By Lior Alkalay
Senior Analyst, eToro
Markets had initially been euphoric over the news that Spain has requested official assistance from the E.U. to recapitalize its banks. Analysts point out that that at least eliminates one significant structural weakness which had been undermining investor confidence over the past several months. Despite the Spanish government’s repeated insistence to the contrary, the odds were against it (remember Bankia) and market players were well aware that Spain could not make this work short of a miracle.
But analysts point out that the rescue of Spain’s banks does not come without consequences: It reinforces the Spanish government’s need to stabilize its public debt-to-GDP ratio, and puts the onus squarely on the E.U.’s policymakers to find a long-term solution.
As it stands, the bailout amount for Spain is earmarked at €100 billion; however a recently released IMF projection of €37 billion for the Spanish banking sector was seen by some analysts as too conservative, and the IMF’s assertion that that would be more than sufficient to shore up the sector invalid. But there is a valid argument which suggests that the €100 billion might not, in fact, be sufficient at all.
Investors Still Waiting for Central Banks’ Action
Although the Spanish bailout surpassed in scale most preliminary assessments, notably from the IMF and senior Spanish bankers, it has nonetheless failed to kick start a broad confidence. The Spanish bailout was set to give bulls the oxygen to pull the market higher by the year’s end, not to end the woes forever. We had anticipated that the rescue of Spanish banks would be viewed as a sign that the woes are over, yet investors remain unsatisfied. The most prominent signal markets that are sending is that they want the central banks to release more liquidity – think of it as side dish to spur market appetite.
The most indicative sign of this hunger for liquidity is gold. Gold prices had spiked before equities and recovered amid anticipation of more quantitative easing, but has since consolidated back below $1,600 signaling central bank stimulus is more distant than previously thought. What are the central banks waiting for? In the U.S., the Fed says they are waiting for still more confirmation of a U.S. slowdown and in Europe the ECB is waiting for the outcome of the Greek elections. An action from the ECB would sufficiently kick start a rally and allow us to start the journey towards a positive close of the second half of 2012, but the Fed’s roll out of another QE around September will be essential to finish the year with a bang.
So, how can we figure out exactly where we are in the waiting game? Rather simply; the gold market is ahead of the curve when it comes to liquidity and stimulus anticipation, and therefore a break of gold into bullish territory above $1,650 and then $1,700 would be the signal that the waiting game is over and the bullish run has begun.
Long Term Risks Remain
Why? First the baseline capital position figures that the IMF used in arriving at their estimate were from late 2011, and those positions have significantly deteriorated since. Second, there is no allowance for potential bank loan write-offs, which means that the possibility of future defaults for some banks could be understated. Third, the IMF did not take into account future potential write-downs of Spanish sovereign debt held by those banks already on the watch list.
The situation gets worse; the bailout whether from the E.U.’s European Stability Mechanism (ESM) or the European Financial Stability Facility (EFSF) would be channeled to Spanish banks through the Spanish government’s Fund for Orderly Bank Restructuring. In other words, the bailout which would rescue Spain’s banks would add to the Spanish government’s woefully high debt burden, by one estimate adding nearly 11% to the public debt ratio which by 2015 would be more than 100% of GDP.
And it gets worse still; the bailout funds come through the ESM instead of the EFSF, that debt would be considered senior to other government debt, which could damage future spreads on the subordinated debt.
Already, the Spanish government is having difficulty meeting E.U. targets though there could be additional time concessions offered as a reward for the government’s efforts at banking sector reform. The question is whether or not Spain’s balance sheet can cope with this kind of additional debt burden.