euro themes - spain

7/28/2019 Euro Themes - Spain

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ECONOMICS RESEARCH 4 May 20

PLEASE SEE ANALYST CERTIFICATIONS AND IMPORTANT DISCLOSURES STARTING AFTER PAGE 19

EURO THEMES

Spain Dealing with sudden reversals

Market anxiety about Spain has flared up again. It has been reawakened by avery large 2011 fiscal underperformance, a poorly managed upward revision to

the 2012 deficit target, confirmation that Spain re-entered recession in the first

quarter, and a perception that the ECBs recent injection of liquidity may be

reaching the limit of its effectiveness.

One additional factor has dented market confidence further: in the past sixmonths, Spains economic and financial challenges have been exacerbated by

large capital outflows, which intensified in the early months of 2012. If this

sudden reversal of international capital flows is not arrested, it could pose aserious threat to the countrys economic and financial stability.

We have not changed our view, put forward in July 2010, that Spain remainssolvent with risks. Even under the worse-than-expected fiscal cost of

recapitalising troubled banks, Spain appears fundamentally solvent. The fiscal

adjustment required to stabilise public debt must bring the primary budget

balance from a deficit of roughly 6% of GDP in 2011 to a surplus of 2% of GDP

within the next five years. As long as the commitment to long-term fiscal

adjustment remains in place, this requirement appears manageable. Managing

the fiscal imbalances and the banking-sector fallout of the ongoing credit cycle

alone does not, in our view, require external official support.

However, what the Spanish authorities cannot manage on their own is sustained,large capital outflows of the sort that have recently been experienced. If foreign

investors continue to reduce their exposure to Spain at an economically disruptive

rate, the country will require external financial support to manage this adjustment.

A sudden stop in capital flows has been offset by financing channeled throughBanco de Espaa

-150

-100

-50

0

50

100

150

200

Jan-00 Jan-02 Jan-04 Jan-06 Jan-08 Jan-10 Jan-12

Banco de Espana ex BdE

Note: 12-month moving total, billion euros. Source: Haver Analytics, Barclays Research

Update: This report replaces the previously published version to reflect updated Analyst

Certification information. The content remains unchanged.

Antonio Garcia Pascual

+44 (0)20 3134 6225

[email protected]

Michael Gavin

+1 212 412 5915

[email protected]

Piero Ghezzi

+44 (0)20 3134 2190

[email protected]

Jonathan Glionna

+44 (0)20 3555 1992

[email protected]

Miguel Angel Hernandez, CFA

+44 (0)20 7773 7241

[email protected]

www.barcap.com
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Barclays | Euro Themes: Spain - Dealing with sudden reversals

4 May 2012 2

Spain Back in the line of fire

After a two-month respite following the ECBs surprise 3y LTRO operations, Spain has

returned as the focus of investors scepticism and anxiety. The change in sentiment was

triggered by a combination of factors:

the announcement of a large fiscal slippage in 2011 (2.5pp of GDP, which brought thefiscal deficit to 8.5% of GDP);

the delay in the presentation of the 2012 fiscal budget (until end March 2012); a relaxation of the 2012 deficit target (from 4.4% to 5.3% of GDP, with an initial

government proposal of 5.8% of GDP revised in a messy, public and somewhat

acrimonious negotiation with other eurozone authorities);

a rapid deterioration in economic activity which confirmed that the economy is movinginto a double-dip recession; and

price action in government bond markets that was interpreted by some as evidence that thepalliative effects of the ECBs recent LTRO operations were beginning to reach their limit.

Market sentiment aside, in the past six months or so, Spains economic and financial

challenges appear to have been exacerbated by large capital outflows that had not previously

been a problem. Spain is experiencing a sudden stop, familiar to analysts of emerging-market

financial crises, in which international investors are seeking to reduce exposures that were

created during the 2003-2008 credit boom, or expressing a negative view on Spain by shorting

Spanish assets. Much of the foreign selling has been in the Spanish government bond market,

where foreign ownership (excluding the ECB) had, by Q1 12, decreased to less than 25% of

the outstanding central government securities, close to half what they owned in early 2010.

In this context, investors are focusing on the still incomplete clean-up of the legacy real

estate assets that remain on banks balance sheets. They are also worrying about additional

bank losses that are likely to emerge as economic activity shrinks in the months ahead.

Moreover, investors are wondering whether the government remains solvent, in light of last

years fiscal underperformance, the potential costs of bank recapitalisation, and public

political debate in Europe about the merits of fiscal austerity.

Figure 1: Spanish government bond spreads back almost toNovember 2011 levels

Figure 2: Spanish equities have fallen to 2009:Q1 levels

0

100

200

300

400

500

Dec-07 Dec-08 Dec-09 Dec-10 Dec-11

10-year sovereign spread to Germany (bp)

0

20

40

60

80

100

120

Dec-07 Dec-08 Dec-09 Dec-10 Dec-11

MSCI Spain MSCI Spain (financials)

Source: Bloomberg Source: Bloomberg

Spains economic and

financial challenges appear to

have been exacerbated by large

capital outflows


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4 May 2012 3

The fiscal swing required to stabilise public debt is roughly 8% of GDP over a five-year period,

which would achieve a primary surplus of just over 2% of GDP by 2016. Our view is that this is

manageable, and will likely be achieved. When we look at the evidence provided by European

countries that underwent prolonged periods of fiscal consolidation in the past, the average

fiscal adjustment for these countries has been of about 10% of GDP over a seven to eight-year

period (for details, see Spain: solvent with risks, 8 July 2010). Moreover, Spain ran an average

primary surplus of over 2% between 1998 and 2008. So the adjustment that Spain needs toachieve would appear to be within the realm of historical precedent, both in a cross-section

and time-series sense. If a primary surplus of about 2.25% of GDP is achieved by the 2016

time frame, we project a gradual decline in the public debt relative to GDP, even after including

the fiscal costs of bank recapitalisation. In this important sense, the government is solvent. But

is this enough to reverse the sudden stop and change investor sentiment?

Does it add up? Public debt dynamics (yet) again

The Spanish economic and financial crisis is not fiscal in origin, but rather stems from the

unwinding of the more generalised financial and economic boom seen during the run-up to

the 2008 international financial crash. But as the Spanish economy has traversed the

downside of this economic and financial cycle, weaknesses in the underlying fiscalimbalances have been exposed, and potentially large fiscal risks have been created from

domestic banks exposure to the ailing property and construction sector. A potential

inability to manage the fiscal consequences of the broader economic and financial

correction is a legitimate market concern, and market anxiety about a potential public credit

event looms large as a potential amplifier (and international propagator) of the crisis. So,

even though budgetary problems are more consequence than cause of the crisis in Spain,

the question will the government be able to pay is a key consideration at this stage.

The base case: Debt dynamics are precarious but manageable

Figure 3 illustrates our core conclusion: the Spanish public debt dynamics add up, as long as

the government makes (and society continues to support) a long-run fiscal effort. This is true

in a base case that we consider plausible and conservative in some cases, and under importantrisk cases as well. Ultimately, we consider the task to be challenging, but manageable.

Figure 3: Public debt dynamics add up under our base case, and under a banking-sectorstress test (Debt of the general public sector, % of GDP)

30%

40%

50%60%

70%

80%

90%

100%

110%

2000 2005 2010 2015 2020 2025 2030

Base case Higher cost bank recapitalization

Source: Barclays Research

The fiscal swing required to

stabilise public debt is

within the realm of historical

precedent

Market anxiety about a potential

public credit event looms

large as a potential amplifier

of the crisis


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4 May 2012 4

This type of analysis is a pure exercise in arithmetic: its conclusions are only as good as the

assumptions used. The assumptions of our base case (see also Figure 4) are as follows:

A recession that reduces real GDP by 2.0% in 2012, with another 0.5% decline in2013. Recovery is forecast to take hold over the course of 2013, with growth turning

positive in calendar 2014, and strengthening in 2015. In the long-run steady state

(which, in these projections, means after 2015), we anticipate nominal GDP growth of3.75%, reflecting roughly 2% inflation and 1.75% real economic growth. We view this

as a reasonable base case for the coming two years, and conservative over the long run

in the sense that we assume no cyclical rebound from the ongoing recession, but rather

a smooth convergence to the steady-state growth rate. On the other hand, we do not

forecast a significant decline in inflation, which would complicate the debt dynamics (by

increasing the real interest rate on the public debt).

Interest rates on newly issued public debt are assumed to be 6% in 2012 andthereafter. (The average interest rate on the public debt, currently at 4%, adjusts

gradually, as the cost of newly issued debt is steadily rolled into the overall stock of

debt.) We view this as a conservative assumption; 10y bonds are even now yielding less

than 6%, and shorter-term debt issued by the government is substantially less

expensive than this.1 Given the likelihood that risk-free interest rates are likely to

(eventually) rise over time, the assumption of a constant Spanish interest rate implies a

supposition that the Spanish bond spread will decline, which may seem optimistic. But

the implied spread to German yields declines in five years to only 320bp (from roughly

420bp today), which we consider very conservative, if anything resembling our baseline

scenario materialises.2

We project a gradual but firm and persistent adjustment of the non-interest budgetbalance from -6.1% of GDP in 2011 to -3.3% of GDP in 2012 , about -1.5% of GDP in

2013, -0.15% in 2014, and a surplus of just over 1% of GDP in 2015. After 2015, we

assume a non-interest budget surplus of 2.25% of GDP. Of the roughly 8 percentage

point swing in the primary surplus that we envision, we believe that about 2.8% is

already in place, with another 5.2% yet to be approved and implemented.

We calculate that the fiscal cost from recapitalisation of the banking system will beslightly over 6 % of GDP (of which about 1.4% of GDP was paid in 2011 and is already

included in the stock of debt). The remaining fiscal costs, about 4.7% of GDP, are likely

to materialise in 2012-13. In an extreme but plausible stress scenario, we estimate that

the recapitalisation cost for the sovereign would reach 11% of GDP. (See the appendix

for a detailed explanation of these estimates.)

We also account for two large items that will increase public debt in 2012. First andmost importantly, the government is planning to clear the excess accumulation of

accounts payables with providers of goods and services to the different sub-central

government administrations (regions and municipalities). These accounts, on which theadministration does not pay interest and which in normal times, have been at around

3% to 3.5% of GDP, have increased since the crisis hit in 2008 to about 7% of GDP. The

government is planning to clear c.EUR35bn (about 3.3% of GDP) in 2012. In turn, the

1 The average maturity of the outstanding stock of public debt is about 6.6 years.2 The forward curve suggests that the 10y German interest rate will rise from 1.6% now to about 2.8% in five years. A 6%Spanish interest is thus consistent with a risk premium of about 320bp in five years time. In our baseline scenario, Spainspublic debt is projected to stabilise at a level comparable to that of France, with a more pronounced downward trend. Arisk premium comparable to Frances (now about 135bp) would therefore be plausible; 320bp strikes us as veryconservative.


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4 May 2012 5

cash transfer to providers is likely to have a mitigating effect on the negative growth

outlook. Second, there will be 0.9% of GDP increase in public debt in 2012 on account

of Spains contribution to the loans to Greece, Ireland and Portugal, according to the

Spanish contribution to the EFSF loans.

Figure 4: Barclays base case assumptions for the debt sustainability analysis

2011 2012 2013 2014 2015 Long run

Real GDP growth 0.70% -2.00% -0.20% 1.00% 1.50% 1.75%

Inflation 1.37% 1.20% 1.20% 1.75% 1.75% 2.00%

Nominal GDP growth 2.09% -0.80% 1.00% 2.75% 3.25% 3.75%

Average interest rate on new debt --- 6.00% 6.00% 6.00% 6.00% 6.00%

Fiscal cost of bank recapitalization 1.40% 2.35% 2.32% 0.00% 0.00% 0.00%

Other extraordinary fiscal costs 0.00% 4.22% 0.00% 0.00% 0.00% 0.00%

Primary fiscal balance -6.10% -3.30% -1.60% -0.15% 1.10% 2.25%

Note: The 2011 fiscal costs of bank recapitalisation, 1.4% of GDP, are the costs to the government thus far which arealready part of the stock of public debt. Source: Barclays Research.

Under these assumptions, the Spanish public debt dynamics look precarious in the nearterm, but manageable over the longer term. The bad news is that the projected public debt

continues to rise until 2015, when it reaches 91.5% of GDP. The very rapid rate of increase

in the public debt is potentially unnerving, but our estimate of the peak level of

indebtedness is marginally above the euro area average of 89%. (Of the c.23% of GDP rise

in debt from the end-2011 level, about 4.7% is due to additional fiscal costs of recapitalising

the banks, and will not therefore require market financing. The remaining c.18% would

need to be financed by the market.) The good news is that a 2.25% of GDP primary surplus,

well within the historical experience of many countries around the world, is sufficient to

turn around the adverse debt dynamics, and secure a continued decline in the public debt

burden, under our assumptions about long-run interest rates and growth. 3 Under the other

assumptions of our base case, the public debt is projected to decline about 7.5 percentage

points in the decade after the 2015 peak, which strikes us as a rate of improvement thatwould, if it materialised, justify substantially lower anxiety about the public credit than now

exists, even though the level of debt would be higher.

Our base case incorporates a fiscal cost of bank recapitalisation equal to about EUR65bn, or

c.6% of GDP, of which roughly 1.4% of GDP was already recorded in 2011. However, there is

substantial uncertainty around this estimate, and we have therefore stress-tested our

projections for an additional EUR57bn (about 5.4% of GDP) in costs. As Figure 3 (above)

illustrates, the debt dynamics remain manageable in this risk case. The public debt is projected

to peak at 97.6% of GDP in 2015, compared with 91.5% in the base case, and it declines more

slowly thereafter. But in this case too, the projected rate of decline is pronounced enough to

alleviate anxieties about the sustainability of the Spanish public debt.

Public debt dynamics are resilient to severe, but temporary adverse shocks

The long-run resilience to higher costs of bank recapitalisation illustrates a more general

point, which is that the Spanish debt dynamics are robust to a number of large, temporary

shocks, as long as these do not upset the longer-term assumptions of the analysis. For

example, in Figure 5 we illustrate the results under two severe, temporary shocks. The first

3 Spains average primary balance 1998 -2008 was +2.1% of GDP. This includes the 2003-2008 credit boom, duringwhich it was arguably easier to maintain a healthy fiscal position. However, the primary budget surplus averaged2.15% during the pre-boom period 1998-2003, suggesting that a primary surplus of this magnitude should beattainable during more normal economic and financial conditions.


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4 May 2012 6

scenario is a much deeper recession, in which growth is lower than the base case by 3% in

2012 and 2% in 2013, with a cyclical rebound that is 3% higher in 2014 and 2% higher in

2015.4 The debt peaks at a higher level, but after the cyclical event plays out, the evolution

of the public debt remains stable.

Figure 5: Debt dynamics are also manageable under severe, but temporary adverse

shocks (Public debt, % of GDP)

30%

40%

50%

60%

70%

80%

90%

100%

110%

2000 2003 2006 2009 2012 2015 2018 2021 2024 2027 2030

Base case Deeper recession Slow fiscal adj


In the final risk case, we assess the impact of a substantially slower pace of fiscal

adjustment, with primary fiscal balances of -4.5% in 2012 (vs -3.3% in the base case), -

3.0% in 2013 (vs -1.6%), -1.5% in 2014 (vs -0.15%), and 0.0% in 2015 (vs 1.5%). Here, too,

the debt rises to a higher level and declines more slowly than in the base case, but the

dynamics are stable, which implies that the government is solvent in this risk case as well.

It is important to acknowledge that this analysis is not a general equilibrium one, and does

not incorporate all potential feedbacks. For example, a slower pace of fiscal adjustment mightlead to a temporarily stronger economy than in the base case, which could partially offset the

adverse impact on the public debt dynamics. In a less benign example, an economic downturn

of the magnitude that we used to illustrate the fiscal sensitivity to economic activity could

trigger societal dynamics that upset political support for the gradual fiscal consolidation that is

embedded in our projections. The risk cases are intended to provide us with some quantitative

insight into the sensitivity of our base case to disappointing developments on a number of

different levels. But they all embed the assumption that a long-run fiscal consolidation will

continue to be supported by society, and for some risk cases this assumption may reasonably

be questioned. We explore this issue in some more detail below; for now, we emphasise the

point that, assuming the long-run scenario remains intact, and although public debt will rise

sharply in the next couple of years, the Spanish debt dynamics look reasonably robust to

temporary or cyclical developments, even ones that are large by comparison with what weconsider to be plausible downside risks.

There is less budgetary room for manoeuvre in the long run

The same is not quite true for the assumptions about the long run. One way to see this is to

note that in our base case, the public debt peaks at just over 90% of GDP. Given our

assumption about the steady-state interest rate and rate of economic growth, to stabilise

4 In this scenario, we adjust the primary budget surplus downward by 0.5% of GDP for every percentage point shortfall inGDP. This adjustment in the budget balance has more impact on the debt dynamics than the GDP shortfall itself.

Assuming the long-run scenario

remains intact, the Spanish debtdynamics look reasonably robust

to temporary or cyclical

developments


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4 May 2012 7

the debt at this level would require a primary budget surplus of 2% of GDP. 5 Our

assumption that the primary budget achieves 2.25% of GDP is therefore more than

adequate to stabilise the debt ratio (as we see in the eventual downward drift in Figures 1

and 3), but there is not a lot of room for policy slippage (no more than 25bp, to be precise,

probably more precise than one should be in a long-run analysis of this sort). Nor is there

much room for disappointment in the long-run rate of growth or interest rate, unless there

is an offsetting fiscal effort.

Now, there is a sense in which this hair-trigger property of the model exaggerates the actual

risks surrounding the long run. If a society can generate 2.25% of GDP, 2.50% should not be

ruled out. Moreover, a 6% interest rate (4% after adjustment for inflation and roughly 320bp

higher than future German yields implied by forward curves) looks like a very conservative

assumption about an economy where the public debt is on a gradual but pronounced

downward trend. If other elements of the base case were unchanged but we assumed a risk

premium similar to the 135bp that France is now paying, debt would decline very rapidly.

There is room for good news, as well as bad, and we would not want to leave the impression

that the long-run financial outlook is balanced on a mathematical razor blade.

That said, the analysis does highlight an inescapable imperative to secure a long-term

adjustment in the primary fiscal balance from last years 6.1% of GDP deficit to a surplus of

something on the order of 2.25% of GDP, and to do it in a way that is sustainable for a long

period of time. It also suggests that there is some theoretical room for delay relative to our

base case, but the room is not unlimited.

Is the fiscal consolidation feasible?

How dismal is the fiscal arithmetic?

Some investors believe, and elements of the commentariat have lately been arguing, that

fiscal adjustment is all but impossible when an economy is as weak as Spains, even if the

political commitment to adjust is in place. The idea is that fiscal adjustment weakens the

economy (through familiar Keynesian channels), and the weakened economy underminesfiscal performance so dramatically that austerity is largely, if not totally, self-defeating.

To investigate this idea further, let us denote by m the Keynesian multiplier. That is, a

contractionary fiscal shock of one percent of GDP is assumed to reduce GDP by m

percent. Let us denote by t the impact of a change in GDP on the budget balance; that is, if

GDP declines by one percent while tax rates, unemployment compensation programs, and

other elements of the budget structure are left unchanged, the budget deficit would worsen

by t percent of GDP. With this notation, we can compute the magnitude of the fiscal

measures required to reduce the budget deficit by one percent of GDP, which is:

1/(1-m*t).

Suppose you believe that Keynesian effects of fiscal policy are very powerful: for example, thatthe multiplier m is 1.5. (These are not our estimates, but arbitrary ones designed to illustrate

the fiscal pessimists point of view.) In a highly-taxed society like much of Europe, the marginal

impact of a change in national income on the budget is likely to be high; let us use 0.6 as a

high, but not ludicrously high estimate of the sensitivity. Under these assumptions, to achieve

1 percent of GDP improvement in the fiscal balance would require 10 percentage points of

5 The debt-stabilizing primary budget balance is [d*(r-g)/(1+g)], where r is the nominal rate of interest, g is thenominal growth rate, and d is the ratio of debt to GDP.

Some have argued that

austerity is largely, if not totally,

self-defeating


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4 May 2012 8

fiscal adjustment! A full 90% of the fiscal effort would be undone by the adverse impact of the

fiscal measures on the economy and, therefore, the budget.6

Applied to the Spanish context, this nave calculation predicts that the 8 percent of GDP

swing required in the Spanish budget balance would demand fiscal measures equivalent to

80% of GDP! This is, of course, absurd, and results from inappropriately applying the model

to policy changes that are so large that it cannot reasonably be used.

While we do not agree with the fiscal pessimists that fiscal consolidation is next to

impossible, we agree with the general principle that consolidation is likely to be costly in

terms of economic activity in the short run, and that the economic repercussions aggravate

the process of fiscal adjustment. This provides a clear justification for gradualism in the

adjustment path; we doubt that any responsible person would advocate that the 8 percent

of GDP fiscal adjustment that Spain faces should (or could) be undertaken in a single year.

Moreover, the path of fiscal consolidation that we project for Spain, which we have argued

is consistent with fiscal solvency over the medium term, is nonetheless less ambitious than

the governments. This may be partly because our estimates of the fiscal spending

multipliers and tax elasticity are higher than that the government is implicitly using. We

also think it will become clear to the government and to the EC that such a front-loadedfiscal consolidation is unnecessary (and not feasible in our view). In particular, the

government Stability and Growth Pact approved on 27 April proposes a reduction in the

primary budget deficit of 3.9pp of GDP in 2012 and an additional 2.4pp of GDP next year, to

bring the primary balance to 0.2% of GDP surplus in 2013. We are instead projecting a

primary deficit of 1.6% of GDP in 2013. We emphasize that under our scenario the

government remains solvent, with a trajectory for the public debt that is rather similar to the

one envisioned in the UK governments fiscal consolidation. We advise investors to focus on

the medium-term outlook, and to resist becoming overly fixated on deviations between the

governments plan and outcomes over a few short years.

For Spain, we think it is reasonable to assume that m is in the vicinity of 0.67 and t around

0.5, which means that a 1% fiscal consolidation only produces an effective deficit reductionof 0.7%.8 Using the government target, to achieve 3.8pp of GDP consolidation in 2012 it

should be on the back of fiscal measures worth about 5.4% of GDP. Our more conservative

estimate of a likely 2.8pp of GDP consolidation in 2012 is based on adjustment measures

worth about EUR41bn (about 3.8% of GDP).9

6 If m*t is greater than one, the number 1/(1-m*t) could be negative. This describes a world in which a KeynesianLaffer curve exists, such that an increase in public spending would create such a powerful effect on demand andeconomic activity, that it would be (more than) self-financing. We dont share the view that we live in such a world,even during a period of weak demand and low economic activity.7 There is a body of opinion which holds that the fiscal multiplier in countries like Spain must be high, because thefiscal contraction cannot be offset with a decline in the interest rate (which is determined by the ECB, in Frankfurt). Wethink this is an inappropriate conclusion for Spain, where country risk has become an important determinant of assetprices and overall financial conditions. To the extent that a fiscal consolidation reduces the riskiness of Spanish assets,it can secure a strong improvement in financial conditions, offsetting the direct effects of the fiscal contraction on

demand and economic activity. Some analysts think this can result (and in some historical examples, has resulted) inan expansionary fiscal consolidation. We would not, however, go so far in Spain under present conditions. Spainsstatus as a small, open economy also tends to generate a smaller multiplier than might be seen in a larger, moreclosed economy.8 At least in the short run. Most Keynesian models have the property that demand shocks from fiscal and monetarypolicy have only temporary effects on economic activity. In the long run (of some unspecified duration), throughvarious adjustments of wages and prices, economies heal and the policy multiplier becomes zero.9 In addition, the sizeable difference between the more aggressive government adjustment path an ours is mainlythreefold: first, the government is probably using multipliers (ie m and t) of smaller size than ours, we think becausethe government is considering that a large share of the expenditure cuts can be applied to activities (such as transfers)with low a low fiscal multiplier. Second, the government is including in the fiscal consolidation path, measures for 2013-15for which we do not have details yet; we are simply assuming a more conservative path than the governments. Third, weare also assuming slightly less fiscal adjustment in 2012 than the government, in particular we are excluding the EUR2.5bnexpected revenues from a tax amnesty, which may or may not yield such revenues.


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4 May 2012 9

Is there political support for fiscal adjustment?

Since Spain joined the EMU in 1999 and until 2004, under the conservative Partido Popular (PP),

public expenditure (ex interest) remained constant as a share of GDP at 36%. Since 2004, when

the Socialist government took office, public expenditure increased every year to peak at 44% of

GDP in 2009. The trend reversed in May 2010 as the Socialist government stopped its counter-

cyclical and expansionary fiscal policies and began implementing cuts to the public sector wage

bill and pensions. Public expenditure dropped to 41% of GDP by end 2011.

Against this background, the conservative PP won a land-slide victory and took office in

December 2011, gaining a comfortable majority in parliament. PPs campaign was centred

on fiscal consolidation, structural reforms and the clean-up of the banking sector. PPs clear

victory was probably as much a result of support for the conservative-party policies (ie,

fiscal consolidation and structural reforms) as a vote of disenchantment against the

Socialist party, 23% unemployment, and the ongoing economic crisis. The latter seem to be

a relevant factor in the outcome of the elections as evidenced in recent polls published by

Spanish local media, which show a drop in PPs support following the labour market reform

and the announcement of the 2012 fiscal budget.

The PP has clearly signalled that it intends to take a more hawkish fiscal consolidationstrategy with a view to reverting public expenditure to about 35% of GDP by 2015, a level

similar to 1999-2003. We think that the ability (or otherwise) of the conservative

government to effectively control the expenditures of the regions will largely determine the

success of the fiscal strategy, as the increase in regional expenditures have been the main

factor driving the increase in public expenditure in recent years. Achieving a fiscal swing of

approximately 8pp of GDP over a five-year period (our estimate) will require a less generous

and more efficient welfare state, including sizeable cuts to social expenditures, health and

education, which are responsibilities of the regions (health and education represent about

80% of the total expenditure of the regions).

It is not clear whether the political support for the new government will remain in place to

carry out its fiscal consolidation plans, structural reforms and complete the clean-up of thebanking system. First, the Spanish society may not accept a less generous welfare state,

especially in a context of rising unemployment. Second, the complex politics of fiscal

devolution to the regions are likely to make a possible fiscal intervention of a large region

not viable (more on this below). Third, politics have also played an important role in the

clean-up process involving the savings bank sector. Savings banks had very close ties to the

regions and as a result, some of the savings bank mergers were politically driven rather than

based on pure economic and financial reasons. And political ties to the former savings

banks remain and those may delay the clean-up process (although one can also argue that

as problem banks are addressed and the boards are removed, those ties may eventually

disappear).

Can the central government effectively control the regions?

The short answer is in theory, yes; in practice, it will not be a trivial task. The central

government is backed by a brand new constitutional debt-break and a new organic law that

sets expenditure-ceiling rules for all the sub-central government levels, and allows the

central government, if needed, to potentially intervene a region and take away fiscal

responsibilities. Also the new draft law of good governance proposes that any local

authority that fails to comply with the fiscal consolidation targets (ie, that fails to comply

with the new constitutional amendment or the new organic law above mentioned) can be

dismissed and be banned from running for public office for a period of up to 10 years.

It is not clear whether the

political support for the newgovernment will remain in place


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4 May 2012 10

In practice, however, these brand new mechanisms of fiscal control have not yet been put

to the test. We think that politically it would be very costly for the central government to

revert the process of fiscal devolution by taking responsibilities away from any region, even

if temporarily.

On the revenue side, the central government controls a large share of the regional taxes.

Specifically, the central government controls the tax rates of the personal and corporateincome tax (PIT and CIT), as well as the VAT. The fiscal revenues from these taxes are

shared between the central government and the regions (50% each). Hence, any decision

by the central government to increase the PIT, CIT and VAT rates has a direct impact on the

fiscal revenue of the regions. In the approved 2012 budget and in the new 2012-15 SGP, the

government has approved (or proposed) changes to the corporate and personal income tax

regime as well as an increase to indirect taxes, including a hike to the VAT rate in 2013 (the

standard VAT rate is currently 18%, which is 3pp below the standard rate of Italy and 5pp

below Ireland, Portugal and Greece).

Bond buyers, banks, and the BOP Will Spain require help?

For a country in Spains financial position, a policy framework that promises long-term

sustainability is necessary, but may not be sufficient to avoid a crisis. The problem is familiar

to those who have watched sovereign crises unfold in the past. There is at least a small risk

that even a coherent program will unravel, because of unfavourable external conditions, a

domestic political shock, or for some other reason. But in sovereign credit events, recovery

rates are typically low, in substantial part because much of the debt owed by the sovereign is

senior and not subject to restructuring, which means that credit risk is concentrated on those

market participants who do not enjoy the senior status of the IMF, the ECB, or (in a different

way) the domestic banking system. This means that even a relatively small probability of

default can justify a high market risk premium, which can intensify doubts about the

sustainability of the public debt, if the sovereign is (or, as in Spain, will soon enough be) highly

indebted. But once market participants start to worry that debt service may ultimately be

unsustainable, the small perceived probability of default is likely to be ratcheted higher, whichcan set in motion a downward spiral of confidence and debt prices that may result in full loss

of access to debt markets, and that can be very difficult to break without some form of

external assistance. (See Can Italy save itself?, 7 November 2011)

In the final months of 2011, it seemed as though negative market dynamics like this

threatened to envelop Italy, and with somewhat less intensity, Spain. In the end, the ECBs

3y LTRO operations enabled Spanish and Italian banks to act as bond buyers of last resort

for their respective sovereigns, allowing them both to finance their governments and

providing an exit option for the international bondholders who have been reducing their

exposure.10 It has not been lost on investors that the fate of the Spanish banking system has

thereby become even more dependent upon the sovereign credit.

Banks and bondholders

It is not inevitable that foreign investors will continue to reduce their exposure to Spain at an

economically disruptive rate. But it is a nontrivial risk. The question therefore arises whether,

in the risk case of an extended international buyers strike, the Spanish banking system

could continue to play the supportive role that it (along with the ECBs Securities Market

Program) has played in the past few quarters. One aspect of this question is whether this

10 Very importantly, the LTRO operations also reassured markets that banks would be able to fund themselves in theevent that rollover of amortizing bank debt was not complete. This may have been the most important element of theLTRO, but in this section we are focused on the public finances.

There is at least a small risk that

even a coherent program will

unravel, because of unfavourable

external conditions or a

domestic political shock


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4 May 2012 11

would leave banks with an exposure to the sovereign that is unreasonable or

unmanageable. This is not necessarily the most important consideration facing

policymakers, but it is interesting and important to consider how the Spanish banking

systems balance sheet could be altered in a risk case in which local banks are forced to

compensate for an extended international buyers strike.

In Figure 6, we illustrate the impact on the banking systems exposure to government in asevere, but not unthinkable, scenario, which incorporates the following elements:

Domestic banks finance 80% of the general governments net issuance in 2012 and2013 (with other local institutions assumed to finance the remaining 20%).

Domestic banks have already accommodated a massive reduction in foreign investorsexposure to the Spanish government, totalling an estimated EUR30bn in the four

months of 2012 alone (an annualized rate of EUR 90 bn/year). Going forward, we

assume in our stress test that banks absorb foreign selling amounting to EUR50bn per

year. (For our purposes, it does not matter whether the foreign selling reflects failure to

roll existing exposures or secondary-market selling.) To put this in perspective, we

estimate that foreign (ex-ECB) ownership of central government debt securities had

fallen to EUR141bn in March 2012 (see Spain: Banks still buying, foreigners still selling

(but less), 30 April, 2012). Our projection implies another EUR83bn of cumulative selling

by the end of 2013, reducing foreign exposure to a mere EUR56bn. This seems

implausibly severe, but thats the point of a stress test.

Finally, we estimate that the government will need to provide fiscal support to thebanking system in the amount of EUR50bn in the next two years. In the following

calculations, we assume that this support takes the form of government bonds that are

held by those banks that end up needing the fiscal support.

Figure 6: Stress testing for an international bond buyers strike

Dec-09 Dec-10 Dec-11 Feb-12 Dec-12 Dec-13

Bank exposure to general government as % of:

GDP 21% 22% 26% 30% 39% 49%

Public debt 38% 37% 38% 43% 48% 55%

Bank capital and reserves 79% 83% 76% 85% 105% 136%

Bank assets 7% 7% 8% 9% 12% 16%

Source: Haver Analytics, Barclays Research

In this scenario, Spanish bank exposure to the general government would rise from roughly

30% of GDP in February 2012 (the last month for which we have data) to 39% at the end of

2012 and 49% at the end of 2013. By 2013, bank exposure would amount to 55% of the

general governments debt.

It would also amount to 136% of the banking systems capital and reserves (assuming that

the systems capital remains close to the present level). This is dramatically higher than in

the very recent past; in December 2011 this ratio was only 76%. But as Figure 7 illustrates,

while it may not seem desirable, theres nothing historically unprecedented about this level

of exposure. And, for what its worth, the equivalent ratio for US banks is roughly 124%, and

in Germany it is 141%. It is certainly true that in this scenario the banks would be broken by

a sovereign credit event. Thats also true in Spain today, and we suspect its true in the vast

majority of the worlds economies.
https://live.barcap.com/go/publications/content?contentPubID=FC1816302https://live.barcap.com/go/publications/content?contentPubID=FC1816302https://live.barcap.com/go/publications/content?contentPubID=FC1816302https://live.barcap.com/go/publications/content?contentPubID=FC1816302


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4 May 2012 12

In this scenario, it seems to us that the financial shoe doesnt pinch because it leads to an

unreasonable or unmanageable exposure to the public sector; it pinches because the banks

would almost certainly have difficulties financing the required increase in exposure. As Figure

8 illustrates, bank exposure to the Spanish private sector has been declining since 2008, as

households and firms unwind the preceding credit boom. This private deleveraging creates

some room on bank balance sheets for additional bank financing of the government, but it has

been proceeding at the rate of roughly EUR60bn during the past year, only about half the sizeof the fiscal support required of the banks in our (admittedly somewhat extreme) stress test.

The problems would of course be compounded if banks have a hard time rolling over their

outstanding liabilities in international capital markets, or faced large deposit outflows. In short,

unless banks are provided with the liabilities that they need to increase their exposure to the

government, private borrowers would be forced into an even more rapid (and economically

destabilizing) deleveraging than they have been experiencing.

Under alternative monetary arrangements, Spains central bank could act as lender of last

resort for the banking system and provide the required financing itself. (It could even lend to

the government more directly, unless constrained by law.) But that is ruled out under the

existing framework, because the Spanish central bank cannot expand the supply of euros to

finance either governments or banks. Moreover, even if Spain had its own currency, thecentral banks capacity to ease the financial stress would be limited by the fact that the run is

external. The genius of the ECBs LTRO operations was that they provided not only liquidity for

banks, but also the euros that Spain needed to plug a hole in the balance of payments.

Bondholders and the balance of payments

This brings us to Spains external finances which will, in our view, be the lynchpin of the

financial crisis in the months (and, quite likely, years) to come. The 2003-2008 credit and

investment boom was associated with a very large increase in the current account deficit,

which peaked at well over 10% of GDP. As the boom has been unwound, the current

account deficit has shrunk. (We expect it to shrink further, to about 0.9% of GDP in 2012,

and to reach a small surplus in 2013.) But the deficit has not yet disappeared, and until it

does it will require external finance.

Figure 7: Spanish banks finance of government Back to thefuture?

Figure 8: Spanish banks exposure to the nonfinancial privatesector has been falling since 2008 (EUR bn)

0%

50%

100%

150%

200%

250%

300%

1970 1975 1980 1985 1990 1995 2000 2005 2010

Bank exposure to gen'l government (% of capita l and

reserves)

500

750

1,000

1,250

1,500

1,750

2,000

2000 2003 2006 2009 2012

Credit system exposure to private sector

Source: Haver Analytics Source: Haver Analytics


13/22


4 May 2012 13

The problem today is not that the current account deficit is excessive. We view the current

account adjustment to economically sustainable levels as essentially complete, with further

reductions that we anticipate bringing it well within the sustainable range. The problem is

that during the credit boom, Spain accumulated very large liabilities to external creditors of

many kinds, and as the economic and financial situation has become more precarious,

these creditors have been trying (with some considerable success recently) to exit the

country. Figure 10 shows how dramatically external financial flows have collapsed in recentmonths, and how reliant the Spanish balance of payments has become upon financing

channelled through Banco de Espaa. During the 12 months through February 2012, the

country experienced EUR125bn of capital outflows (of which roughly EUR 77bn reflected

foreign selling of central government debt securities). These outflows and the current

account deficit were financed by inflows channelled through Banco de Espaa.

If the potential problem were limited to foreign holdings of central government debt, which

have fallen to only EUR141bn, as we noted above, we might feel some confidence that an

end to the outflows is in sight. However, the countrys exposure is much larger than that.

Spains loan, deposit, and portfolio investment liabilities (that is, liabilities that are

reasonably easy to liquidate) to foreign creditors is an order of magnitude greater than this.

Figure 9: The current account deficit has fallen, but stillrequires financing

Figure 10: A sudden stop in capital flows has been offset byfinancing channeled through Banco de Espaa

-140

-120

-100

-80

-60

-40

-20

0

20

Jan-91 Jan-96 Jan-01 Jan-06 Jan-11

Current account balance (bn euro)

-150

-100

-50

0

50

100

150

200

Jan-00 Jan-02 Jan-04 Jan-06 Jan-08 Jan-10 Jan-12

Banco de Espana ex BdE

Note: 12-month moving total. Source: Haver Analytics Note: 12-month moving total, billion euros.Source: Haver Analytics, Barclays Research

Figure 11: Spain has accumulated large liabilities to foreign investors

Assets Liabilities Net

International investment position 1,387.7 2,376.8 -989.1

Direct investment 496.4 480.1 16.3

Portfolio investment (ex-BdE) 257.5 873.6 -616.0

Loans, deposits, and other assets 539.3 847.8 -308.4

Banco de Espaa 94.5 175.4 -81.0

Source: Haver Analytics


14/22


4 May 2012 14

Spain also has considerable foreign assets. But the net international investment position is

still negative, in an amount equal to more than 90% of the Spanish GDP. And previous

experience has highlighted the fact that foreign assets are very often not in the hands of the

domestic borrower that needs to liquidate a foreign liability. When confidence is weak,

gross liabilities become at least as important as the net position.

There are no guarantees that the recent flight from Spanish assets will continue. There is in our

view nothing intrinsically unsustainable about the external position Spain is not the only

economy with large external liabilities, and the current account adjustment is well underway.

Indeed, if we define external sustainability as maintaining a constant ratio of net external liabilities

to GDP, Spain could afford to run a steady-state current account deficit in excess of 3% of GDP.

The vulnerability arises from the large stock of liabilities, not an unsustainable rate of foreign

borrowing. Keeping foreign creditors engaged on such a large scale requires confidence,

and there is a risk that foreign investors confidence in Spain will not soon recover. If it does

not, the flight from Spanish assets is potentially much larger than the rapidly dwindling

foreign ownership of government debt.

What next for Spain?

Managing the fiscal imbalances and the banking-sector fallout of the ongoing credit cycle does

not, in our view, require external official support. Neither the IMF, the EU, nor the ECB are likely to

be able substantially to improve the governments strategy for fiscal consolidation, and they are

certainly unable to improve the likelihood that political support for the adjustment will be

sustained in the difficult years to come. Indeed, external conditionality can serve as a lightning

rod for domestic opposition to painful adjustment measures. Recapitalising the banks may be

expensive, but in our view the expense will turn out to be very modest by the standards of

previous financial crises around the world, and in any event the required finance is domestic, not

international, and it need not even be raised in markets. In our view, these problems are

manageable by the Spanish authorities if political support for their strategy remains intact. And if

it does not, it is unclear what external policy bodies can do to remedy the situation.

What the Spanish authorities cannot manage on their own is sustained, large capitaloutflows of the sort that have recently been experienced in Spain. It is not impossible that

these will subside. A convincing resolution of uncertainties surrounding the banking sector

and strategy to secure fiscal sustainability should reduce underlying anxieties and reduce

capital outflows. But if it does not, external financial support will be necessary to prevent a

highly disruptive and disinflationary balance of payments crisis.

In the event that capital outflows continue and external financial support is needed, there

are two modalities that could, at least conceptually, address the external financing gap. The

first is support that is channelled through the ECB, through some combination of a

reactivated Securities Market Program (SMP), and something like the recent LTRO

operations, which would channel international liquidity to Spain via the banks, who may use

this to help fill the governments financing gap and cope with any funding gaps of their

own, without creating an even more destabilizing credit crunch. If outflows are limited in

size and duration, and the ECB retains political support to act as Spains international lender

of last resort, this may be sufficient. And given the political and economic complications

that may be involved in submitting Spain to a full-fledged IMF/EU/ECB program, it seems

likely that this approach would be the policy response of first resort.

However, given the magnitude of the external liabilities that could potentially attempt to exit

Spain, it is easily imaginable that the required financial support could outstrip the

eurozones willingness to respond through the ECB. In this case, there would be little

alternative to a full-fledged IMF/EU/ECB program.

Spains vulnerability arises

from its large stock of liabilities,

not an unsustainable rate of

foreign borrowing


15/22


4 May 2012 15

Appendix: Costs of the bank recapitalization

Our updated expected loss analysis

Consistent with our base case macroeconomic scenario, we estimate future expected losses

for the Spanish banking system of EUR198bn (see Figure 14). We expect NPLs to peak at

around 13% in H2 13 (excluding the effect of write-offs). While losses will increase across

all portfolios, real estate losses will represent the lions share: by our estimates, economicactivity and housing prices will continue to weaken and this will imply that the NPL ratio for

construction and developer loans will rise to 35%, from 20% currently. Average housing

prices could drop by an additional 20-25% for a total peak-to-trough adjustment of 35-

40%. Consequently, we estimate the average recovery rate in the construction and

development portfolio to be just 35%, consistent with an average loss severity of 90% on

land collateral and 55% on non-land.

Mortgage NPLs will continue to increase, in our view. Unemployment is expected to

continue rising through mid-2013, peaking at c.26%. We expect 12 month-euribor, the

base rate for Spanish mortgages, to remain below 2.5% over the next 1.5 years, which will

partly cushion the impact of the increase in unemployment. Considering these two factors,

we see the residential mortgage NPL ratio rising to 5.0%, from 2.8% currently. We expect anaverage loss severity on residential mortgages of 20%, based on the following LTV analysis.

Figure 12 shows the as reported current distribution of non-performing mortgages by LTV

bucket, which we smooth for analytical purposes. Banks update mortgage LTVs based on

indexed house prices, which we believe are not fully reflective of the true value of the

collateral backing delinquent mortgage exposures. For this reason, we make an initial

adjustment to reported LTVs equivalent to a 10% decline in house prices, which has already

occurred but is not reflected in reported numbers. To the result, we apply a 25% fall in real

estate prices, in line with our expectation. The result is an average expected loss on

delinquent mortgages of 15%. Under this scenario, over half of all non-performing

mortgages would be in negative equity (Figure 13). We finally add foreclosure costs of 5pp

to arrive at our 20% expected loss assumption.

Figure 12: Distribution of non-performing mortgages by LTV

Figure 13: Portion of mortgage NPLs in negative equity after25% further decline in house prices, after adjustments

0.000

0.002

0.004

0.006

0.008

0.010

0.012

0.014

0.016

0.018

0.020

0% 20% 40% 60% 80% 100% 120% 1 40%

Smoothed Actua l

0.000

0.002

0.004

0.006

0.008

0.010

0.012

0.014

0.016

0.018

0.020

0% 20% 40% 60% 80% 100% 120% 140%

Source: Company data, Barclays Research Source: Company data, Barclays Research


16/22


4 May 2012 16

We have also estimated bank losses under an alternative stress scenario where we assume

lower growth in 2012 (-4% real GDP) and 2013 (-2%) and housing prices falling by 35%

from current levels. In this stress scenario total expected losses would amount to

EUR266bn.

Figure 14: Spanish banking system, estimated future expected losses

Gross balances (EUR bn) Baseline Stress

Retail mortgages 656 656

Other retail loans 137 137

Real Estate Corporate and Construction Loans 397 397

Real estate assets (acquired) 95 95

Non-Real Estate Loans 545 545

Other Loans 45 45

Total Exposure Relating to Lending Activities 1,880 1,880

NPL ratio (% of exposures)

Retail mortgages (2.8% currently) 5.0% 6.5%

Other retail loans (6.9% currently) 14.0% 18.0%

Real Estate Corporate and Construction (20.1% currently) 35.0% 40.0%

Real estate assets (acquired) 100.0% 100.0%

Non-Real Estate Corporate Loans (4.9% currently) 8.0% 10.0%

Other Loans (2.7% currently) 5.5% 7.0%

Loss Severity (% of delinquent balances)

Retail mortgages 20% 30%

Other retail loans 85% 100%

Real Estate Corporate and Construction 65% 75%

Real estate assets (acquired) 65% 75%

Non-Real Estate Loans 50% 65%

Other Loans 60% 80%

Expected Loss (EUR bn)

Retail mortgages 7 13

Other retail loans 16 25

Real Estate Corporate and Construction 90 119

Real estate assets (acquired) 62 71

Non-Real Estate Loans 22 35

Other Loans 1 3

Total Expected Loss on Lending Activities 198 266

Expected Loss (as % of exposures)

Retail mortgages 1% 2%

Other retail loans 12% 18%

Real Estate Corporate and Construction 23% 30%

Real estate assets (acquired) 65% 75%

Non-Real Estate Loans 4% 7%

Other Loans 3% 6%

Total Expected Loss on Lending Activities 11% 14%

Buffers

Stock of provisions 110 110

Uncovered losses 88 156



17/22


4 May 2012 17

Against the lifetime expected losses, 198bn in our base case, banks have already set aside

110bn of provisions, leaving 88bn of uncovered sector losses at the end of 2011. These

will not be entirely funded by the public sector, though. In addition to bank earnings,

bondholder involvement can lessen the impact of bank recapitalisations on public finances,

while other proposals such as the creation of bad banks, can have the potential to mitigate

the need for public sector support.

Potential for bondholder involvement

In light of the potential capital shortfall faced by many banks, we expect the Spanish

authorities and the banks themselves to continue looking for additional sources of capital.

One key source is subordinated debt, which banks can buy back at a discount or swap into

equity. Over recent months, Spanish listed banks have launched several capital

management transactions, which have allowed them to improve their core capital levels by

over 12bn in aggregate. Most of these transactions have taken the form of debt-for-equity

exchanges. Transactions undertaken by non-listed institutions have come in the shape of

discounted debt buybacks.

Figure 15: Aggregate capital structure of Spanish banks

12.2 9.5

22.73.7

4.0

8.1

10.8

5.0

15.9

10.8

7.1

18.3

0

10

20

30

40

50

60

70

80

LT2 UT2 T1 Total

Rest Bankia/BFA

La Caixa/Caixabank BBVA/SANTAN

Source: Bloomberg, company data, Barclays Research

Banks will likely continue using liability management transactions to strengthen their capital

bases. Although these transactions have been investor-friendly to date, such lenient

treatment of bondholders may change if sovereign debt pressures persist. In fact, with the

sector reform approved in February, the government already allowed banks to defer coupon

payments on tier 1 securities to comply with the new provisioning requirements. Pressed for

capital, banks could seek to further these measures by deferring hybrid coupons

indefinitely, launching deeply discounted liability management transactions, or setting up

bad banks, which allows them to allocate losses to specific sub-sets of liabilities (see

European Banks: Completing the Spanish banking sector clean-up). As shown in Figure 15

above, Spanish banks have an aggregate subordinated debt buffer of 65bn. Excluding

BBVA, Santander and Caixabank, which we view as the most solvent institutions in the

country, the buffer is 31bn, which we believe could provide an additional capital cushion of

10bn going forward.


18/22


4 May 2012 18

Sector-wide bad bank could increase transparency but not reduce fiscalcosts of banking

In recent weeks, the Spanish government has been toying once again with the idea of

creating a bad bank to hold the problem assets of the Spanish banking system. Figure 16

below shows the bad bank structure alluded to in the press. Banks would transfer their

problem assets to a newly created asset management company (AMC or bad bank). In

return, the banks would receive equity stakes in these AMCs; this means that banks would

continue to indirectly own the problem assets. However, problem assets would be

deconsolidated from the banks balance sheets, as no single bank would own more than

50% of the AMC.

Figure 16: Bad bank structure as currently envisaged

Bad bankequity

Trouble assets

Bank A

Bank B

Trouble assets

Bad bankequity

Bank C

Troubleassets

Bad bankequity

BAD BANK

Post-transfer losses Post-transfer losses

Post-transferlosses

Bad bankequity

Trouble assets

Bank A

Bank B

Trouble assets

Bad bankequity

Bank C

Troubleassets

Bad bankequity

BAD BANK

Post-transfer losses Post-transfer losses

Post-transferlosses


A key element in this process would be asset valuation. The Spanish authorities could

appoint an independent valuation agent, which would value the assets before the transfer. If

the valuation haircut exceeds the provisions already set aside by the banks, a loss equal to

the shortfall would be incurred, reducing the banks capital base. Some banks may need to

be recapitalised as a result.11.In contrast, if the haircuts end up being too lenient, post-

transfer losses would be born by the bad bank owners, which are the banks themselves.

Either way, the banks would continue to be liable for losses on problem assets. The Spanish

authorities could also opt for the creation of a publicly owned bad bank, which would shield

banks from losses materialising after the assets have been transferred however, losses

would fall on the public accounts instead. In our view, in the absence of external investors,

the creation of a sector-wide bad bank will not reduce the fiscal costs of banking sector

recapitalisations. However, it can still improve investor confidence, if accompanied by a

credible asset valuation process. This could pave the way for a return of private foreign

capital into the country. However, the process may reinforce investor concerns if thevaluation process shows large provisioning shortfalls.

11 A potentially positive element of a programme (EU/IMF) is that the supervisory authorities would very likely beforced (as part of the loan conditionality) to carry out an independent review of the loan portfolio as well as of thelegacy real estate assets to be transferred to the AMCs (possibly similar to Irelands PCAR exercise of March 2011). Inour view, that process is important to credibility and put a ceiling to the estimated losses from the problem real estateexposures


19/22


4 May 2012 19

Bottom line: an additional 50bn of public sector support likely in 2012-13

Starting from our 88bn of uncovered sector losses, we arrive at an additional cost of

banking sector recapitalisations of 46bn in our base case, on top of the 16bn of capital

already provided, taking the total costs of bank recapitalisations to 62bn (Figure 17). Pre-

provision profits have remained resilient in recent quarters, supported by cheap LTRO

funding and we estimate that the sector could generate 30-35bn of pre-provision profit a

year. Of this, however, only a fraction can be offset against sector losses, because excess

profits in stronger banks cannot be applied to cure losses in weaker institutions. As we

showed in The new Spanish banking sector reform: Credit, macro, and equity implications,

the 50bn of additional provisions implied by the governments February banking reform

can only be reduced by 30bn after two years of earnings. In addition, subordinated

bondholder involvement can also lower the need for public capital injections, by around

10bn according to our estimates, while remaining assets within the Deposit Guarantee

Fund could provide an additional 2.0bn cushion.

Figure 17: Bad bank structure as currently envisaged (mn)

Barclays estimate of uncovered lifetime losses 88,000

loss absorption afforded by 2 years of pre-provision profits -30,000

potential bondholder involvement -10,000

assets within the FGD (after capital injection into CAM) -2,000

Requirement for additional public sector support, not yet deployed 46,000

Funded public capital injections provided to date 16,000

Total cost of banking sector recapitalisations 62,000


The table below summarises the public support provided to the Spanish banking sector to

date. Funded capital injections have totalled 16bn, of which 15.4bn have been provided

by the FROB and 600mn by the FGD. In addition, the FGD has committed funds of 5.3bn

to be injected into CAM prior to its acquisition by Sabadell, and it has provided assets

protection schemes on almost 24bn, as part of the disposal process of nationalisedlenders. Pending sales of Banco de Valencia, CatalunyaCaixa and NovaCaixaGalicia, now

controlled under FROB control, will likely add to this buffer of contingent liabilities in the

coming months.

Figure 18: Summary of public sector support provided to banks to date (mn)

Pre-FROB intervention of CCM 596

Initial cost of FROB 1.0 (ex. Banco Base) 9,674

Total cost of FROB 2.0 (ex. CAM) 4,751

Capital injection into Banco de Valencia 1,000

Funded public capital injections provided to date 16,021Capital injections committed to date (not yet funded) 5,250

Potential losses on asset protections schemes granted to date 23,907

of which CCM 2,475

of which CajaSur 392

of which CAM 16,640

of which Unnim 4,400

Gross loss exposure of Spanish public sector, to date 45,178



20/22

Analyst Certification(s)We, Antonio Garcia Pascual, Michael Gavin, Piero Ghezzi and Jonathan Glionna, hereby certify (1) that the views expressed in this research report accuratelyreflect our personal views about any or all of the subject securities or issuers referred to in this research report and (2) no part of our compensation was, is orwill be directly or indirectly related to the specific recommendations or views expressed in this research report.

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