“We are not on the edge of a precipice”

Thus spoke Mariano Rajoy, the Spanish prime minister, this weekend.  As Wile-e-Coyote often demonstrates, our senses can easily be fooled; once a country enters the danger zone, circumstances can change very rapidly, so rapidly that reasonable plans are rendered obsolete and rational expectations turn to panic.

Unlike the US, Spain avoided the CDO and off-balance sheet madness.  Unlike Greece or Italy, Spain didn’t suffer from excessive sovereign indebtedness.  However, it built a huge real estate bubble financed with bank loans.  When the bubble popped, loans soured and banks became undercapitalized. 

Crucially, Spain let the problem fester for more than two years, failing to merge or close underperforming banks or to force the viable ones to recapitalize.  In that it was not alone in Europe; to this day, the only large bank that has had the courage to go to the markets for a large capital raising exercise at a huge discount to market price was Unicredit from Italy.  That share offering took place earlier this year, when markets were very difficult but still open at a (steep) price.

Having failed to recapitalize to absorb the impact of deteriorating real estate portfolios, the Spanish banks entered 2012 facing a new challenge:  sharply falling prices of their sovereign bond holdings (over 8% year-to-date) against which they had not been required to carry any capital.  By now, markets are closed and the capacity of the State to implement, on its own, a large forced recapitalization is doubtful.  ECB assistance alleviated the Spanish banks funding difficulties and gave Spain some time to prepare a new plan, but it didn’t improve solvency.

The problem is that markets may be slow to grasp what is actually going on, but once they do, they are likely to overreact.  As if this were not enough, it has transpired that some €97 billion of bank deposits left the country during the first quarter.  If the situation doesn’t improve quickly, that number is likely to rise much higher.  I remember a Brazilian lawyer I worked with, back in the 1980s, telling me that he kept essentially all of his money abroad in US dollars save for some minimum in local currency.  Right now, and unlike Brazil in the 1980s, it is perfectly legal for Spanish locals and multinationals operating there to transfer or hold money outside the country.  It is also much easier for individuals to drive across the French-Spanish border if need be.

Faced with this crisis, the Spanish government has made the surprising decision that it wouldn’t let any bank fail.  Why shouldn’t unviable banks be closed after paying off their depositors?  How does the government expect to keep all afloat when it doesn’t have the necessary money?  And if it needs to get funds from fellow eurozone members or the ECB, how can it expect to do so without signing a formal agreement carrying tough conditions?  Even if it is a partial simplification, I don’t think that German or French taxpayers will advance money to Spanish banks to, in effect, fund capital flight.

Clearly, the Spanish government has to do some thinking and needs to act quickly and decisively.  In my view, to be credible, it cannot maintain its stance of blanket support for its banking sector: it doesn’t have the money to back it up, is not likely to get it, and I don’t think that it should either: not all banks are systemically important and some examples must be made of the most egregious abuses.

Other European governments are also in the line of fire.  By now, an exit by Greece from the eurozone would likely be greeted with relief by the markets IF it were handled properly, meaning decisively and credibly.  For the eurozone to survive, the line has to be drawn somewhere, which means exercising solidarity.  If it is drawn to include Spain, Spain has to convince the likes of Germany, France, Italy and Benelux that it means business.  The firewall built by the core countries must also be credible.  This means that France in particular must provide a clear set of spending controls as well as growth-inducing policies.  And Italy needs to convince that it can take care of its own debts as well as shouldering its share of firewall building.

I am not convinced that the euro is viable long-term, whether its member count is reduced or not, but I think that a disorderly breakdown can be avoided. 

Back in the 1980s, faced with a mounting financial crisis, a well known Mexican finance minister said that the country was on the edge of the precipice but that it would overcome by taking a decisive step forward.  That particularly step was not taken, thank God, but Mexico did much to transform itself into a successful economy; the EU would benefit from studying how Mexico overcame its crises, in particular the so called tequila crisis of 1994.