FT Alphaville " A week of Spain-related excitement is not over just yet Spain has been grabbing the headlines all this week and while it may be Friday afternoon, the excitement isn't over just yet. Moody's is widely expected to announce whether it's going to downgrade Spain's Baa3 credit rating (possibly to junk) Friday after the European markets close. Oliver Wyman's second audit of the country's banking system should come out around the same time. Ahead of all that we wanted to talk you through a quick recap of the latest developments because, as UBS strategist Justin Knight rightly points out, "the areas of concern are now becoming numerous" and it's making the question of when Spain might request aid increasingly complex. Starting with the ESM and direct bank recapitalisation (emphasis ours): The bond market reacted sharply on Tuesday and Wednesday to the part of the statement issued by the finance ministers of Germany, Netherlands and Finland in which they ruled out allowing the ESM to take over (as opposed to merely financing) the Spanish state's current bank recapitalisation scheme in the future. This development once more raises the spectre of potential EFSF/ESM subordination of bond holders in the event of a restructuring. While it could be argued that the possibility of ECB bond buying makes the probability of Spanish debt restructuring less likely (particularly as the ECB has formally declared itself on an equal seniority status with existing bondholders), it means that any future set-back in the Spanish market could be more severe than it otherwise would have been. On the question of whether the ESM could take over pre-existing bank recapitalisation schemes, Knight reckons Tuesday's statement makes it highly unlikely: The difficulties of a new common supervisory body automatically accepting all of the prior decisions made by a government in recapitalising its banking system would make it likely that the ESM would only be involved in injecting capital via new schemes. Then there's the issue of the Catalan elections, brought forward to November 25. They could be followed by a referendum on independence. While the chances of an independent Catalonia any time soon are pretty small, the political mood there makes it very difficult for Madrid to press too hard for financial austerity, given that it will just drive the Catalans further into the arms of the separatists. The government is in a very difficult position because it also can't afford to indulge the province with concessions and sweeteners (the usual way of dealing with secession crises) because the country's deficit is already off target. Back to Knight: To be legal, referendums of this kind need to carry approval by the central government, something which may prove difficult to acquire, if only for the reason that the Spanish constitution does not allow for the secession of regions. Mr. Mas has said that he will go ahead with the referendum whether he secures permission or not. It is easy to envisage further market weakness if tensions increase at that point, were it to be reached. It is important to note that many very important questions around dissolving common structures and apportioning common assets and liabilities (not to mention those around EU and euro membership) would have to be answered before secession became reality. Additionally, a way around the Spanish constitution would need to be found - it not only has no provision for regions to secede but also states in Article 2 that it is "founded on the indissoluble unity of the Spanish nation." Even without a convincing prospect of secession, the Catalan situation is a real problem for prime minister Mariano Rajoy. The strength of feeling in the region will have to be dealt with one way or other by Madrid, even if the government is able to block actual independence. The region limits what Rajoy can achieve in terms of austerity measures. The government also seems likely to delay a formal aid request until after Catalonia's elections, given that the conditions which would come with a eurozone bailout would be a great gift to Artur Mas, the Catalan leader who is calling for a referendum. Further delays in requesting the aid, until the government's hand is forced by the market, is flagged up as a key risk by Knight. But he notes three reasons why a delay is likely nonetheless (emphasis ours): Enhanced conditions and greater scrutiny The insistence of the ECB that it will only (but not automatically) buy bonds of a country if it is in a full adjustment programme or in an "Enhanced Conditions Credit Line" (ECCL) suggests that conditionality vis-à-vis deficit and structural reform would be greater than that which the Spanish state had already signed up to in its existing aid programme for bank recapitalisation. In addition, the fact that the ECB will invite the IMF into a monitoring role would suggest that scrutiny over implementation of reforms would be also greater - and take place in real time. Deputy prime minister Soraya Saenz de Santamaría said in a radio interview on Tuesday that the Spanish government would need to be told by how much the ECB would intervene in the bond markets before it could make the decision to request aid. While it holds its own logic, a statement of this kind would not suggest that the Spanish government is currently on the point of requesting aid. A likely miss of the deficit target According to UBS economics, the 2012 Spanish general government budget deficit is likely tobe greater than 7%, compared to a current official target of 6.3% and that next year's target of 4.5% is unlikely to be met either... Although on Thursday the Spanish government said that the 2012 target would be met, data released earlier in the week suggested that the central government's deficit up to August was 4.26% (net of extraordinary items) versus the whole year's target of 4.5%. Past seasonality of central government budget balances would suggest that monthly deficits do not improve from here into year-end. Whatever one's viewpoint, it is clear that at very least there is a risk that the target might not be achieved. Were that to be the case, the Spanish government in an ECCL programme would suffer slippage by the time of the first review, and the consequence of that could be immediate demands by the troika for extra reform measures. It is reasonable to believe that this also forms part of the Spanish government's thinking. Elections in Galicia On 21 October, scheduled regional elections will be held in Galicia and in the Basque country. According to recent opinion polls, the ruling centre right Partido Popular (PP) may not achieve an overall majority in Galicia. The region is a traditional stronghold for the centre right, with other parties being in power for only 7 of the 37 years since the democracy era began. During much of the period, the regional government was led by the late Manuel Fraga, a founding father of the PP and of its predecessor party. It is also the home region of Spanish primeminister Mariano Rajoy - who may wish to wait until after elections have taken place beforeexplaining the aid package, and its conditions, to the Spanish people. But back to Friday's events. Moody's said back in August that it will base its decision on whether to downgrade the sovereign's rating on three things. First, the bank audits; second, the availability of bailout funds following the ruling by the German constitutional court; and lastly, any changes in the EU's approach to managing the crisis (namely the likelihood of a banking union). Oliver Wyman is widely expected to conclude from its audit that the Spanish banking system needs around €60bn to recapitalise. And Karsruhe has given the ESM the green light. So unless the the audit turns out to be worse than expected, Spain only has the crisis-management point worry about. Knight notes: It would seem to us that the greatest risk here is whether the ratings agency reacts to the joint finance ministers" statement discussed above. At least there's not long to wait to see what happens. Related links: Viva España? Spain's other crisis - FT Alphaville Separatism threatens the future of Spain - FT This entry was posted by Masa Serdarevic on Friday, September 28th, 2012 at 14:53 and is filed under Uncategorised. Tagged with Artur Mas, catalonia, ESM, Mariano Rajoy, moody's, oliver wyman, Spain.