German parliament is required to rubber-stamp each request. Nevertheless, Mariano Rajoy, Spain’s prime minister, has denied that the government will seek a bailout by the weekend.

No matter. Markets reckon a bailout is a done deal. There has been a sharp steepening in the Spanish credit curve, according to Markit, with the two-year CDS now trading at around 140 basis points tighter than the five-year. In August, the differential stood at around 70bp. Similarly, Spanish corporate CDS curves have steepened in sympathy with the sovereign. As of Tuesday's close:

Rather than Spain requesting a full troika bailout – along with the strong conditions and the political stigma that accompanies such a request – markets reckon Spain will tap what is known as the enhanced conditions credit line (ECCL), which would unlock European Central Bank (ECB) sovereign-debt financing and offers fewer conditions.
However, scant details are in the public domain about how, in practice, the ECCL operates. Here are some details:

1. The ECCL has been ostensibly modelled on the IMF’s precautionary credit line, which has since been renamed the precautionary credit and liquidity line. However, the ECCL is based on ex-ante conditionality and while the IMF’s credit line is for liquidity assistance and balance-of-payments financing, the ECCL is ostensibly more flexible. "In theory, Spain could use this credit line  to pay public sector workers or to buy 10-year bonds – there is no real sense a borrower is constrained in theory but creditors have a monitoring process in place," says Malcolm Barr, economist at JPMorgan.
(On a side note, any shift in the IMF’s role from a member of the troika to a monitoring arm ex-Africa for official sector investors and markets pushes the Fund into an unprecedented position. It would also challenge its reputation for independence at a time when emerging market economies argue Europe remains over-represented at the IMF board.)

2. If Spain tapped the ECCL at say 6.5% of GDP – versus the maximum 10% ceiling – it would amount to €70 billion, compared with its up to €100 billion facility for banking support. The duration of the credit line is one year in the first instance, renewable for six months twice.

3. The process for application, follows via JPMorgan:

"The applying member state makes a formal request for a credit line to the Eurogroup. The Commission, in liaison with the ECB, then provides an analysis to the Eurogroup. The Eurogroup then decides, on the basis of unanimity, the form, amount, duration and conditionality associated with granting that request. These are then reflected in a MoU [memorandum of understanding] and Financial Assistance Facility Agreement signed by all parties. While the IMF is not cited as a having a formal role in the process, its involvement will be “actively sought” in both the design and implementation phases of the programme (the ECB has reminded us of that in the design of the OMT [outright monetary transactions]). But it is not clear what that seeking of IMF involvement will mean in practice."

4. There are two stumbling blocks in moving the initial application to a MoU: establishing the conditionality and need for parliamentary approval, notably from German lawmakers. However, the former is unlikely to present a real obstacle, says Barr at JPMorgan. "Spain has internalized what the European Commission has told them; the conditionality centres on the implementation of the budget plan," though issues remain over regional spending as well as labour and pension reforms.

5. If Spain asks for support via the ECCL, market consensus decrees that policymakers have no real choice but to grant the request, which would unlock ECB financing. According to JPMorgan:

"The ECB has stated that having an ECCL in place is a necessary condition for it to buy bonds under OMT, but that it will retain its own judgement on the appropriateness of such interventions. We have previously speculated that the ECB would want to hold sub-three-year yields below a threshold in the 3%-3.5% range. If Spanish yields were trading below that level, it is very possible that we would not see ECB intervention in the immediate aftermath of the signing of an MoU.

Remember that the ECB have only said they will purchase paper with residual maturity of up to three years. What happens if the Spanish authorities want to see intervention in the secondary bond market, buying bonds at longer maturities? It would appear there are two means to achieve that. The first would be for Spain to draw funds under the ECCL, and then use them to purchase their own debt. The second would be to make a separate application for a programme of secondary market purchases by the EFSF, where intervention amounts and tactics are set by the Eurogroup in liaison with the ECB, rather than by the Spanish sovereign. It is not impossible that the latter could be combined with the initial request for an ECCL by Spain, giving the programme more flexibility at the outset."

Bets on when Spain requests an ECCL vary from next week to end-October or November, after elections. Still, this line will only prove a cyclical tool in an attempt to solve a structural problem. The real rate of Spanish interest payments continues its leap above the real rate of growth of the economy, which is not expected to expand until 2014, on the more-benign projections.

Against this backdrop, the government will be forced to cut spending to achieve an offsetting primary budget surplus for years, which would dampen growth further and risk a self-fulfilling debt crisis with Spain’s debt-to-GDP ratio rising from 80% to possibly 100% by 2014. Although Spain's yield curve has historically endured more pain and its debt stock is lower than Italy, the only way out of the crisis is internal devaluation – with inflation in core Europe a seemingly distant prospect. Here is a reminder why a coercive debt restructuring in Spain just won’t wash thanks to the maths via JPMorgan again:

"When the Greek PSI took place, the debt of Greece was around €350 billion,  €259 billion of which in bonds. Of these bonds, around €52 billion was held by the  ECB/Eurosystem. Of the €207 billion in private hands, around €130 billion was held by non-domestic investors. The rest was mostly held by domestic banks and state pension funds which had to be recapitalized following the PSI. Around €5 billion of bonds held by private non-domestic investors escaped PSI as they were  foreign law bonds. Therefore, the Greek PSI provided a net debt relief to Greece of around 53.5% x €125 billion = €67 billion, or 33% of GDP.

Applying the same haircut and assumptions (ie only general government bonds are subjected to haircuts), the net debt relief to Spain from haircuts on non-domestic holders would be only €66 billion or 6% of GDP and for Italy €265 billion or 17% of GDP. In other words, this cost/benefit analysis suggests that a Greek-style PSI would be rather unattractive for Italy and worthless for Spain. Of course, one could imagine a wider restructuring than the Greek PSI, eg by including loans and regional or local government debt, but surely such an option would be more difficult to negotiate or keep voluntary and would present greater legal challenges.."