After banks, Spain faces fight to save regions

Spain's overspending regions have enjoyed a holiday from the headlines, content to let debt-laden banks take most of the blame for the Mediterranean country's slide into crisis.

But most of the regions, which were largely responsible for Spain missing its deficit goals by a wide margin last year, could soon become an even bigger problem for the country and its banks if sovereign borrowing costs do not fall.

Unable to get money from a government itself struggling to raise funds on the markets and reluctant to take up expensive short-term bank loans, some regions may need to restructure their debt holdings, meaning bondholders will lose out.

Those bondholders are widely believed to be the domestic banks, which already need a 100-billion euro ($127 billion) lifeline from the European Union to cover real-estate losses. "For the regions, it's a possibility. At some point, the government cannot take over all the debt," said Alessandro Giansanti, a senior rates strategist at ING.

"The worst-case scenario? At some point, the regions will not be able to repay their bonds in the market and bondholders will need to suffer losses, when it will come out who the real holders of these bonds are. It comes back to the banks."

Spain's government had a tentative plan to throw the weight of its higher credit rating behind the regions by mutualising their debt through "hispanobonos" or guarantees for each region's bonds in return for meeting ambitious deficit targets.

Most regions would qualify for such a mechanism after reporting a balanced budget for the first quarter because of multi-billion euro cash transfers from the central government.

But, after Spain's sovereign debt was cut last week to within one notch of junk status by Moody's, there are doubts over how Madrid will prevent its debt pile from exploding, let alone how it will rein in the regions, which have another 15 billion euros to refinance in the coming six months.

Fears are now mounting that Spain will join Greece, Ireland and Portugal in needing a state bailout. "Quite clearly the sovereign is struggling to finance itself and then the support for the regions will be increasingly more difficult to undertake," said Elisabeth Afseth, fixed income analyst at Investec.

"It is clearly of concern that you have some of the regions trading at heavily discounted prices to existing debt and they are largely running deficits and need further funding."

Delayed bills

The debt pile for the country's 17 autonomous regions grew to 145.1 billion euros, or equal to 13.5 percent of gross domestic product, in the first three months of the year, up from 140.1 billion euros at the end of last year.

Regional liabilities will only rise further as Spain grapples with a recession and a shrinking tax base that have helped make the country the focus of the euro zone debt crisis. The regions have in recent years financed their deficits by delaying payments to providers such as street sweepers and medical equipment suppliers.

Earlier this year, the government extended 27 billion euros in credit via the state credit agency, or ICO, to the regions for them to pay the mountains of bills owed to their suppliers. But raising more money for the regions through the ICO is not an option as the regions have exhausted its credit lines.

Worse still, Spain itself risks losing favour with investors. The benchmark 10-year sovereign is trading above the 7 percent level that is seen as unsustainable in the medium-term.

"It's impossible (for the regions) to issue bonds, even with the government guarantee from Spain ... They would need to issue in the short term and I don't think the market would appreciate another increase in the debt/GDP ratio of Spain when we are already close to 90 percent," said Giansanti.

Structural reform

Spain's sovereign debt as a percentage of GDP hit 72.1 percent at the end of the first quarter, and is expected to grow to 90 percent this year, largely due to the bank bailout.

Fitch Ratings said regional debt as a percentage of national GDP could rise to 17 percent over the medium term, and that dealing with the debt is just a short-term salve rather than a long-term solution.

"There is support in the form of liquidity from the central government and the willingness to support (the regions) and that is positive for us. What we would like to see is more structural reform," said Guilhem Costes, senior director of international
public finances for Fitch.

The regional bonds barely trade and the gap, or spread, between the price traders quote to buy and sell the bonds is in some cases as much as 20 times wider than the buy/sell gap on sovereign bonds.

Catalonia, Spain's largest region by GDP, has a total debt burden of 42 billion euros, the highest in the country. This has risen by nearly 15 percent from the first quarter of 2011 and accounts for almost a third of all regional debt.

In May, the Catalan government appealed to the state for help as it runs out of options to refinance the remainder of the 13.5 billion euros it had in outstanding debt this year, even after taking strict measures to control its budget.

Catalonia has plenty of reason to worry. The yield on its two-year debt has doubled in the space of two months to above 13 percent, meaning investors demand more of a
premium to hold its bonds in case of default than they do of Portugal, which was bailed out by lenders in May last year.

All Spain's big regions, Valencia, Madrid and Andalucia, face the same spiralling cost of paying their way, even if their economies and their debt burdens vary hugely.

One option would be expensive short-term bank loans, a situation Catalan President Artur Mas, for one, has said he wants to avoid. Failing that, restructuring would be the only way out.