FT Alphaville " Funding Spain and the year of the negative feedback loop On Friday, FT Alphaville discussed the process of de-euroisation that is currently underway as foreign investors continue to withdraw from the sovereign bond markets of peripheral countries. For Spain and Italy, the issue is of particular concern, as the ability and willingness of remaining investors to fund them will, in large part, determine whether the or not countries will need to be bailed out. According to research analysts at Credit Suisse though, the recent focus on Spain, rather than Italy, is misplaced: We remain cautious, but increasingly on Italy rather than Spain at current levels - the news flow from Spain is likely to be negative - the economic backdrop is ugly, the regions will be difficult to get under control, and much remains to be done to sort out the banking sector. Part of that sorting out of the banking sector will mean the (hopefully) slow, though unavoidable, painful recognition of loans turned sour due to the housing bust. Eventually that may bite enough that Spain has to bailout some of its lenders. But before that happens, the same banks have busily been stepping into the hole left by foreign investors and funding their sovereign. Banks scratch sovereign's back now, sovereign scratches banks" backs later if needs be? In any case, the Credit Suisse analysts think that Spanish banks have already done quite a lot of scratching of their sovereign's back and they don't even have much more to do for 2012, as a lot of the required issuance has already been done. That whole 10-year yields being above 6 per cent thing, may be rather scary if it were to persist, but the analysts are keen to point out that those levels were breached in the absence of much actual trading. Italy, by contrast: Italy has remained relatively under the radar during the Easter weakness but has considerable supply requirements which it is less clear the domestics will be able to support. To make the relative positions of the sovereigns quite clear, the analysts submit as evidence the amount of funding Spanish banks got from the ECB's long-term refinancing operations (LTROs) that provided three years" worth of funding at bargain rates (click to expand): The above shows Spanish banks gobbling up a substantial €202bn of net funding. Meanwhile, here's what's needed to cover the sovereign's funding requirements for the rest of the year: Spanish banks currently have €89bn on deposit with the ECB. Between December and February, they purchased €62bn of government bonds and experienced deposit flight of €23bn. From these numbers, and the above calculation, it seems quite reasonable to assume that the domestic banks will be able to meet their sovereign's needs through 2012. There is, however, something about all of this that feels like doubling-down. Consider the example the Credit Suisse analysts give of Italy's UniCredit: On this point, it was interesting to note this week that the chief executive of UniCredit felt the need to state that the bank's holding of Italian government bonds had not increased since the end of December (€38 billion). Although the stigma of taking LTRO cash may still not be clear cut (but we believe likely to be viewed increasingly as negative), stronger banks clearly do not want to be seen to be increasing their sovereign exposures. Which reinforces our view that it is the weak "captured" domestic banks that have nothing to lose that have been putting on the Sarkozy carry-trade and increasing their domestic sovereign exposure. Any indication that the stronger banks are increasing their Spanish and Italian government bond holdings we would therefore take as a negative signal. The eurozone sovereign crisis is, as many will have already suspected for some time, at the point where all the unhealthy banks and their struggling sovereigns are tying themselves to each other. Maybe this will make them stronger, and maybe they'll just all fall off the cliff together. Pause of now familiar visions of slow motion train wreck. All of that said, even with the frighteningly shared fate of banks and sovereigns, the message we take from this is that unless there is some frightening deposit flight, it is likely that the Spanish sovereign can be funded from domestic sources, as perverse as it may seem that the weakest are likely to be helping the most. It is in this environment, with at least some of the pressure off, that the government can attempt this task: The government must play a fine balancing act - implementing sufficient reforms so that markets (and European policymakers) remain convinced that Spain is addressing the underlying problems, but without dragging Spain into a negative austerity feedback loop. Gets list written on crumpled paper out of back pocket. Bank<-> sovereign feedback loop Credit valuation adjustments <-> credit default swap spreads doom loop Austerity <-> economic health That's it, we're calling it. 2012 - Year of the Negative Feedback Loop Related links: Bringing the debt home, Italian and Spanish banks edition - FT Alphaville De-euroisation is (still) de problem - FT Alphaville Eurozone credit contagion, in 8 easy steps - FT Alphaville Come back, sovereign feedback loop! - FT Alphaville Spanish bonds / banks / bonds / banks - FT Alphaville This entry was posted by Lisa Pollack on Monday, April 23rd, 2012 at 12:24 and is filed under Capital markets. Tagged with austerity, eurozone sovereign debt crisis, Italy, Spain.