When EUR100 billion is not enough!

As the weekend’s Spanish banking bailout fails to impress markets it is worth taking a step back to assess the situation.

On the face of things a pledge of up to EUR100 billion sounds like it should be good news, at least for the intended Spanish bank recipients. There are however a number of reasons why the broader 'audience' was singularly unimpressed by the actions of the Eurozone:

The claim by the Spanish Prime Minister (just before he jetted off to Gdansk to watch a football match) that the EUR100 bn plan to recapitalise his country’s devastated banks had “resolved” much of the cause of the crisis, was greeted with great scepticism. The first issue that the markets have with this claimed ‘resolution’ is that there remains huge uncertainty. The funds are not expected to be used for the ‘strongest’ of the embattled nation’s banks, but likely entirely for the Caja’s and the extent of the requirement is not likely to be revealed until the results of the current independent bank report.

Known unknowns
The second uncertainty comes from the delivery mechanism for the prescribed funds. The ESM, or European Stability Mechanism, will not be ready in time to provide the loan as the treaty that governs its functionality is still to be ratified by many countries. Its current ‘temporary equivalent’ the European Financial Stability Fund (EFSF) will therefore have to be used and this means that the payment will have to come via the Spanish bank bailout fund, FROB, and it will appear in the national accounts of Spain, thus increasing the gross national deficit by around 9 percent of GDP.

Circularity
This is where the circularity of the issues facing the Eurozone become apparent. The Spanish banks have recently become the dominant if not only buyer (and holder) of their own government's national debt. Therefore despite the fact that the ‘new’ bailout via the EFSF will not be senior to the current government debt bondholding (one minor benefit of the EFSF over the ESM in delivering the funds) because it raises the indebtedness of the nation, it pushes down the value of the debt held by the banks that the process was meant to protect in the first place. It is true that as long as the sovereign does not default on the debt then the banks will receive the notional amount of the bonds at expiry, however between now and their maturity, the devaluation of their asset holdings means that the Spanish banks may end up having less, and not more liquidity in order to function. This puts in doubt the ability of the Spanish lenders to do what was intended… lend!

Don’t call me Shiarly!
So after just a few hours of trading the dichotomy and uncertainty of the ‘bailout’ and the implications for Spain became the dominant factor over the ‘good news’ of a EUR100 bn investment. In addition to this, the announcement overnight from the Cypriot Finance Minister, Vassos Shiarly that Cyprus may have to become the fifth nation to require a bailout as its banks are so heavily exposed to the Greek economy has added to the concern.

Elsewhere, Quantitative Easing rhetoric in the US and UK has continued to pick up some momentum and while I still see it as contingent and not imminent in either country at the current juncture, the suggestion from Monetary Policy Committee member Adam Posen that he was “too optimistic” when he switched his vote away from further QE will increase uncertainty surrounding the Bank of England's path.

Glass half full in UK
As I see things, however, the glass remains half full in the UK. The Spanish bank bailout should be seen as a moderate positive for the UK on a relative basis, as while it is in no way a panacea to the ills of the Eurozone, it provides the banking sector with funds that likely insulate the UK financial services exposure to Spain, at least at the margin. Today may be a touch more reflective after the sharp turnaround in sentiment yesterday but I continue to favour GBP vs. EUR as the most efficient expression of short EUR - particularly if Federal Reserve commentators keep the prospect of QE3 in the US alive.