Madrid will regret refusing a front-door bailout. The straightforward way of dealing with Spain’s banking problem would be for the government to borrow 50 to 100 billion euros from the European Financial Stability Facility (EFSF) or the soon-to-be-created European Stability Mechanism (ESM), and inject that money into the banks. But Mariano Rajoy, the country’s prime minister, continues to deny publicly that the country needs such a rescue.
There are probably two reasons. First, Madrid is worried about the consequences of following Greece, Ireland and Portugal down the bailout road. Not only would there be stigma, which could shut Spain out of the bond markets and force it to seek more extensive help from its euro zone partners; the government might have to agree to further reforms on top of everything it is already doing to tighten up its finances and free up the labour market.
The second reason is that Rajoy clings to hopes that there are back-door ways to rescue the country. To help the government, ECB could relaunch its programme of buying sovereign bonds. Provided it is done on a scale large enough to impress markets, it could push Spanish yields down from the current, punitive 6.7 percent. It could be done quickly – but the ECB is clearly reluctant.
To help the banks, Madrid’s favourite idea is to get the EFSF or the ESM to inject capital directly into its lenders. That would shore them up without the government’s own debt rising. The snag is that this would require an overhaul of the funds’ mission – and Germany is against the idea. Madrid therefore has floated the idea of injecting 19 billion euros of bonds into BFA-Bankia, the largest problem bank. BFA-Bankia would then swap those bonds with the ECB for cash. But the central bank doesn’t want to be seen as financing government deficits in such an overt manner.
Germany and the ECB may come to relent. But that may require a further worsening of the crisis, and a scenario where Greece would leave the euro. At that point, Spain could face a deposit run and Italy could also be in trouble. At the moment, there isn’t enough money in the bailout funds to rescue both countries. Rajoy should grab the money to shore up his banks while he can.