Tuesday, July 24, 2012

More angst in Spain: time for the ECB to step up

Bond yields have moved sharply higher in Spain as a fresh wave of angst centred on the deepening recession and a formal request of financial assistance from the Valencia region to the central government.

The formal request from Valencia is the first to make use of the 18 billion liquidity fund for regions (the FLA).  The regions collectively have 35.7b of maturing debt this year which needs to be refinanced.  Valencia is unlikely to be the only region that seeks assistance.

This development came on top of a hectic week for Spain in which the government announced a further 65 billion in deficit reduction measures (spending cuts and an increase in the rate of value added sales tax) to meet its (revised) deficit reduction target of a deficit of less than 3% of GDP by 2014.  Last week’s bond auction was disappointing and the Bank of Spain announced the economy contracted 0.4% in the June quarter (c.f. -0.3% in Q1) and is likely to remain in recession until 2014.  Finally, EU finance Ministers approved the 100 billion bank bailout at the end of last week with the first tranche of 30 billion being made available at the end of the month.

The financial challenges in the regions should come as no surprise.  Indeed it was mainly failure on the part of the regions to meet budget targets last year that led to Spain missing its target.  It is also the case that central government has reserved all of the new flexibility in deficit reduction targets for itself, keeping the pressure on the regions to get their own houses in order.

In the meantime, bond yields are back in unsustainable territory.  Once again we make the observation that the inevitable answer to unsustainable yields lies in further bond purchases.  The European Stability Mechanism (ESM) will not be ready to take this action anytime soon, which leaves it to the European Central Bank to step up and reinstitute its Securities Market Program (SMP).