Spain capital flight doubles as risk of European bailout rises

Distraught Spain is playing a high-stakes game of chicken with the European Union, using to its advantage the likelihood that it will drag Europe and the rest of the world into a downward economic spiral if it doesn't get the funds it needs to keep its banks afloat. 

“The battle for the euro is being waged now in very important countries like Italy and Spain,” Spanish Economy Minister Luis de Guindos said yesterday.

Spain faces a raft of economic problems, but the government insists that if the European Central Bank provides the lifeline that Spain's reeling banks need, the other issues will resolve themselves because structural reforms to the economy are already in place. All it needs, other than affordable credit, is time, the government says.

But the fiscal conservatives, led by Germany, are not flinching.

Spain, Europe’s fourth biggest economy and home to some of world’s biggest banks, is neck-deep in a crisis that has bled into just about every aspect of daily life. There is little cash, the economy is shrinking, there's no credit, and pessimism abounds. People are wondering what currency to convert their savings to and how to open bank accounts in Switzerland, an unthinkable scenario just a year ago.

Spain says it needs around 50 billion euros to recapitalize its banks, but it’s unclear where the money will come from. Mr. de Guindos said that “in the next few days, very important steps will be taken” to inject money directly into European banks – something that European authorities have so far rejected.

Spain's Central Bank said today that capital flight in March surged to 66 billion euros, double the previous record set in December 2011, before the worst of the country’s economic problems were exposed.

The Spanish government says that the remedy for the situation is not more reform but cash at affordable rates to jumpstart the economy – something that only the ECB can do. The cost of borrowing has broken records this week and is slowly climbing to the unsustainable rate of 7 percent for a 10-year government bond. The money saved by steep budget cuts is increasingly going to cover the higher cost of government borrowing and the deficit is growing. The benchmark stock index is at its lowest point for decades. And this is all likely to worsen.

Prime Minister Mariano Rajoy, who has been a willing adherent of German-led austerity, reached out to Germany and the US to press his case, privately and through the press, but there is no sign yet that the government's dangerous gamble – a full bailout is the inevitable outcome down the line if it doesn't get the money it needs now for its banks – will work out. Several officials also said Germany was receptive, but offered few details.

“Spain is threatening with seeking a bailout to force the ECB to help it recapitalize its banks in order to give its measures more time to work. That is the negotiation,” says Roberto Ruiz Scholtes, UBS strategy director of wealth management research in Spain. “It’s a poker game that could also backfire if markets end up shutting out Spain from more credit for all its other problems. Spain could end up badly hurt.”

Burgeoning uncertainty about Spain's economic stability and the government's brinkmanship are precipitating fears of a prolonged recession in Europe, which are only compounded by concerns about a disorganized Greek exit from the eurozone.

Financial meltdown

The newest and most deadly symptom of the crisis was triggered by the government nationalization of one of the country’s biggest banks, Bankia, on May 9. A bedrock of the ruling conservative Popular Party, the bank reevaluated its 2011 results shortly after its seizure, and a tiny profit became a staggering black hole of nearly 24 billion euros.

Stockholders and investors cried fraud, but the government and Popular Party blocked attempts to investigate the Bankia meltdown. In fact, Spanish Central Bank Governor Miguel Angel Fernández resigned this week after the government gagged him when he tried to give his account to Parliament. 

Yesterday the ECB scolded Spain for being opaque about an issue with such sweeping implications beyond its borders. 

“When we are faced with dramatic recapitalization requirements, the reaction of governments is to underestimate the importance of the problem. This is the worst way to do things because in the end everyone ends up doing the right thing, but at the highest possible cost,” ECB governor Mario Draghi said.

He rejected Spanish pleas to inject money into Spanish banks, instead calling for an EU-wide financial agreement still under negotiation.

USB and other financial analysts calculate the Spanish financial sector will need around 50 billion euros to recapitalize. The government believes that stabilizing the banks will buy the country enough time for it austerity measures and economic reforms to begin pulling the economy back up, but some analysts express doubt about that strategy because Spain has not been transparent in the past.

“Spain’s is a piece-meal approach, but it’s failed in the past, and the government is still creating uncertainty over how much money it needs and how it’s going to get it,” said Mr. Ruiz Scholtes.

Spain has not said how it intends to pay for the 24 billion euro recapitalization of Bankia it has already promised, which would cover about half the needs of the financial sector. The government proposed issuing more debt, but the EU and ECB balked at the idea and instead offered to give Spain an extra year to comply with an EU mandate to lower its deficit to 3 percent by 2014, down from a 2012 projection of 5.3 percent in exchange for more tax increases, more austerity and transparency, and more rapid implementation of reforms.

About a quarter of Spain’s bank branches will eventually be closed, and 15 percent of its employees will be laid off, according to a research note from Spanish bank BBVA released yesterday.

Spain’s gamble

Germany and the ECB don’t seem inclined to accept any plan that would involve sharing the pain. Fiscal conservatives want Spain and Italy, the next in line for a systematic crisis, to cut their way out of this crisis.

Spain can hold out from requesting a bailout for some time, but not too much. It has already secured half of its cash requirements for the year and it has enough resources at its disposal to press its case.

“A bailout is not inexorable or unavoidable. The government wants the political convenience of capitalizing their banks at cheaper rates, and that is what is being discussed,” says Ruiz Scholtes.

But the EU is moving slowly on this and any help could be delayed for longer than the Spanish economy can survive. How long that is is anybody’s guess.

Talk of a Greek economic collapse often draws comments that Greece's economy is too peripheral to have huge consequences for the global economy, but the situation is very different when it comes to Spain. A Spanish collapse could be catastrophic. Europe does not have enough money in its bailout fund to rescue Spain if its economy collapses and economists, investors, and governments around the world are throwing out possible economic and political solutions in hopes of averting an unpredictable domino effect.

Germany and others are playing their part by demanding more reforms, “but they are aware they can’t tighten the noose too much or it can strangle Spain,” Ruiz Scholtes says. 

Italy yesterday also pressed Germany to speed up negotiations to integrate Europe’s financial systems, creating a united front with Spain. Some financial analysts say that Spain's financial crisis has prompted a debate on an issue that needs to be corrected – the lagging integration of EU economies.

“The encouraging part is the debate how to centralize decisions in some sort of EU banking supervision,” said Luigi Speranza, head of inflation economics in BNP Paribas, a French bank. “Any pool of resources must correspond to an agreement on some integration. You need to establish the rules. We have to find framework for financial support, more fiscal integration possible and acceptable. And the debate is over finding common ground.”