Spain – The Elusive Steady State

How the Euro Undermines the Traditional Adjustment Path For a Country Facing Fiscal and External Sector Imbalances
In recent weeks, hopes have increased that Spain may be heading towards a steady state. The emergence of a current account surplus suggests to some that the country is following the traditional adjustment path of a country facing a fiscal/ balance of payments crisis, while the European Central Bank’s (ECB) commitment to further unconventional monetary measures has stemmed capital flight. Unfortunately, we cannot share this optimism. The presence of the euro disrupts the traditional post-crisis adjustment path for Spain, and while aggregate capital flight from Spain has measured over 30% of GDP over the past year, we still fear a resumption of large-scale outflows. For now, the market is supported by investor belief in a “Draghi put”, and indeed for all of our medium-term concerns, we remain tactically long 2-year Spanish Government Bonds (SPGB) in our model portfolio. However, we expect a renewed bearish phase for peripheral markets soon after the ECB actually begins its Outright Monetary Transactions (OMT), and hence we are looking for opportunities to take profit on our long SPGB position and to increase the bearish bias in our portfolio of trade recommendations.

The Traditional Adjustment Path to a Steady-State Solution 
When countries encounter a fiscal and balance of payments crisis (it is rare that the former can occur without the latter), there is a traditional pattern of adjustment that can lead to a steady-state outcome.

· Fiscal and monetary policies are usually tightened, but a country’s currency is allowed to depreciate amid ongoing capital outflows.

· A weak currency can boost exports, thus providing a source of growth during a time of monetary and fiscal restraint.


Figure 1: Spain: Hopes are Rising for a Traditional Adjustment Path

Source: Nomura, CEIC

· A country’s external position strengthens as: 1) Trade and account imbalances start to improve, initially via import compression amid recession, but in time via exports. 2) An undervalued currency can entice fresh foreign buying of domestic assets/limit fresh outflows.

· Fiscal deficit financing becomes easier as: 1) A recession increases the pool of surplus liquidity available to invest domestically (the current account is just a measure of savings over investment). 2) By not intervening in foreign exchange (FX) markets, a central bank can prevent capital flight actually leading to money leaving the country. (If a central bank does not intervene, then a foreign bank will sell the domestic currency to a local bank, which will need to invest these funds domestically.)

The Signs of a Steady-State Solution in Spain… 
Some investors have expressed tentative confidence that Spain may be following this classic adjustment path. Spain’s current account is rapidly improving due to weak import demand. In July and August, Spain recorded current account surpluses, the first such surplus since August 1998 (see Figure 1 below). As a percentage of GDP, Spain’s current account deficit has shrunk to 2.9% of GDP in Q2 2012 (four quarter rolling sum) from 4.2% of GDP a year earlier and a peak of 10.6% in Q2 2008 (Figure 2). Moreover, as a sign of improved confidence, in September ECB funding of Spanish banks fell to €400bn from €411.7bn in August, while bank deposits increased by 0.1% m-o-m, the first gain since March, and there was a €18.4bn net increase in foreign holdings of SPGBs, the first since November 2011.

Figure 2: Recession Improve Spain’s External Accounts

Source: Nomura, CEIC


Figure 3: We Doubt the Nascent Export Pick-up Will be Maintained

Source: Nomura, CEIC


…and Why They are Illusory
The Growth Constraints – It’s Hardly Rocket Science 
However, in our view, hopes that Spain is approaching a steady-state equilibrium are likely to remain fanciful. Of particular concern is how the euro undermines the traditional adjustment path by inhibiting the capacity for Spain to generate export growth and by facilitating capital outflows.

We will not dwell too long on the first of these constraints – the capacity for growth – as it is fairly obvious to state that the euro has failed to depreciate to the level needed by Spain to generate strong export growth. With Spain denied the fillip of a maxi-devaluation, with policies of “internal devaluation” likely to prove deflationary for some years before it can transform export competitiveness, and with its eurozone trade partners embarking on a policy of pro-cyclical fiscal austerity, it is hard to see where a notable export recovery will come from over the short to medium term. We have little confidence that the recent pick-up in export growth – y-o-y exports rose 5.3% in August on a 3 month moving average (3mma) basis, the highest since last December (see Figure 3, above) – will prove the start of a sustained upswing.

In fact, economic conditions in Spain are in many respects even worse than the already weak GDP data suggest. Figure 4 (below left) shows that real GDP growth in Q3 2012 fell by 1.6% y-o-y (-0.3% q-o-q), and Nomura’s European economic research team believes that over the coming two years GDP will contract by a cumulative 6.1%. However, the contraction in GDP growth is moderated by an improved performance from the external sector. The -1.3% y-o-y drop in Q2 GDP would have been far worse if not for a 2.6 percentage point contribution from net trade. Domestic demand subtracted 3.9 percentage points (Figure 5, page 16). Weak import demand is driving this improved net trade performance. It is hard to boost tax revenue when growth is supported by lower imports, while weak domestic demand continues to diffuse credit risk throughout the Spanish economy and banking system.

Figure 4: Spain Faces a Multi-Year Recession…

Source: Nomura, CEIC


Figure 5: Percentage Point Contribution to y-o-y GDP Growth

Source: Nomura, CEIC


The Liquidity Constraint – the Euro as a Facilitator of Capital Outflows
The euro is a facilitator of capital flows. During the first decade of the euro, Spain was able to attract sizeable levels of capital inflows that saw the country’s Net International Investment Position (NIIPS, which measures Spanish foreign financial asset holdings minus foreign holdings of Spanish assets) rise from a deficit of 31.7% of GDP at end-1998 to a peak of 93.7% at end-2009. While Spain experienced a domestic asset bubble, there was no ancillary pressure for the currency to appreciate as Spain was part of the euro. Similarly, investors that were nervous about a possible property market collapse were able to draw comfort from the assumption that a hard economic landing would not lead to a devaluation of Spain’s currency.

The situation is now reversed, as the euro facilitates capital outflows:

· The euro is not sufficiently cheap to entice fresh foreign buyers of Spanish assets, or provide an FX valuation deterrent against fresh sellers of Spanish assets. Instead, foreign portfolio investment has tended to be tactical in nature and triggered by changing assumptions on the perceived “ECB put”.

· Eurozone investors – including Spanish institutions – can relocate their funds outside of Spain into core/ semi-core European countries without incurring adverse FX translation risks.

· In the vast majority of cases, when a central bank stops intervening to prevent its currency from depreciating, no currency actually leaves the country from that point on, even if the balance of payments show continued capital flight. This is because few currencies have value outside of their national borders. For instance, if investors sell the JPY then the bank that buys the currency can only reinvest these funds in JPY-denominated securities. However, in the case of Spain, the euro can be used across 16 other countries. This means that it is easier for capital flight to drain liquidity in the domestic banking system, which in turn requires exceptionally large ECB liquidity support to provide offsetting inflows.

· The unbounded balance sheet of the ECB provides significant ability to offset capital outflows by providing fresh loans to the Bank of Spain (BoS). This can help perpetuate capital outflows, as Spain does not yet have a traditional constraint such as a depletion of FX reserves, and nor is it facing a more notable tightening of domestic liquidity conditions in the banking sector as the ECB is providing an offsetting liquidity infusion.

Figure 6: BoS is Needed to Offset Private Sector Capital Flight

Source: Nomura, CEIC


Figure 7: Spain’s Elevated Target 2 Liabilities

Source: Nomura, CEIC


Need Capital Flight to Stop After a 30% of GDP Outflow? 
The ability of the EUR to facilitate capital outflows is evident in the sheer scale of the outflows that Spain has experienced in recent quarters. Figure 6 (below left) shows that Spain recorded a financial account surplus of 3.3% of GDP in Q2 2012 (four quarter rolling sum). However, excluding Bank of Spain (BoS) inflows (which are the BoS accumulating liabilities with the ECB) the financial account over this period was actually a deficit of 29.8% of GDP. ECB liquidity was used to offset the liquidity impact of capital flight. Figure 7 shows the BoS offset of these private capital outflows: Spanish Target 2 liabilities to the Eurosystem measured €419.9bn at end-September, or 39% of GDP.

Figure 8 (page 18) outlines Spain’s Net International Investment Position (NIIPS) and shows a similar pattern. The aggregate NIIPS has been stable in recent years, showing a deficit of 90.6% of GDP in Q2 2012, down from the end-2009 peak of 93.7%. However, excluding BoS liabilities, the NIIPS deficit has declined to 60.9% of GDP from 97.9% over this period, in other words a pronounced 32.8% of GDP decline.

Figure 8: Spain’s NIIPs Highlights Private Sector Capital Flight

Source: Nomura, CEIC

The sheer scale of capital flight from Spain may fuel optimism in some quarters that most of the money that may have been willing to leave the country has already left. This is possible, but unfortunately we do not see a natural reason for why outflows have bottomed. As noted above, there is not a natural “equilibrating” factor to stem capital outflows for Spain given its presence in the euro-bloc. Additional areas of concern are as follows:

· Spain’s economic outlook is such that solvency risks will likely remain elevated, even if the country obtains a financial support package from the European Stability Mechanism (ESM) and ECB.
· While Spain’s NIIP (ex BoS) has declined by over 30% of GDP, at 60.9% it remains far above the 31.7% seen on the eve of the inception of the euro in 1999. We do not expect all of the euro-era excessive inflows to be reversed, but clearly the country still houses a considerable pool of “bubble-era” foreign investments.

· ECB liquidity continues to offset capital outflows and facilitate transactions by preventing a cathartic collapse in the Spanish banking system. This provides a window for investors to exit. After all, were ECB liquidity support of Spain to end, the demand to exit Spanish exposure would increase markedly, but the ability to do so would decline commensurately as asset prices collapsed and financial sector credit risk surged. (It is also worth noting that EU Treaties allow for capital controls for limited periods…)

In our view, the recent uptick in capital inflows into Spain is a function of the market responding to the ECB’s pledge to (when asked) implement an aggressive bond buying programme and for the ESM to provide financial support to Spain, commitments that have since been watered down. Given our view that a new phase of market weakness will happen soon after the ECB begins its OMT (we discuss this issue in more detail below), in an echo of the market sell-off that greeted the second long-term refinancing operation (LTRO), investing in Spain based on the assumption that the country was entering into a steady-state solution could be an unprofitable strategy.

Index-Based Funds and Rating Downgrade Risks 
One partial exception could be if many major real money investors had already exited Spain and/ or reduced their exposure to the minimum level allowed by their benchmarks. If so, incremental fixed income outflows could slow. Figure 10 (page 19) shows ownership of SPGBs. As of September, foreign investors held 35.4% of outstanding SPGBs, down from a 57.2% a year earlier. (In value terms this amounts to a €99.7bn reduction.) We believe that the majority of these residual investments are now held against benchmarks and hence represent relatively “sticky” funds, which could slow the pace of incremental outflows. However, even here we expect these indexed funds to turn into an outflow because of our assumption that Spain may lose its investment grade rating within 12-18 months, which would spur forced selling.

Figure 9: Bank Deposit Flight Expected to Continue into 2013

Source: Nomura, CEIC


Figure 10: Percentage Ownership Structure of SPGBs

Source: Nomura, CEIC


Slower Outflows, But ECB-Sensitive Outflows Nonetheless 
Our assumption therefore remains that the medium-term trend in Spain remains towards continued capital outflows. We accept that the pace of these could slow as some portfolio investments move close to minimum benchmark weightings, but even then we are concerned about “step risk” as rating downgrades spur forced selling.

The manner in which the euro facilitates capital outflows also has resonance for the build-up of Spanish domestic liquidity as the deepening recession increases net savings in the economy (as demonstrated by the swing of the current account from a deficit to a surplus). While home currency bias means that Spanish investors are more likely to hold Spanish assets than foreign investors, the nature of the euro means that we cannot be confident that the build-up of domestic liquidity will mean a commensurate increase in domestic buying of domestic financial assets. Within a currency area, concepts of “home” become blurred, especially if “home” is a country that is at risk of a macro devaluation were the currency area to break. It is hard to see a country in the euro ever encountering the “domestication” of its bond market in the manner which has reached an extreme in Japan, with foreign investors comprising just 7% of the Japanese Government Bond (JGB) market. Similarly, deposit flight from the banking system is expected to be a persistent trend, especially because at the retail level deposit outflows have really only started: bank deposit growth in September was -12.6% y-o-y, but of this household deposits declined by just 3.7% y-o-y.

Factors That Could Limit the Countervailing ECB Inflows 
Despite our view that there is considerable room for continued capital outflows, it is worth considering two possibilities that could limit the ability for the ECB to provide offsetting capital inflows and hence the degree to which domestic liquidity conditions in Spain can be partly insulated from these outflows:

· The ECB reaches a limit on its willingness to expand liquidity to Spanish banks. At present, ECB liquidity support for Spain measures €400bn or around 38% of GDP. Is there a point where the ECB will refuse to increase its exposure to Spain, and if so is this 50% of GDP, 60% of GDP or even higher? We assume not at this point, but this is a crucial assumption that holders of Spanish assets need to make.

· Spanish banks run short of collateral. ECB funding is collateralised, and so when banks run out of collateral they lose the ability to fund. This may seem a remote possibility in Spain where bank assets measure €3.5trn. However, the actual value of this collateral is far less that the headline number as the ECB imposes penal haircuts on pledged collateral. Domestic loans comprise €1.7trn of these assets, and are subject to haircuts of up to 80%, while some are ineligible. Spanish bank holdings of SPGBs measured €232.5bn in August and we believe that most of these have already been pledged as collateral. However, while we expect the availability of collateral to remain tight, we do not assume it to be a binding constraint in terms of ECB funding of Spain. First, if the need arose we would expect a further watering down of the ECB’s collateral requirements including its haircuts. Second, when (if) the ECB assumes its OMT bond buying programme, this will essentially provide uncollateralised funding to Spanish banks and ease their liquidity demands.

Rates Strategy Views – Sell Spain into the OMT 
The main conclusion of the above analysis is that Spain remains in an unstable equilibrium. In our view this means a continued medium-term trend of reduced private sector foreign holdings of Spanish financial assets (on a net and gross basis) and it reinforces our strategically bearish view on the SPGB market. Spain’s inability to grow means that solvency concerns will remain high and indeed grow over the coming quarters, and the role of the euro as a facilitator of capital flows means that we draw limited comfort from increasing levels of domestic liquidity.

As such, decisions to invest in SPGBs will for now remain hinged on whether investors are willing to believe that sufficient ECB monetary policy support will be provided to keep Spain liquid. That assumption has clearly underpinned the significant rally in SPGBs (and peripheral debt) in recent months following Draghi’s August commitment to do “whatever it takes to save the euro”. Indeed, for all of our long-term concerns in Spain we initiated a tactical long position in 2 year SPGBs at 4.78% in our model portfolio on 2 August when we expected a sizeable ECB-driven rally. However, we hold this position with a degree of nervousness since the medium-term outlook for SPGBs remains bleak.

In terms of when we close out our long position in Spain and initiate more aggressively bearish trades across Europe (our portfolio retains a “risk-off” bias), we expect the market sell-off in peripheral Europe to occur soon after the ECB actually starts buying SPGBs. This reflects how the market has in our view over-estimated how aggressive the ECB’s OMT will be. The ECB has failed to address the subordination problem that dogged the Securities Market Programme (SMP), and has suggested it will purchase bonds for 1-2 months and then pause to see if Spain passes its quarterly review of conditionality, which means that the holding period for investors looking to co-invest with the ECB may need to be just 1-2 months. In addition, beyond the 1-3yr ECB intervention zone of SPGBs, the ESM has said it will provide market support by issuing a form of Credit Default Swap (CDS). This does not fill us with confidence as the ESM cannot legally accept a first loss from a sovereign. The ECB and ESM “firewall” appears very porous. Indeed, we remain surprised by the extent to which the market has been patient as Spain has delayed asking for ESM support and triggering ECB buying for longer than expected. When the ECB does start to buy 1-3yr SPGBs, we expect up to a 100bp rally in 2-3yr bonds to take yields to around 2%, or our expected floor on SPGB yields in this sector. This rally is one we believe investors should sell into.

Figure 11: Bund Curve Over the Past Six Months

Source: Nomura, Bloomberg


Figure 12: Stay Received EUR IRS Blues/Golds

Source: Nomura, Bloomberg


Meanwhile, our view on Bunds remains unchanged. Based on our assumption that the eurozone crisis will deteriorate further, particularly in the first quarter of next year after the OMT begins, we are structurally bullish Bunds and have a medium-term view that the curve will have negative yields out to 5 year and that 10 year yields will drop significantly below 1%. We believe that our medium-term targets could be met in the post-OMT-driven phase of renewed peripheral market weakness which will spur a renewed flow of liquidity into core markets. Until then, however, Bunds may remain in their broad 1.20-1.70% range. For now, however, we think the bias remains for Bunds to gravitate to the strong end of this range, and they remain a buy on dips towards 1.55%. This reflects how the market’s continuing hope for an ECB refi rate/ depo rate cut over the coming months, the ongoing deterioration in German (and eurozone) economic data, and the fact that given that while SPGBs are not yet reacting to Spain’s delay in requesting ESM support (presumably due to expectations that any sell-off will spark a formal request) the uncertainty is nonetheless providing support for core markets.

Meanwhile, a backdrop of the ECB not being able to raise rates for many years to come, the need for aggressive and ongoing liquidity injections into the eurozone banking system and the possibility of a deposit rate cut into negative territory, leave us confident that the bias remains for lower Euribor fixings despite the extent of the declines seen already. We continue to recommend receiving Euro Interest Rate Swaps (EUR IRS), particularly in the Blues/Golds, and positioning for reduced curvature. Our two structural trade recommendations, which reflect this view in our model portfolio, are to receive the EUR IRS 3fwd 2yr and the 1fwd 2s5s10s (1-2-1 weighting), and we are continuing to add to these recommendations into temporary corrections higher in yields.