Background

Hours following Madrid’s announcement on Saturday to seek EU help due to its struggling financial sector, eurozone finance ministers agreed on a Spanish bailout package to recapitalize Spain’s failing banks. The decision, reached after a two-and-a-half hour conference call of the monetary union’s 17 finance chiefs, signaled the eurozone’s commitment to inject enough capital into Spain’s banks to strip away some uncertainty from the markets. "The loan amount must cover estimated capital requirements with an additional safety margin, estimated as summing up to 100 billion euros in total," a Eurogroup statement said.

Unlike bailouts offered to Ireland, Portugal, and Greece, the Spanish banking bailout will come only from EU funds and not from the IMF. However, it will be overseen by a troika of the IMF, the European Commission and the European Central Bank

The amount of aid Spain will request has not been announced since Madrid wants to delay specifying an exact figure until after two independent audits are issued on June 21 on its banking sector’s capital needs.  An IMF report released late last week estimated that Spanish banks would need to raise at least 37 billion euros, although IMF officials recommended that Spain ask for more.

Spanish banks are crippled by significant losses incurred in their real estate portfolios and the continent’s macroeconomic malaise which have contributed to the country’s record high borrowing costs. Spanish bonds matched a record high rate of 6.7 percent on May 30, coming perilously close to the 7 percent level, a rate that economists say is unsustainable and led other troubled EU economies to seek EU/IMF bailouts.  Although bond yields have dropped since their May 30 high, at a successful bond auction held on June 7, Spain’s 10-year bond yields were still at a high rate of 6.04 percent, higher than the 5.74 percent of the last auction in April (see chart below). On June 7, Fitch Ratings, a credit-rating agency, cut Madrid’s sovereign debt by three grades down to “BBB” from “A.”   

The aid agreement, which will make Spain the fourth country to request a bailout since the EU economic crisis began, is heatedly disputed by Madrid as being a rescue package.  Spanish Prime Minister Mariano Rajoy referred to the financial package as a “$100 billion euro credit line.”  Rajoy also described the EU aid as a victory and claimed that his prudent economic policies allowed Spain to avoid a full bailout that would have ceded sovereignty to the EU and forced the country to submit to painful new austerity measures.

“This has nothing to do with a rescue,” Economy Minister de Guindos insisted, arguing the money would only be directed to the 30 percent of banks with the greatest exposure to the 2008 housing bubble burst.

The exact wording of the emergency loans will not be set for another few days, but de Guindos said the terms would be “very favorable.” According to Reuters, conditions in the aid package did not include additional structural reforms and austerity measures beyond what has already been put in place by Spanish Prime Minister Rajoy. Irish Finance Minister Noonan said the funds would be provided at the same interest rates as previous bailout packages.

Analysis

Spain’s decision to finally request formal financial assistance from the EU brought to a close a game of brinksmanship with Germany which had been dead set against agreeing to anything short of a full EU/IMF bailout of Spain’s entire economy.  Spanish officials refused to agree to a full bailout for national pride reasons. The country has also endured its own economic austerity programs that sparked large protests and did not want to implement a new round of harsher EU/IMF austerity measures. 

Spanish officials therefore attempted to use fear of a Spanish economic collapse to win an EU banking aid package under more favorable terms than bailouts offered to Greece, Portugal, and Ireland.  The strategy appears to have worked.  Despite the deteriorating conditions of its regional and national banks, Spain obtained an agreement to receive the much-needed loans to its banks with relatively light conditions attached.

The Spanish banking bailout will also allow eurozone policymakers to shore up their position ahead of the Greek elections on June 17. Should Alexis Tsipras’s anti-reform SYRIZA Party win control of the Greek parliament, Athens could be very close to a euro exit and unleashing a wave of economic instability across Europe. 

A strong pledge by both the EU and Madrid to tackle insolvent Spanish banks is crucial to calming financial markets.  The commitment of up to 100 billion euros will likely be seen by financial markets as a realistic amount to cap Spain’s banking problems.

The eurogroup did not specify whether the funds for Spain’s banks would come from the European Financial Stability Facility (EFSF), the eurozone’s temporary rescue fund, or the ESM, the permanent mechanism due to become effective next month. Since the ESM has more operational flexibility, its speedy ratification by EU members must be made a priority if the agreement is to carry any weight in the future. But with loans already made to Greece, Ireland, Portugal, and now Spain, the EU has committed around 500 billion euros to finance European debt rescues, which means any further deterioration of economic conditions on the continent could overtax the already strained financial rescue mechanism.

The generous Spanish loan package will affect future loan packages, since other states will also try to negotiate better terms.  Greece’s Alexis Tsipras has already seized on the Spanish deal by claiming that his country deserves better terms for its bailout package.  Irish opposition leaders have criticized the Irish government for not obtaining better terms for their country after learning of the deal offered to Spain.  Italy will probably use Spain’s deal to push for a bailout on more favorable terms if it pursues one over the next year.

Conclusion 

Spanish officials succeeded in using the threat of a Spanish economic meltdown to get past German objections to win a limited financial bailout on its own terms.  While Madrid would become the fourth eurozone government to receive a EU financial bailout, the assistance would be directed only at Spain’s banking sector without taking the state out of credit markets. Having temporarily assured the markets of Spain’s ability to absorb its banking losses, EU officials now need to ensure the ESM will be ready to contain new economic turmoil that could occur should Greek voters choose to part ways with euro membership in next week’s elections.