ECONOMICS RESEARCH

4 May 2012

EURO THEMES Spain Dealing with sudden reversals

Market anxiety about Spain has flared up again. It has been reawakened by a very 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 six months, 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 a serious threat to the countrys economic and financial stability. We have not changed our view, put forward in July 2010, that Spain remains solvent 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.

Antonio Garcia Pascual +44 (0)20 3134 6225 antonio.garciapascual@barcap.com Michael Gavin +1 212 412 5915 michael.gavin@barcap.com Piero Ghezzi +44 (0)20 3134 2190 piero.ghezzi@barcap.com Jonathan Glionna +44 (0)20 3555 1992 jonathan.glionna@barcap.com Miguel Angel Hernandez, CFA +44 (0)20 7773 7241 miguel.a.hernandez@barcap.com www.barcap.com

A sudden stop in capital flows has been offset by financing channeled through Banco de Espaa
200 150 100 50 0 -50 -100 -150 Jan-00 Jan-02 Jan-04 Jan-06 Jan-08 ex BdE Jan-10 Jan-12

Banco de Espana

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

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Barclays | Euro Themes: Spain - Dealing with sudden reversals

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 the fiscal 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 moving into a double-dip recession; and price action in government bond markets that was interpreted by some as evidence that the palliative effects of the ECBs recent LTRO operations were beginning to reach their limit.

Spains economic and financial challenges appear to have been exacerbated by large capital outflows

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 to November 2011 levels
500 400 300

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

120 100 80 60

200 100 0 Dec-07

40 20 0 Dec-07

Dec-08

Dec-09

Dec-10

Dec-11

Dec-08 MSCI Spain

Dec-09

Dec-10

Dec-11

10-year sovereign spread to Germany (bp)

Source: Bloomberg Source: Bloomberg

MSCI Spain (financials)

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Barclays | Euro Themes: Spain - Dealing with sudden reversals

The fiscal swing required to stabilise public debt is within the realm of historical precedent

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 to achieve 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

Market anxiety about a potential public credit event looms large as a potential amplifier of the crisis

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 fiscal imbalances 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 important risk 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-sector stress test (Debt of the general public sector, % of GDP)
110% 100% 90% 80% 70% 60% 50% 40% 30% 2000 2005 2010 Base case
Source: Barclays Research

2015

2020

2025

2030

Higher cost bank recapitalization

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Barclays | Euro Themes: Spain - Dealing with sudden reversals

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 in 2013. 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 of 3.75%, 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 and thereafter. (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 budget balance 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 be slightly 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 and most 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 the administration 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 2

The average maturity of the outstanding stock of public debt is about 6.6 years. 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, Spains public debt is projected to stabilise at a level comparable to that of France, with a more pronounced downward trend. A risk premium comparable to Frances (now about 135bp) would therefore be plausible; 320bp strikes us as very conservative.

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Barclays | Euro Themes: Spain - Dealing with sudden reversals

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 Real GDP growth Inflation Nominal GDP growth Average interest rate on new debt Fiscal cost of bank recapitalization Other extraordinary fiscal costs Primary fiscal balance 0.70% 1.37% 2.09% --1.40% 0.00% -6.10% 2012 -2.00% 1.20% -0.80% 6.00% 2.35% 4.22% -3.30% 2013 -0.20% 1.20% 1.00% 6.00% 2.32% 0.00% -1.60% 2014 1.00% 1.75% 2.75% 6.00% 0.00% 0.00% -0.15% 2015 1.50% 1.75% 3.25% 6.00% 0.00% 0.00% 1.10% Long run 1.75% 2.00% 3.75% 6.00% 0.00% 0.00% 2.25%

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

Under these assumptions, the Spanish public debt dynamics look precarious in the near term, 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 that would, 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, during which it was arguably easier to maintain a healthy fiscal position. However, the primary budget surplus averaged 2.15% during the pre-boom period 1998-2003, suggesting that a primary surplus of this magnitude should be attainable during more normal economic and financial conditions.

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Barclays | Euro Themes: Spain - Dealing with sudden reversals

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)
110% 100% 90% 80% 70% 60% 50% 40% 30% 2000 2003 2006 2009 2012 2015 2018 2021 2024 2027 2030

Base case
Source: Barclays Research

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.
Assuming the long-run scenario remains intact, the Spanish debt dynamics look reasonably robust to temporary or cyclical developments

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 might lead 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 we consider 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 in GDP. This adjustment in the budget balance has more impact on the debt dynamics than the GDP shortfall itself.

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Barclays | Euro Themes: Spain - Dealing with sudden reversals

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 have argued that austerity is largely, if not totally, self-defeating

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 undermines fiscal 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, that the 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

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

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Barclays | Euro Themes: Spain - Dealing with sudden reversals

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-loaded fiscal 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 0.6 7 and t around 0.5, which means that a 1% fiscal consolidation only produces an effective deficit reduction of 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
If m*t is greater than one, the number 1/(1-m*t) could be negative. This describes a world in which a Keynesian Laffer curve exists, such that an increase in public spending would create such a powerful effect on demand and economic 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 the fiscal contraction cannot be offset with a decline in the interest rate (which is determined by the ECB, in Frankfurt). We think this is an inappropriate conclusion for Spain, where country risk has become an important determinant of asset prices 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) in an expansionary fiscal consolidation. We would not, however, go so far in Spain under present conditions. Spains status as a small, open economy also tends to generate a smaller multiplier than might be seen in a larger, more closed economy. 8 At least in the short run. Most Keynesian models have the property that demand shocks from fiscal and monetary policy have only temporary effects on economic activity. In the long run (of some unspecified duration), through various 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 mainly threefold: first, the government is probably using multipliers (ie m and t) of smaller size than ours, we think because the 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 2013-15 for which we do not have details yet; we are simply assuming a more conservative path than the governments. Third, we are also assuming slightly less fiscal adjustment in 2012 than the government, in particular we are excluding the EUR2.5bn expected revenues from a tax amnesty, which may or may not yield such revenues.
6

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Barclays | Euro Themes: Spain - Dealing with sudden reversals

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 countercyclical 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 consolidation strategy 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

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 the banking 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.

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Barclays | Euro Themes: Spain - Dealing with sudden reversals

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 corporate income 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?
There is at least a small risk that even a coherent program will unravel, because of unfavourable external conditions or a domestic political shock

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, which can 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 the event that rollover of amortizing bank debt was not complete. This may have been the most important element of the LTRO, but in this section we are focused on the public finances.

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Barclays | Euro Themes: Spain - Dealing with sudden reversals

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 a severe, but not unthinkable, scenario, which incorporates the following elements:

Domestic banks finance 80% of the general governments net issuance in 2012 and 2013 (with other local institutions assumed to finance the remaining 20%). Domestic banks have already accommodated a massive reduction in foreign investors exposure 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 the banking 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 Bank exposure to general government as % of: GDP Public debt Bank capital and reserves Bank assets
Source: Haver Analytics, Barclays Research

Dec-10

Dec-11

Feb-12

Dec-12

Dec-13

21% 38% 79% 7%

22% 37% 83% 7%

26% 38% 76% 8%

30% 43% 85% 9%

39% 48% 105% 12%

49% 55% 136% 16%

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.

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Barclays | Euro Themes: Spain - Dealing with sudden reversals

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 size of 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, the central 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 the future?

300% 250% 200% 150% 100% 50% 0% 1970 1975 1980 1985 1990 1995 2000 2005 2010 Bank exposure to gen'l government (% of capital and reserves)
Source: Haver Analytics

Figure 8: Spanish banks exposure to the nonfinancial private sector has been falling since 2008 (EUR bn)
2,000 1,750 1,500 1,250 1,000 750 500 2000

2003

2006

2009

2012

Credit system exposure to private sector

Source: Haver Analytics

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Barclays | Euro Themes: Spain - Dealing with sudden reversals

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 recent months, 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 still requires financing
20 0 -20 -40 -60 -80 -100 -120 -140 Jan-91 Jan-96 Jan-01 Jan-06 Jan-11

Figure 10: A sudden stop in capital flows has been offset by financing channeled through Banco de Espaa
200 150 100 50 0 -50 -100 -150 Jan-00 Jan-02 Jan-04 Jan-06 Jan-08 Jan-10 Jan-12

Current account balance (bn euro)

Note: 12-month moving total. Source: Haver Analytics

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

ex BdE

Figure 11: Spain has accumulated large liabilities to foreign investors

Assets International investment position Direct investment Portfolio investment (ex-BdE) Loans, deposits, and other assets Banco de Espaa
Source: Haver Analytics

Liabilities 2,376.8 480.1 873.6 847.8 175.4

Net -989.1 16.3 -616.0 -308.4 -81.0

1,387.7 496.4 257.5 539.3 94.5

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Barclays | Euro Themes: Spain - Dealing with sudden reversals

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.
Spains vulnerability arises from its large stock of liabilities, not an unsustainable rate of foreign borrowing

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 capital outflows 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.
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Barclays | Euro Themes: Spain - Dealing with sudden reversals

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, economic activity 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 3540%. 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 an average 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 after 25% further decline in house prices, after adjustments
0.020 0.018 0.016 0.014 0.012 0.010 0.008 0.006 0.004 0.002 0.000 0% 20% 40% 60% 80% 100% 120% 140%

0.020 0.018 0.016 0.014 0.012 0.010 0.008 0.006 0.004 0.002 0.000 0% 20% 40%

Smoothed

Actual

60%

80%

100% 120% 140%

Source: Company data, Barclays Research

Source: Company data, Barclays Research

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Barclays | Euro Themes: Spain - Dealing with sudden reversals

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) Retail mortgages Other retail loans Real Estate Corporate and Construction Loans Real estate assets (acquired) Non-Real Estate Loans Other Loans Total Exposure Relating to Lending Activities NPL ratio (% of exposures) Retail mortgages (2.8% currently) Other retail loans (6.9% currently) Real Estate Corporate and Construction (20.1% currently) Real estate assets (acquired) Non-Real Estate Corporate Loans (4.9% currently) Other Loans (2.7% currently) Loss Severity (% of delinquent balances) Retail mortgages Other retail loans Real Estate Corporate and Construction Real estate assets (acquired) Non-Real Estate Loans Other Loans Expected Loss (EUR bn) Retail mortgages Other retail loans Real Estate Corporate and Construction Real estate assets (acquired) Non-Real Estate Loans Other Loans Total Expected Loss on Lending Activities Expected Loss (as % of exposures) Retail mortgages Other retail loans Real Estate Corporate and Construction Real estate assets (acquired) Non-Real Estate Loans Other Loans Total Expected Loss on Lending Activities Buffers Stock of provisions Uncovered losses
Source: Barclays Research

Baseline 656 137 397 95 545 45 1,880 5.0% 14.0% 35.0% 100.0% 8.0% 5.5% 20% 85% 65% 65% 50% 60% 7 16 90 62 22 1 198 1% 12% 23% 65% 4% 3% 11% 110 88

Stress 656 137 397 95 545 45 1,880 6.5% 18.0% 40.0% 100.0% 10.0% 7.0% 30% 100% 75% 75% 65% 80% 13 25 119 71 35 3 266 2% 18% 30% 75% 7% 6% 14% 110 156

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Barclays | Euro Themes: Spain - Dealing with sudden reversals

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
80 70 60 50 40 30 20 10 0 LT2 UT2 T1 Total 10.8 8.1 10.8 3.7 12.2 7.1 5.0 4.0 9.5 22.7 15.9 18.3 Rest La Caixa/Caixabank Bankia/BFA 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.

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Barclays | Euro Themes: Spain - Dealing with sudden reversals

Sector-wide bad bank could increase transparency but not reduce fiscal costs 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

Bank B
Trouble assets Trouble assets Bad bank equity

Post-transfer losses
Trouble assets

Bank A
Bad bank equity

BAD BANK
Bad bank equity

Bank C

Post-transfer losses

Post-transfer losses

Source: Barclays Research

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, posttransfer 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 the valuation process shows large provisioning shortfalls.

11

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

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Barclays | Euro Themes: Spain - Dealing with sudden reversals

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). Preprovision 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 loss absorption afforded by 2 years of pre-provision profits potential bondholder involvement assets within the FGD (after capital injection into CAM) Requirement for additional public sector support, not yet deployed Funded public capital injections provided to date Total cost of banking sector recapitalisations
Source: Barclays Research

88,000 -30,000 -10,000 -2,000 46,000 16,000 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 nationalised lenders. 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 Initial cost of FROB 1.0 (ex. Banco Base) Total cost of FROB 2.0 (ex. CAM) Capital injection into Banco de Valencia Funded public capital injections provided to date Capital injections committed to date (not yet funded) Potential losses on asset protections schemes granted to date of which CCM of which CajaSur of which CAM of which Unnim Gross loss exposure of Spanish public sector, to date
Source: Barclays Research

596 9,674 4,751 1,000 16,021 5,250 23,907 2,475 392 16,640 4,400 45,178

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