The cost of saving Spain, a €1.1 trillion ($1.56 trillion) economy, would dwarf previous bailouts and could test the financial strength of Europe as a whole.

But if Spain can continue to repair investors’ trust, as in recent weeks, then Europe stands a chance of containing the debt crisis to three countries, Greece, Ireland and Portugal, whose combined economies are half the size of Spain’s.

Spain’s banking sector remains a big worry. Moody’s Investors Service cut 30 Spanish lenders’ credit ratings on Thursday, citing the sector’s fragility. Spain’s other challenges include a large budget deficit, burst housing bubble and feeble growth.

But despite continued strains, financial markets have grown more confident that Spain won’t need a bailout.

Even pessimistic projections of bank losses don’t appear to threaten the country’s solvency, while the government has stepped up overhauls of the budget, banks and labor market, and the economy has shown more resilience than expected.

Spanish bonds and stocks, including those of banks, rose Thursday despite the downgrades and concerns that Spanish lenders could be hit by the deepening crisis in neighboring Portugal.

Spain’s borrowing costs have stabilized and come down slightly in recent months, whereas investors have continued to dump bonds of the three smaller crisis-hit countries.

“Investors increasingly have come to differentiate between these countries and…Spain,” said Antonio Garcia Pascual, economist at Barclays Capital in London.

Policy makers in Europe and the U.S. have long believed that Spain would be the crucial battlefield in the euro zone’s struggle to prevent a collapse of creditors’ trust in its weaker nations.

Last year, U.S. officials even worried that the crisis could spin out of control and undermine the global economic recovery.

“That fear has subsided,” Dallas Federal Reserve President Richard Fisher told reporters in Berlin on Wednesday, praising Spain’s “corrective surgery” on its banks and finances.

Spain is forcing its banks to raise capital from either markets or the state. The government remains under pressure to reduce its budget deficit and Spain’s unemployment rate of just over 20%.

Prime Minister José Luis Rodríguez Zapatero was due to outline further steps to improve budget controls, labor rules and productivity at a European Union summit in Brussels Thursday.Investors could still turn against Spain if it fails to deliver, or if events elsewhere trigger a market panic.

“Spain isn’t out of the woods. But the market is less afraid of the worst-case scenario occurring than a few months ago,” said Ben May, European economist at London consultancy Capital Economics.

The worst-case scenario is that Spain’s property market falls so hard that the country’s struggling regional savings banks, known as cajas, need more money to cover their losses than the Spanish state can raise.

Similar problems sank Ireland last year. Concerns about Ireland’s solvency are mounting despite international rescue loans granted in November.

But a report by credit-rating agency Fitch this month pointed out that Spain’s banks and their property risks are significantly smaller than Ireland’s in proportion to the overall national economy. As a result, “it will likely be easier for Spain to cope with the country’s real-estate collapse” even if Spanish home-price falls and banking losses become as severe as Ireland’s—”an extreme scenario which is not likely to materialize,” according to Fitch.

In an Irish-style meltdown, Spanish banks would need to raise nearly €100 billion in extra capital, Fitch calculates, an estimate similar to that of the most pessimistic economists. If the state had to provide all of those funds, Spain’s public debt would jump by about 10 percentage points of gross domestic product.

That amount would be challenging for Spain to borrow quickly from bond markets.

But economists say it wouldn’t undermine the state’s solvency, since public debt stood at just over 60% of GDP at the end of 2010, well below the ratios of Germany, the U.S. and many other Western countries.

Economists expect Spanish property prices to fall further this year, but not as drastically as in Ireland.

Some major urban markets appear to be bottoming out, analysts said. Spaniards’ attachment to homeownership as their main form of saving, and Spain’s unforgiving laws for mortgage debtors, slow down price declines and banks’ loan losses, said observers.

“In Spain, you are liable for all your mortgage debt even if your house is repossessed, so you do everything you can to avoid losing your house,” said Unai Ansejo, an investment manager at the public-pension fund of the Basque region.

Spain’s budget deficit, at 9.2% of GDP last year, remains too high for comfort, but was down from more than 11% in 2009. Spain improved its credibility with investors by meeting its deficit-reduction target, despite overspending by some regional authorities. This year’s deficit target of 6% is achievable, said economists, but might require extra fiscal measures if economic growth disappoints.

The economy grew at an annualized rate of 0.9% in last year’s fourth quarter, marking another contrast with Greece, Ireland and Portugal, which stayed mired in recession. Spanish consumer spending is falling thanks to mass unemployment and households’ efforts to reduce their debts, but Spanish exports are doing better than expected, growing at an annualized 16.6% last quarter.

Source: Wall Street Journal

The reorganization may offer a window for U.S. private-equity and hedge-fund firms to take advantage of the situation and earn a profit for their investors, much as they did when U.S. banks were caught in the maelstrom of the 2008 financial crisis and needed new capital to survive. Hints of potential deals already have begun to crop up.

Over the weekend, several Spanish newspapers said billionaire investor George Soros, U.S. hedge-fund group Paulson & Co. and private-equity groups Cerberus Capital Management and Blackstone Group were set to meet executives of lender NovaCaixaGalacia to discuss possible investments.

Days earlier, a report in Spanish daily El Economista said Cerberus and Paulson & Co. were looking at unlisted cajas Banco Mare Nostrum and Banco Base. Mare Nostrum is reportedly set to merge with Caja Duero-España, creating the fourth-largest savings bank.

Sovereign money is cropping up as well, with Qatar and the United Arab Emirates both recently pledging to invest money in the savings banks, though the recipients have not been revealed.

It’s a possible sea change from last December, when a well-publicized deal by U.S. private-equity firm J.C. Flowers to buy €450 million of convertible bonds in Banca Civica fell apart over concerns about Spain’s sovereign-credit risk. Banca Civica was one of five savings banks to fail the European-bank stress tests last November.

“U.S. private-equity money is very active,” said Adolfo Ramirez-Escudero, member of the board and executive director for capital markets at commercial-property broker CB Richard Ellis Group. “They are interested in nonperforming loans and in property portfolios. They also are looking to recaps on listed companies once restructured.

“We have familiar names and faces from the ’90s back in the Spanish market,” he added. “They will do deals but they will have some competition, and the obvious and easy bargains will not be easy to find; asset management and good property skills will be required to find the right balance between returns and risk.”

The cajas got clobbered in the real-estate bust that now hobbles the economy and has pushed Spain to the verge of a sovereign-debt crisis. As part of its recovery effort, the government is moving to clean up the sector.

There are two main ways for the cajas to recapitalize. The first would be to seek outside investment, whether from a market flotation or injections of capital from private-equity firms, hedge funds or sovereign funds. The other would be to jettison some of the troubled real-estate assets they hold. But this may be the most difficult, because such sales would likely require damaging write-downs.
Paulson looking at Spain

The weekend reports about NovaCaixaGalacia make clear that for international investors, price will be a key factor. Many observers in Spain say the cajas are not facing up to the reality of how they are seen from the outside — as a troubled group of savings banks that need outside help.

“The idea they have is that this kind of white knight is going to come out of the blue,” said Higinio Guillamon, Madrid-based director of Wezer Capital, which provides investment-advisory services to international clients and runs a small private-investment vehicle.

Outside of a price that may be much lower than the cajas want to accept, foreign investors will also require a change in dynamics, he commented. “If private investors come in, the business has to change, governance, management — that’s what I think is going to be digested. It’s coming, but it’s going to be a long and protracted process,” Guillamon elaborated. “These guys are in shock.”

Paulson, the third-largest U.S. hedge-fund firm by assets, has done a lot of research on European sovereigns and financial institutions in the region. The firm has been looking at Spain and thinks there are potential opportunities there, according to an investor who spoke on condition of anonymity.

Paulson hasn’t announced any deals in Spain and there may not be any. But the firm feels that it has the expertise to figure out if potential rewards from investing there are worth the risk, the investor said.

Paulson has a London office and has been an investor in Europe for many years. The firm is a big investor in French car maker Renault SA /quotes/comstock/24s!e:rno  (FR:RNO  43.03, +0.78, +1.85%) , and has held that investment for many years.

A Paulson spokesman declined to comment.

Paulson generated huge returns in 2007 by betting against subprime-mortgage securities. The firm also made money in 2008, while many other big rivals suffered record losses, partly by betting against financial institutions.

However, the firm launched the Paulson Recovery Fund in late 2008 to invest in financial-services companies that are looking to shore up weakened capital positions.

As 2009 began, Paulson was among a group of private-equity investors who acquired failed U.S. bank IndyMac from the Federal Deposit Insurance Corp., injecting $1.3 billion into the lender.

Paulson also bought big stakes in U.S. banks including Bank of America Corp. /quotes/comstock/13*!bac/quotes/nls/bac (BAC 14.69, +0.66, +4.70%)  and Citigroup Inc /quotes/comstock/13*!c/quotes/nls/c (C 4.64, +0.12, +2.65%) , as well as insurers including Hartford Financial Services Group Inc. /quotes/comstock/13*!hig/quotes/nls/hig (HIG 28.47, +0.66, +2.37%)  and Conseco.

Financial-services stocks have rebounded strongly in the past two years, pushing the Financial Select Sector SPDR exchange-traded fund /quotes/comstock/13*!xlf (XLF 16.77, +0.36, +2.19%)  up more than 130%.

Paulson may now be looking elsewhere for financial institutions that need new capital.

A Spanish investment, if it happens, may be more likely to be in the Paulson Recovery Fund and could tap into similar themes that drove deals like IndyMac, the investor familiar with Paulson said. Such transactions involved reorganizing the capital structures of financial institutions to generate potentially big returns with limited risk, the investor explained.
Selling the problem

Spain’s savings banks are exposed to the real-estate and construction sector to the tune of €217 billion ($300 million), with €100 billion of that categorized as risky — loans in default, functioning but at risk of default and repossessed properties and assets, according to the Bank of Spain.

Mark FR Wilkins, chief executive of IberianAssets, which provides analysis and solutions for real-estate debt realization, said two teams of analysts from U.S. hedge funds visited recently to look at distressed-debt portfolios, and more are on the way. The increase in interest, he added, stems from a view that Spain’s economy has hit bottom.

“They smell blood,” Wilkins said, noting it’s still unclear whether property values have reached bottom across the country. Wilkins added that the hedge-fund visitors are running up against cajas that don’t yet feel the pressure to sell. “They’re slightly sitting on their hands waiting for something else to happen, to see whether in the midyear, the IPOs of Banca Civica and Caja Madrid [now renamed Bankia] will be a success. Those will be a litmus test to see if weaker cajas have the imperative to start selling portfolios.”

But that may be a big gamble, and even well-publicized investment plans from Qatar and the United Arab Emirates into the cajas in recent days don’t mean money will flow to frail cajas loaded with debt, according to Wilkins.

Price is an issue for hedge funds, which he said are willing to pay 30 or 40 cents on the euro. A loan of €100 million two years ago now has a book value of €60 million, he calculated. A bank that already has made a provision would have to take another 65% to 70% hit on that loan when it comes back down to current value to appeal to hedge funds — not easy for a caja to swallow.

“The whole issue of real-estate portfolios has to be seen within the major issue that is playing out at the moment, which is what is going to happen to the cajas, ” said Wezer’s Guillamon. “Although we may see some very flashy, important deals happening in the future, it won’t be overnight.”
IPO option

A door may open once the major investment banks start advising on caja flotation, said Wilkins. They are likely to suggest cajas turn some of their debt portfolios into cash, with deals starting at the local level. Those local deals could pave the way for more international investors to come on the scene.

Guillamon said he expects private-equity groups — which he sees as more likely investors, than hedge funds as the liquidity of caja investments may not meet their timetables — will probably try to get in ahead of any IPO by the cajas. That way, he explained, they could have some influence and also get in early and make money on any part of their interest sold in the IPO.

“The way I see it is sometime around summer, third quarter we’ll start seeing those kinds of deals. People coming in and saying let’s go first for 10%, then IPO in a more leisurely fashion. Then that private-equity group would have more leverage. Suppose the caja goes to an IPO directly, then there’s nothing there for a private-equity investor,” he commented.

If the cajas are unable to launch a successful IPO and also fail to reach a deal with overseas investors, part nationalization is likely the remaining option. In such a scenario, the Spanish government may have to deal with a lot of the troubled assets that triggered the problems for cajas in the first place.

If it gets that bad, then distressed-debt sales would become more likely.

Robert Tornabell, economics professor of ESADE Business School in Barcelona, said one thing is clear for the cajas: Time has run out.

“The government and the Banco de España are really worried about the timing. They want a more dynamic ‘ongoing process’ or effective recapitalization of the cajas right now,” he added. “No more delays or excuses.”

Market Watch

Spain is fending off fears in international financial markets that its public deficit is unsustainably high and could prompt the country to follow Greece and Ireland into seeking an EU-IMF bailout.

Economic activity will need to pick up speed if Madrid is to meet its target of slashing the public deficit to below the European Union limit of 3.0 percent of annual economic output by 2013 from 9.24 percent last year.
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“The indicators for the first few months of 2011, while still scant, point in general to a continuation of the path of slow recovery of activity with characteristics similar to the end of last year,” the Bank of Spain said in its monthly bulletin for February published on Friday.

The bank said consumer sentiment was “clearly improving”, with average confidence levels in January and February sharply ahead of the fourth quarter of 2010.

The Spanish economy slumped into recession in the second half of 2008 as the global financial meltdown compounded the collapse of the once-booming property market, which had fueled growth for over a decade.

It inched out of recession with feeble or flat quarterly economic growth rates in 2010. Over the year as a whole, Spain’s gross domestic product declined 0.1 percent, after contracting 3.7 percent in 2009.

The Spanish government predicts the economy will expand 1.3 percent this year but the International Monetary Fund has tipped more moderate growth of just 0.6 percent.

Spain’s deficit-reduction targets are based on its forecast that the economy will grow by a far more robust 2.5 percent in 2012 and 2.7 percent in 2013.

Spain’s industrial production grew 3.8 percent in January from the same month last year, after falling 0.1 percent in December, the national statistics institute said earlier Friday.

Consumer goods output grew 3.2 percent in January, while capital goods output rose by 4.6 percent. Durable consumer goods production fell 5.5 percent.

Raj Badiani, senior economist for IHS Global Insight in London, said the rise in capital goods output “was welcome, signalling that the improved export performance witnessed since early 2010 is helping business investment to revive after a prolonged slump.

“This coincides with the other indicators, suggesting that the economy continued to grow in early 2011, albeit at a painfully slow pace.

“Spain still faces a profound challenge to pull itself clear from severe recessionary conditions which have delivered continuous job losses since mid-2008.”

The Sydney Morning Herald

• EUR continues to re establish itself but will the run continue

• China reduces its US Treasury holdings for second month

US Dollar: The greenback lost ground against all of its major counterparts on Tuesday, with the USD/JPY tumbling to a low of 81.46, but we may see the U.S. dollar recoup the overnight losses as manufacturing in the world’s largest economy is expected to expand at a faster pace in January. The ISM Manufacturing index is forecasted to increase to 58.0 from 57.0 in December, and businesses may continue to ramp up their rate of production this year as the rebound in economic activity picks up steam. However, as equity futures foreshadow a higher open for the U.S. market, the rise in risk appetite may dampen demands for the greenback, and the dollar may struggle to hold its ground as risk sentiment continues to dictate price action in the currency market. DATA: USD Mortgage applications

Pound: The British Pound advanced to a fresh yearly high of 1.6141 despite the slew of mixed data out of the U.K., and the GBP/USD may continue to retrace the decline from back in November as investors speculate the Bank of England to gradually normalize monetary policy later this year. Mortgage approvals in the U.K. increased 42.6K in December to mark the slowest pace of growth since March 2009, while manufacturing expanded at a record pace in January, with the PMI reading advancing to 62.0 in January from a revised 58.7 in the previous month. As the recovery gradually gathers pace, the National Institute of Economic and Social Research expects the BoE to hike the benchmark interest rate three times this year, but there could be a growing split within the MPC as the tough austerity measures dampens the outlook for future growth. As the GBP/USD maintains the upward trend from earlier this month, the pair looks poised to test 1.6200-20, the 23.6% Fibonacci retracement from the 2009 low to high, but we may see the pair consolidate over the near-term if we see the daily RSI continue to hold below 70. DATA: GBP PMI (JAN)

Euro: The Euro rallied to a high of 1.3774 on Tuesday as the economic docket reinforced an improved outlook for future growth, and the single-currency may push higher going into the North American trade as the EU looks at alternative measures to restore investor confidence. Unemployment in Germany weakened 13K in January amid forecasts for a 10K drop, while the jobless rate unexpectedly slipped to 7.4% from 7.5% in December to mark the lowest reading since November 1992. At the same time, manufacturing in the Euro-Zone expanded at a faster pace during the same period, with the PMI reading advancing to 57.3 from 57.1 in the previous month, and the recent developments may encourage the European Central Bank to re establish its exit strategy later this year as the economic recovery gathers pace. DATA: EUR PPI MoM/YoY (DEC)

General:
The Dow Jones industrial average closed above 12,000 Tuesday for the first time since June 2008. The milestone was another mark of recovery from one of the worst financial crises in the nation’s history and a sign that investors expect the economy to keep growing instead of taking a second dip into recession

Mid-prices

GBP/USD 1.6173
GBP/EUR 1.1689
EUR/USD 1.3831
GBP/JPY 131.71
GBP/AUD 1.5987
GBP/NZD 2.0712
GBP/ZAR 11.4845
GBP/CHF 1.5896
GBP/CAD 1.5970
GBP/SGD 2.0585
GBP/THB 49.64
GBP/HKD 12.595

Voltrex

• Isn’t it?

Good morning. Here’s a little test to get the grey matter working on a chilly Wednesday morning. Find the words “one and a half per cent” in the following sentence, extracted from Bank of England governor Mervyn King’s letter to the chancellor yesterday:

“The MPC’s central judgement, under the assumption that Bank Rate increases in line with market expectations, remains that, as the temporary effects of the factors listed above wane, inflation will fall back so that it is about as likely to be above the target as below it two to three years ahead.”

Found it? No? Check out the phrase “under the assumption that Bank Rate increases in line with market expectations”. That’s a heck of an assumption for the governor to make unless he has some idea of what lies ahead. The December short sterling futures* contract – a distillation of market expectations if ever there was one – implies a three month interest rate of 1.76%. Shave off the differential between the overnight rate and the three-month rate and you come to 1.46%. The governor seems to be assuming that Bank Rate will increase to something like that by the end of the year (and, by the same logic, to around 3% by March 2013).

It took the market a while to fall in with this notion yesterday morning, partly because the letter did not appear on the Bank’s website at the same time as the ONS published the inflation numbers and partly because the hidden meaning was so cunningly concealed. But once investors had sussed it, they rapidly revised their earlier disappointment that the inflation figures had not been higher. (They were high enough but the 4.0% CPI inflation rate was exactly on target.) Having fallen by half a cent or more against the euro and the US dollar when the numbers were announced, sterling rebounded strongly on the governor’s hint at higher interest rates. The pound starts today a cent and a half higher against the US dollar than Tuesday’s opening level. It is up by one and a half yen, half a euro cent and an average of two cents against the commodity dollars.

The UK inflation figures – or at least the governor’s letter – rather overshadowed the rest of the day’s data. Euroland fourth quarter gross domestic product fell short, with growth of 0.3% instead of than the predicted 0.4%, but investors managed to contain their disappointment. The euro was saved by better than expected results from ZEW’s surveys of German and euro zone economic sentiment. The US dollar took a hit from January’s retail sales figures. Not only were the monthly and annual increases (both 0.3%) well below forecast, the December figures were revised lower too. The NAHB’s housing misery index remained at 16 (on a scale of zero to a hundred) for another month.

Sterling blotted its copybook overnight when Nationwide’s index of UK consumer confidence scored a 47, having been expected to come in at 49 after the previous month’s 54. Although there was no strong reaction to the number it set a vaguely negative tone for London’s opening. It is possible the tone could become yet more negative this morning when the employment numbers are published. The rate of unemployment is predicted to be steady at 7.9% and the claimant count rate is forecast to fall by two or three thousand. In recent months the jobs numbers have tended to paint a picture of a shift towards part-time employment with dispirited ex-workers dropping out of the scene altogether. There is no reason why today’s data should be any more upbeat.

Be prepared also for the governor to pooh-pooh the interpretation of yesterday’s letter to the chancellor when he makes his speech about the quarterly Inflation Report. He is almost certain to make the point that the MPC makes its decisions one at a time. There is not the remotest chance of him committing to a Bank Rate of one-point-anything in December. Some of sterling’s more romantic and less steadfast supporters might find that disappointing.

There are no ecostats due from Euroland today. Canada publishes the figures for manufacturing shipments and international securities transactions. The United States announcements are for building permits, housing starts, industrial production and capacity utilisation. This evening the Federal Open Market Committee releases the minutes of its last policy meeting. Let’s guess they will include the prediction that interest rates will remain at their extremely low level “for an extended time”.

Sterling faces two event risks today, within an hour of each other. Neither is likely to give it the same sort of boost that it received from the governor’s letter yesterday.

*Short term sterling interest rates futures are a non-deliverable proxy for a three month deposit at a time in the future. Their purpose is to provide protection against interest rate movements, not actual loans or deposits. They trade on the Euronext exchange (which started life as LIFFE 30 years ago) priced in terms of 100 minus the interest rate. The December 2011 contract is currently priced at 98.24, implying a 1.76% rate of interest on a three month deposit. Three month deposits currently return roughly a third of a percentage point more than the 0.5% Bank Rate. On that basis the December contract at 1.76% translates into a 1.46% Bank Rate in December.

MoneyCorp

• But you never know…

Good morning. Twenty general practitioners in Surrey are testing a system that uses a call centre to handle appointment requests. Perhaps such an arrangement could allow the government to sidestep the controversial European court ruling that gives convicts the vote, rather than going head-to-head against Strasbourg and risking an open-ended litigation bill.  The prime minister could comply by giving prisoners the vote but requiring them to cast it through a call centre. “If you would like a list of all the candidates who support capital punishment press one; if you are only serving time for something trivial like aggravated assault press two; if you were fitted up or it was all a big mistake press three; if you are trying to make a doctor’s appointment press one-one-one; to return to the previous menu press nine.”

And to make sterling jump two cents higher against everything press 0.75. There is little chance that the Monetary Policy Committee will make that decision today and equally little chance that the statement announcing the decision will be any different from those that the Bank of England has been churning out since July last year. Investors will have to wait until 23 February for the minutes of today’s meeting but that will not prevent them from forming their own anticipation of how the committee might have voted. Comments in today’s press from former MPC members DeAnne Julius and Tim Besley are illuminating. Both say they would vote for a rate increase but only if there was a majority in favour of no-change. They believe the MPC should pave the way for higher rates but that the time to begin the tightening process is not yet ripe.

Nevertheless, the market is convinced that a rate increase is on the way. That is perhaps why they totally ignored the announcement of a record UK trade deficit in December.  Sterling did not even flinch. In fact it had a fairly successful day, holding its own against the US dollar and edging higher against everything else except the euro, where it lost quarter of a cent.  The principal mood on Wednesday was one of heightened caution. Equity prices were subdued and the commodity dollars moved lower, partly as a result of China’s interest rate increase the previous day. The euro’s relative success seemed accidental. If anything, news that Bundesbank president Axel Weber had withdrawn his candidacy to replace Jean-Claude Trichet at the European Central Bank ought to have depressed the euro.  Herr Weber, who will be retiring, has been one of the ECB’s most vocal policy hawks and his departure will be seen as softening the ECB’s stance.

There is no chance of any softening in the States. The Federal Reserve’s policy stance is already as soft as they come. Fed Chairman Bernanke told congress yesterday that “we do not now have a problem” with inflation. He said the current $600 billion round of quantitative easing would run through to completion in June unless inflation picked up or the economy began to grow “very quickly”. Mr Bernanke has no intention of tightening policy any time soon.

The announcement of 24k new jobs in Australia and an unemployment rate unchanged at 5.0% was, ostensibly, good for the Australian dollar but after a moment’s consideration investors decided they did not like the details.  Their problem was that all the new jobs – and more – were part-time positions. Full-time employment went down by -8k in January. Although the eventual reaction of the Aussie was negative it was not excessively so. Investors are aware that the floods in Queensland are having an effect, but they don’t know by how much the employment data are being distorted.

Today’s agenda is rather fuller than those earlier in the week.  From Europe come Swiss inflation and the industrial production figures for France, Italy and Britain. US weekly jobless claims and the Canadian new housing price index are out after lunch, followed by US wholesale inventories and the monthly budget statement. The NIESR estimate of UK economic growth in January will appear at some point and the REINZ index of New Zealand house prices comes out tonight.

Sterling’s test will come at midday when the MPC reveals its policy decision. Whilst it is unlikely that rates will go up today there is an outside chance that they might. This will mean a tilt towards long positions ahead of the announcement and the possibility of a minor sell-off for sterling if nothing changes.

MoneyCorp

• Has the market forgiven sterling already?

Good morning. On the 100th anniversary of its invention in Ogden, just north of Salt Lake City, Utah has introduced the Browning M1911 semi-automatic pistol as its official “state firearm”. It joins a list of other official emblems such as the beehive, the state tree (blue spruce), the state flower (sego lily), the state massacre (Mountain Meadows) and the state missile (Minuteman ICBM).

The state of Britain’s economy is equally as controversial. Its latest critics include the Bank of Tokyo-Mitsubishi, who say it is “highly vulnerable to external shocks”, and billionaire punter George Soros, who says “I don’t think [the chancellor's austerity measures] can be implemented without pushing the economy into a recession.” Surprisingly, when London traders arrived for work on Wednesday morning they held back from joining the criticism. Almost without exception yesterday’s opening levels marked the low of the day for sterling. It went on to add more than a cent against the US dollar, against which – miraculously – it starts today fractionally above its position before Tuesday’s GDP figures kicked it in the groin. It has made a full recovery against the Australian and Canadian dollars too.

The main reason for its renaissance was to be found in the minutes of January’s Monetary Policy Committee (MPC) meeting. For several months there had been a 1-7-1 voting split: Adam Posen wanted to increase the size of the asset purchase stimulus package, Andrew Sentance wanted to raise the Bank Rate by 25 basis points and six of their peers sided with the boss in support of the status quo. That distribution changed in January with Martin Weale joining Mr Sentance to vote for a rate increase. Even though decisions made at that meeting on 13 January could have been overtaken by events, investors were heartened to see that there was at least an inclination to move towards tighter monetary policy.

They were less charitable towards the dollar. Having bashed it in the past for weak housing figures they churlishly refused to give it credit yesterday for a 17.5% monthly increase in new home sales. The dollar actually moved fractionally lower after the announcement. There was a similar lack of interest in Canada’s Teranet house price index, which was down -0.2% in November after declining by -1.1% and -0.4% in September and October.

The impact of the two central bank interest policy decisions overnight had nothing to do with the interest rates they delivered: the Federal Reserve will stick to its 0-0.25% Federal Funds target range “for an extended period” and the Reserve Bank of New Zealand will leave its 3% Official Cash Rate untouched “until the recovery becomes more robust”. Yet the US dollar went down and the New Zealand dollar went up. The difference was in the economic outlooks offered by the two central banks in their statements.

The Fed expressed concern about employment, saying “employers remain reluctant to add to payrolls”. The RBNZ said “forward indicators of activity have firmed somewhat”, citing export volumes and prices, business confidence and housing market activity as factors that are all showing greater promise. There was not a million miles between the sentiments expressed by the Fed and the RBNZ; they are both guardedly optimistic for the future. The different treatment handed out by the market to the Greenback and the Kiwi had more to do with the prejudice of the moment than the meat in the statements.

Sterling’s exposure to ecostats today is limited to Hometrack’s house price index and the CBI’s retail sales figure. Hometrack has already reported a -2.2% monthly fall in January, to which there was zero reaction. The CBI measure is projected to deteriorate from 56 to 38. A cluster of official Euroland confidence indices will be announced this morning, beyond which there is nothing of particular interest from Europe. After lunch come US weekly jobless claims and the anarchic durable goods orders figures. Pending home sales follow in mid-afternoon. Japanese inflation (or deflation) and retail sales come out around midnight.

It would be extraordinary if investors had already been able to put behind them the memory of Tuesday’s GDP calamity but as London opens it is impossible to deny the possibility. Maybe we’re not doomed after all. Wouldn’t that be a turn-up for the books!

MoneyCorp

“Market doubts have largely disappeared,” Economy Minister Elena Salgado said after the auction.

The minister announced on Monday that the government was raising the minimum core capital ratio of the banks to 8 percent of risk-weighted assets from 6 percent at present. She said that lenders had until the fall to conform with the new benchmark or demonstrate they were in a position to do so. If not, savings banks, or cajas, would be obliged to transform themselves into commercial banks in order to allow the state bank restructuring fund (FROB) to inject capital into them.

Bloomberg yesterday quoted two people aware of the deal as saying that the FROB plans a bond issue in euros to be managed by Citigroup, HSBC, Royal Bank of Scotland Group, Santander and Société Générale.

The regional cajas are seen as the weak link in the domestic financial system because of their exposure to the ailing property sector and their fund-raising limitations.

The minister estimated the amount required by the sector to be 20 billion euros, a figure well below Moody’s Investors Services’ estimate of 89 billion euros.

“The government has missed another opportunity to throw some light on the real recapitalization needs of the sector to the market, leaving investors with ample room for interpretation,” Bloomberg quoted Ignacio Cerezo, a banking analyst at JP Morgan Cazenove, as saying in a research note.

However, José Viñals, the director of the monetary and capital markets department of the IMF, and a former deputy governor of the Bank of Spain, welcomed the development.

“In the case of Spain the markets’ view of the [situation] in the country is probably worse than the reality, and therefore, showing greater transparency and having financial institutions with high levels of capitalization seem to me to be good ways to increase confidence,” he told Spanish newswire EFE.

A number of the cajas currently fail to meet the new capital criteria, while commercial bank Bankinter’s ratio is also currently under 7 percent. Bankinter was the biggest blue-chip loser yesterday with a drop of 5.16 percent. Santander and BBVA were down 3.13 and 2.92 percent respectively.

Salgado also said yesterday that the government expects a budget deficit of 9.2 percent of GDP for last year against a target of 9.3 percent. The Economy Ministry said the shortfall in the central government’s finances was 5.1 percent of GDP, compared with a target of 5.9 percent.

Source: El Pais

One of the main drivers of inflation was the price of oil, which touched $100 a barrel on Friday. But the government’s austerity measures also had an impact in the wake of a hike in valued added tax from July and higher tobacco taxes.

With inflation in Germany also reaching a two-year high of 1.9 percent as the German economy grew strongly, the prospect of higher interest rates has begun to emerge, an eventuality that augurs badly for Spain as it seeks to fend off attacks on its sovereign debt from investors who question its creditworthiness.

With over a fifth of the working population out of a job, the average rise in wages last year in collective agreements covering seven million workers was only 1.3 percent. Almost half of those workers have no clause in their contracts compensating them for the loss of purchasing power because of inflation.

The rise in consumer prices will also badly hit public sector workers who were forced to take an average 5-percent cut in wages as part of the government’s effort to rein in its yawning public deficit and appease the markets.

Source: El Pais

Spain’s regions, which borrowed at similar rates to the central government before the global credit crisis started in 2007, are key players in Zapatero’s drive to get his budget in order and push down the country’s borrowing costs. They control around twice as much spending as the state, employ more than half of all public workers and piled on debt during the recession.

“If investors focused more on the problems in the regions, they would be less optimistic on Spain’s central government debt, and see that the rally in July was a bit overdone,” said Olaf Penninga, who helps manage 140 billion euros ($182 billion) at Rotterdam-based Robeco Group, and sold Spanish bonds last year. “If the central government has to help the regions it would aggravate an already bad situation.”

Risk Premium

The yield on 10-year Spanish government bonds has dropped 79 basis points to 4.09 percent since June 16, according to Bloomberg generic prices. The extra return investors demand to hold the debt rather than German equivalents was at 165 basis points today, down from a euro-era high of 221 points two months ago.

Banks are nevertheless charging Catalonia more for loans than the building companies stung by Spain’s construction slump.

The region, which attracts more tourists than any other in Spain, paid 300 basis points more than three-month Euribor for 1 billion euros of four-year bank loans last month, a spokesman said. Fomento de Construcciones & Contratas SA, Spain’s fourth- largest builder, said on Aug. 2 it agreed to pay a 260-basis point spread to extend 1.1 billion euros of loans until 2014.

While government records on Aug. 9 show that Catalonia sold 1 billion euros of five-year debt via savings bank La Caixa in June, it hasn’t issued a benchmark-sized bond in public markets since March even after taking a road show to Asia in April. “Debt markets closed” as Greece’s fiscal crisis spread through the euro region in the second quarter, said spokesman Adam Sedo last month.

At 5.5 percent, the yield on Catalan 10-year bonds is on a par with Peru.

Greek Fate

The regions’ budget problems come as Zapatero tries to convince investors that Spain can avoid the fate of Greece, which was forced to seek a European Union-led bailout this year after its deficit ran out of control. Zapatero, his popularity slumping in opinion polls, is pushing through the deepest austerity measures in three decades and borrowing costs have declined since officials last month published stress tests on Spanish banks.

The regions’ borrowing difficulties will likely complicate their relationship with the Madrid government. While Catalonia is pushing for more autonomy and Spanish law prevents the central government from bailing out the provinces, some investors expect it would do so if necessary.

‘Big Brother’

“There’s a certain perception that there’s a big brother standing behind,” said Diego Fernandez, a fund manager who helps oversee 240 million euros at Inverseguros in Madrid and is cutting holdings of regional debt. “There could be a region that has more difficulties and so would need some help, which wouldn’t materialize as a bailout but as some kind of larger transfer.”

The EU got around its own no-bailout clause in May and backstopped countries threatened by contagion from Greece’s crisis. Letting a region fail would also push up Spain’s own bond yields and would be “suicide,” said Jose Carlos Diez, chief economist at Intermoney Valores, Spain’s biggest bond dealer.

“It would be absurd — you don’t let a bank fail but you let a region fail?” he said.

Catalonia isn’t the only region that may hurt Spain’s budget battle. The autonomous community of Madrid postponed a bond sale on July 30 because of “market conditions.” Galicia is lobbying Finance Minister Elena Salgado to put a moratorium on 2.6 billion euros it owes the central government and to double the time it has to pay the money back. Salgado refused on July 27.

Debt Load

Regional debt has soared since the end of the decade-long real estate boom that provided local leaders with a surge in tax revenues. While provinces are required by law to balance their books, their overall debt load rose to 9 percent of GDP in the first quarter compared with 5.5 percent at the peak of the boom.

The regions have agreed to cut their combined deficit to 2.4 percent of GDP in 2010 instead of 3.2 percent planned at the start of the year. The shortfall will widen to 3.3 percent of GDP next year compared with a previous forecast of 4.2 percent. Zapatero forecasts the national deficit will narrow to 6 percent next year from 11.2 percent in 2009.

That hasn’t stopped Fitch Ratings giving four provinces a negative outlook on Aug. 4, meaning it now has all 10 of the regions it covers on notice for possible downgrades. Its ratings range from A+ for Catalonia and Valencia — the lowest since Fitch started rating them — to AA for Madrid, while the Basque Country is the only region rated AAA. Fitch cut its rating on Spain to AA+ May 28.

Any deterioration in the regions’ credit quality, coupled with one of the highest private debt loads in the euro area, could undo Zapatero’s efforts and push up Spain’s own borrowing costs, Penninga said.

Source: Bloomberg