Proud, too-big-to-fail Spain ponders bank rescue

LONDON (Reuters) - As the world's 12th largest economy and No.4 in the euro zone, Spain by common consent is too big to fail. But all the signs are that the country is not too big for a bailout of its banks.

Markets have rallied this week partly on optimism that euro zone policymakers, proven masters at improvisation, will reach a compromise with Madrid on the terms of a bank rescue and so defuse the latest threat to the single currency.

Spain, growing in confidence that it can get help without some of the politically humiliating baggage that often goes with it, is looking at ways to fill a capital shortfall at a clutch of troubled lenders that will be at least 40 billion euros, according to sources in the financial sector in Madrid, [ID:nL5E8H769]

If Spain does seek outside help it is expected to ask for funds from the 440 billion euro European Financial Stability Facility (EFSF), the euro zone's temporary rescue fund, or its successor, the 500 billion euro ($625 billion) European Stability Mechanism, due to be operational in July.

"The Spanish government must consider all options," Swedish Finance Minister Anders Borg said. "We must find ways to deal with this fairly quickly because that is today the major threat to the world economy," Borg, whose country is not one of the 17 members of the single currency, told Reuters in Copenhagen.

Underscoring the gravity of Madrid's predicament, credit ratings agency Fitch downgraded Spain by three notches on Thursday.

HIGH STAKES

There are high stakes for Spain and the global economy.

To use a phrase popularized in 1984 when the Reagan administration bailed out the seventh biggest bank in the United States, Continental Illinois, on the grounds that its collapse would have caused economic disruption that would leave all Americans poorer, Spain, it seems, is "too big to fail".

Should either Spanish banks collapse under the weight of bad property loans, or the Madrid government rescue the banks alone and then struggle to pay its own creditors, possibly defaulting or being forced from the euro zone, the chaos that would cause in the world economy is worth other governments paying to avoid.

In contrast, Greece, with only 11 million people to Spain's 46 million and a banking system and trade less deeply integrated with its EU neighbors, may be left to its fate if voters this month elect a government which rejects the terms of a bailout.

The mooted Spanish bank rescue is important because of what it will say about a shifting balance of political power in Europe as politicians propose ways of putting the 13-year-old single currency on more solid foundations.

Germany, Europe's paymaster, has ceded ground and said Madrid should be allowed more time to cuts its budget deficit at a time when its economy is in recession and one in four Spaniards are out of work.

But Chancellor Angela Merkel on Thursday reaffirmed her government's opposition to bending the rescue fund rules, for example by handing money straight to the commercial banks.

The EFSF's statutes say any loans for the purpose of bank recapitalization must be made via euro zone governments - making explicit their sovereign responsibility - and not directly to the ailing lenders.

"It is important to stress that we have created the instruments for support in the euro zone and that Germany is ready to use these instruments whenever it may prove necessary," Merkel said. "That is a clear expression of our political willingness to keep the euro zone stable."

For his part, Spanish Prime Minister Mariano Rajoy is keen to avoid the stigma of a full-fledged bailout of the Spanish state itself, with strict conditions attached of the sort Greece, Ireland and Portugal were forced to accept in return for emergency finance from the European Union and the International Monetary Fund.

The EFSF prescribes much lighter conditionality for a bank-recapitalization loan than a traditional EU/IMF program. But the borrowed money would still go on the Spanish government's books, adding to its fast-growing debt burden.

Rajoy believes Madrid, where the government's own debt level has actually been lower than the likes of Germany and France, deserves credit for its efforts to put its house in order. The country's external deficit is narrowing rapidly, its competitiveness is improving as unit labor costs fall and it has enacted reforms that will inject much-needed flexibility into the labor market.

"Outside of the banking space, they are largely signing up to all the structural reforms and fiscal targets that Europe would like them to pursue anyway," said Malcolm Barr, an economist with JP Morgan in London.

On the other hand, Barr said, Spain's size should not be a sufficient reason for Germany and other northern European creditors to sacrifice the principles of sound long-term currency management for the sake of a quick political fix.

"Independently of size, that's the message that you continue to get from policymakers: that there is a trade-off between short-term expediency and long-term incentives," Barr said.

Spain, he argued, still should commit to do better.

MAJOR MISTAKE

Rajoy said on Thursday he would wait to see the results of independent audits of the country's banking system before talking with Europe over the best course of action to recapitalize the banking system.

The Spanish premier, who enjoys the backing of newly elected French President Francois Hollande, won support on Thursday from Polish Finance Minister Jacek Rostowski.

"I think it is a major mistake to have a system whereby recapitalization of Spanish banks has to go through the Spanish public sector, increasing public sovereign Spanish debt," he said at a conference in Copenhagen.

"I am actually very confident that a sensible solution to the Spanish banks will be arrived at very soon," he added.

If Rostowski is right, would it do the trick and soothe markets?

JP Morgan, for one, has its doubts and suspects Spain will be forced into a full-blown IMF/EU bailout.

If such a package were to provide $75 billion to recapitalize banks and meet the financing needs of the central and regional governments through 2014, it could total $350 billion to $450 billion, the bank reckons. That is up to a third of Spain's entire annual national income.

Riccardo Barbieri, chief European economist at Mizuho International in London, is not sure either. He would like Spain to agree to a loans-for-reforms program that tackled overspending by autonomous regional governments as well as the country's banking problems.

But he said a loan aimed narrowly at addressing banks' capital shortfall could go down well.

"If a big lending program promises to stabilize the banking sector, the markets might be pleased with that because I don't think many people believe IMF/EU programs have been particularly successful," he said.

The bigger picture, though, is that even if policymakers win the battle for Spain, they are still far from winning the war with financial markets over the future of the single currency.

Plans being sketched out for the closer fiscal, banking and political integration needed to underpin the euro will take a long time to finalize, let alone implement. Yet Europe's needs are immediate and urgent, as Spain's plight shows.

"The most worrying thing is that, even if you take an optimistic view, it will take years to sort this out. It would be nice to solve it in six months, not in six years," Barbieri said. "We'll be in stagnation/depression for a long time if we don't come up with a new perspective." ($1 = 0.7960 euros)

(Additional reporting by Mette Fraende in Copenhagen; Editing by Alastair Macdonald)

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