Spain escapes aid but doubts remain

Could Spain be about to pull off the greatest escape since Steve McQueen and Charles Bronson tunnelled their way out of a second world war prison camp in the 1963 film classic?

Ever since the European Central Bank unveiled its crisis-fighting programme last summer, strategists have confidently predicted it was only a matter of time before Madrid would be forced to ask for help. The economic outlook was simply too dismal and the borrowing needs too great for Spain to avoid the same fate as Greece, Ireland and Portugal.

But predictions for when the country would turn to the eurozone’s rescue fund – triggering the ECB’s Outright Monetary Transactions (OMT) bond-buying programme – have repeatedly proved wrong.

Counter to expectations, just the prospect of ECB aid has been enough to keep Spain’s borrowing costs subdued enough for Madrid to access markets.

“People assumed it would just be a matter of time before Spain asked for help, but the market rallied too hard for it to happen,” says Michael Krautzberger, head of European fixed income at BlackRock.

“I think Spain feels comfortable now, and I don’t think they will want to ask for help as long as they do.”

Indeed, many analysts now say Spain could manage to sidestep a programme altogether, as the possibility of ECB intervention continues to keep Madrid’s borrowing costs low for long enough for it to cut the budget deficit and get the economy back on track.

The two-year bond yield – one of the maturities the central bank could target – has plunged from a peak of more than 7 per cent last year to 2.59 per cent yesterday. It has remained at less than 3 per cent for almost a month.

“We are currently in a sweet spot where the OMT is inactive but is standing by reassuringly and everybody is benefiting from the status quo of low peripheral yields in some way,” Richard Crossley, a strategist at Citigroup, said in a note.

The decline in Madrid’s borrowing costs also reflects slightly better

fundamentals, not just the ECB backstop. The banking sector – long the biggest weight around Spain’s neck – is being restructured and recapitalised. International competitiveness and exports are improving faster than expected.

Spanish banks have also benefited from the improving outlook. Many were in effect locked out of funding markets for most of last year. Even after the ECB’s action bank bond issuance was sparse. But since the start of January, Spanish banks have sold more than $10bn of debt, according to Dealogic.

Nonetheless, some fund managers and strategists say the odds are still on Spain eventually being forced into a eurozone rescue programme.

They point out that despite the improvement in Spain’s current account, and bond yields subdued by the ECB’s promise, the economic backdrop is grim and likely to get even grimmer as budget cuts continue to bite.

“You can paint a rosy scenario for Spain, but so far the evidence shows that

it’s very hard to get a budget deficit under control through austerity against a weak economic backdrop,” says John Stopford, head of fixed income at Investec Asset Management.

The sheer scale of Spain’s borrowing requirement will be a major test of the reawakened investor appetite for Spanish debt. The Treasury expects to issue up to €120bn of bonds on behalf of the regions and the central government this year, but some analysts say even this estimate could prove too optimistic.

Raising the required amount will be much tougher if Standard & Poor’s or Moody’s downgrade Spain’s credit rating, which is currently one notch above “junk”. A downgrade by one or both agencies could be the trigger that pushes yields higher – and Spain into a programme.

Mr Krautzberger says it is more likely that spiking bond yields will spur the rating agencies into action than vice versa, but many investors remain wary of the downgrade risk.

Some sceptics also question whether Spain’s financial sector really is on the mend. Although the stronger banks have been able to access markets once more, the sector as a whole still needs more surgery before it can contribute to a recovery in the real economy.

“We don’t think the banking system will fix itself with time,” says Alastair Ryan, an analyst at UBS. “If the banking system is fundamentally broken, the tightening of sovereign spreads is of limited use.”

Spanish officials have been keen to insist that a programme is unnecessary but careful to keep the possibility of one alive – to ensure that investors at least have the option of ECB bond-buying to comfort them.

But even an implemented OMT programme is unlikely to push Spanish bond yields much lower, given that eurozone policy makers will want to keep pressure on Madrid. In fact, some investors say it could eventually backfire.

“Our sense is that the OMT works better as a threat,” says Mr Stopford, who recently sold Investec’s Spanish bond positions.

“If Spain actually entered a programme then people might realise that it’s not a panacea. It could be a matter of buy the rumour, sell the fact.”