Spain moves nearer to full-scale rescue

Is Spain heading towards a full-scale rescue?

Once again Spain, and to a lesser extent Italy, is being forced towards a full-scale eurozone/IMF rescue programme, because of the inter-connectedness of public-sector and banking liabilities.

As the price of Spanish government debt plummets, that generates losses for Spain's banks, which hold around 250bn euros of the country's government bonds, equivalent to a third of central government debt.

That then increases the size of the hole in their balance sheets, and therefore the scale of the official rescue from taxpayers they will eventually require.

But, as importantly, the more that investors and savers doubt Spain's creditworthiness, the more they doubt its ability to stand behind its banks.

This may not be wholly rational, given that the eurozone has promised 100bn euros of rescue funds earmarked specifically for rescuing Spain's banks. But it is also not wholly irrational, since it is by no means clear yet how, when and even whether the eurozone will succeed in turning that 100bn euros into a liability of the banks alone, without adding to the burden on the financially stretched Spanish state.

One consequence is that Spanish banks are becoming more and more dependent, for their very survival, on exceptional funding from the European Central Bank.

"The chilling statistics"

Here are the chilling statistics. In the first five months of the year, Spain's banks lost 3% of their deposits as savers moved their cash to perceived safe havens, such as Germany, or spent their accumulated savings to make up for the collapse in their incomes.

Meanwhile, in not much more than six months, Spanish banks' borrowing from the European Central Bank has risen from 106bn euros (in November 2011) to 365bn euros - or 9.5% of all their borrowing needs.

The relevant comparators are not encouraging. The banks of Ireland and Portugal, two countries already in formal rescue programmes provided by the Eurozone and IMF, are dependent on funding from the ECB to the tune of 13.5% and 10% of their respective liabilities.

Or to put it another way, the ECB's support for Spain's banks is already around the levels in Ireland and Portugal at which the ECB felt that enough was enough, and put pressure on eurozone governments to provide a full-blown rescue programme for those countries.

Which is partly why investors tell me they no longer believe that Spain can muddle through just with a rescue provided by the eurozone's bailout funds, the EFSF and ESM, of its banks.

What may have tipped it over the edge is the disclosure last week that Spanish regions, led by Valencia, will need loans from central governments so that they can repay their debts (some 15bn euros of Spanish regional government debt comes up for repayment in the second half of this year).

Spain's fragility is one you know well: the leg bone of an economy in a recession estimated to last two years is connected to the knee bone of undercapitalised banks is connected to the thigh bone of regions with debts they can't repay is connected to the hip bone of a government which cannot borrow at affordable rates.

Them financial bones stand or fall together, and right now they look set to fall.

Running out of time?

How much time does the Spanish government have to ward off disaster?

Well in part that is down to the patience of the European Central Bank - or rather its appetite to increase its exposure to Spain's banks.

It is also down to Spain's appetite for paying penal borrowing costs for a period.

What is particularly frightening about what has happened to Spanish debt prices today is not just that they imply Spain would have to pay an unaffordable 7.5% to borrow for ten years - which is the normal litmus of the difficulty being faced by a government when borrowing.

Perhaps more serious is that it would have to pay interest of 7.4% to borrow for five years and more than 6.5% when borrowing for as little as two years.

You, dear reader, would probably pay less than 6.5% when borrowing for two years. And you are not a sovereign government (I presume).

In other words, there is no temporary refuge for Spain in borrowing for shorter periods. Its day of reckoning, in the sense of a decision on whether to become the first really big eurozone economy to subject itself to the humiliation of being run from Brussels and Washington, by the European Commission and IMF, looms.