As Spain's recession undermines efforts to cut the deficit, the risk of bank losses is keeping 10-year yields at almost 6 percent as investors speculate the government will be forced to bail out the financial system.
The nation's 10-year borrowing costs have climbed about 70 basis points this year as Prime Minister Mariano Rajoy struggles to convince investors he can control public finances amid soaring unemployment and a contracting economy. Banks threaten to disrupt the premier's efforts as bad loans reach the highest levels in almost two decades.
"Spain is likely to need support in both the banking and government sectors," said Jamie Stuttard, head of international bond portfolio management at Fidelity Investments, which has $1.2 trillion of assets. "Government bond market developments hold the key."
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Yields on 10-year Spanish bonds surpassed 6 percent on seven trading days this month, boosting concern that borrowing costs may reach levels that prompted bailouts for Greece, Ireland and Portugal. The rate was 5.88 percent at 12:33 p.m. London time.
Investors lost 1.2 percent, including reinvested interest, on Spanish debt repayable in one year or more over the past three months, according to indexes compiled by Bloomberg and the European Federation of Financial Analysts Societies. The bonds are the worst performers in Europe after Greece.
The Bank of Spain said April 23 that gross domestic product contracted 0.4 percent in the first quarter, tipping the nation into its second recession since 2009. Rajoy said March 2 that that nation would miss its 4.4 percent deficit target and then agreed 10 days later with euro-region finance ministers to a new goal of 5.3 percent.
Spain's budget shortfall will reach 6 percent this year and 5.7 percent in 2013, as the government pushes through the deepest budget cuts in at least three decades, according to forecasts from the International Monetary Fund published April 17. Debt will reach 84 percent of GDP next year. While that's less than France and Italy, it's up from 40 percent in 2008, when a real estate boom started to collapse.
"The debt load is still relatively low, but the dynamics behind it are worsening," said Piet Lammens, head of research at KBC Bank NV in Brussels. "They have no growth and low employment. Spain is the next in line for the market as it doesn't believe the country can keep up its austerity measures. What is needed is a separation between the banking risk and the government risk. The combination of the two is really lethal."
Bad Loans
For Spanish banks, non-performing loans as a proportion of total lending jumped to 8.16 percent in February, the highest level since 1994, from less than 1 percent in 2007, according to Bank of Spain data published April 18.
The ratio rose from 7.91 percent in January as 3.8 billion euros ($5 billion) of loans soured in February, a 110 percent increase from the same month a year ago. That pushed the total credit that the regulator lists as "doubtful" to 143.8 billion euros, or about 10 percent of GDP.
Ireland was forced to seek a 67.5 billion-euro international rescue in November 2010, as costs to save its banks and finance the budget deficit became too big. The Spanish government has repeatedly said it doesn't plan to use taxpayers funds to bail out banks.
"Spain is quite comparable, to a certain extent, with Ireland," said Elaine Lin, a strategist at Morgan Stanley in London. "But problems are not obvious. No-one knows how much the banks will need. With the economy not growing for the next year and a half, even if the banks get bailed out, there are still a lot of risks and the market pricing reflects this."
Spanish banks probably need 50 billion euros of additional capital, Morgan Stanley analysts estimate. The figure may rise to as much as 160 billion euros in a worst-case scenario, Lin said. The banks could try to raise the capital themselves or get it from either the Spanish government or the European Financial Stability Facility, she said.
"It isn't clear whether all of that can come from the private sector," said Luca Jellinek, head of European interest- rate strategy at Credit Agricole Corporate & Investment Bank in London. "I would guess they will need some help. Overall, it's not going to be fun. Countries like Spain have effectively binged on their credit cards and stopping that is difficult. There are tough choices to make."
Less than three months after changing the banking law to force lenders to recognize deeper real estate losses, Spain's government is seeking more ways to restore confidence in its financial industry.
Market Credibility
Spanish banks may pool property in jointly owned companies under a proposal designed to get assets off lenders' books, an official at the Economy Ministry said April 23.
Rajoy's government has time to implement more austerity measures and gain market credibility, said Nicola Marinelli, who oversees $153 million at Glendevon King Asset Management. The nation can cope with bond yields at current levels, he said.
"Spain will probably be given the benefit of the doubt" and retain its ability to borrow in financial markets, London-based Marinelli said by phone. "There is still time before things get to the worst. A lot of effort has been put in by the government and the banks and this takes time to work."
Credit-default swaps insuring Spanish debt have risen to 468 basis points from 380 at the start of the year, according to data compiled by Bloomberg. They reached a euro-era record of 511 basis points on April 16. That compares with 440 basis points for Italy, down from 484 basis points at the start of the year. Swaps on German debt are 86 basis points.
"It's hard to avoid assistance altogether at this stage," said Richard McGuire, a senior fixed-income strategist at Rabobank International in London. "It's very unlikely Spain will be able to dig its way out of this hole. Some form of external assistance will be needed, perhaps a bailout of the banks."
Bloomberg News
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