Apr 19, 2012 11:52 AM IST | Source: CNBC-TV18

Spain's first step must be to recapitalise banks: Rabobank

The biggest fear is that Spain's cost of debt is hovering around the dangerous 6% limit, says Lyn Graham Taylor of Rabobank.

Spain is getting ready to auction its 10-year government bonds today. This is another test to see how yields and demand will respond in an environment that has seen yields climb steadily. The results of the auction will give a good indication of which way markets are headed going forward.

The biggest fear is that Spain’s cost of debt is hovering around the dangerous 6% limit, says Lyn Graham Taylor of Rabobank.

In an interview to CNBC-TV18 he says the Spanish 10-year yield will have to hit somewhere close to 6.507% for the murmurings to get louder. “There will be a little bit of a wait but at that level is when concrete measures will start to be taken by the various European authorities.”

Investors are also looking ahead to a G20 meeting on Thursday and Friday that will discuss boosting the International Monetary Fund's (IMF) debt-crisis war chest to USD 500 billion.

“Any funds coming from the EFSF or ESM are likely to be associated with some funds also coming from the IMF. I think it will be a joint program,” says Taylor.

Below is an edited transcript of his interview. Watch the accompanying video for more.

Q: How alarmed are you by this rise in Spanish yields over the last several weeks? Do you think this has now assumed crisis proportion? Will Spain go the Greece way?

A: I wouldn’t say that Spain is heading the Greece way but definitely we are back in crisis mode. Spanish yields are rapidly on the increase and have been over the last couple of weeks. We are really in wait and watch mode now to see what the next steps are that will be taken with regards to helping Spain out, I guess the most unlikely of those being in the first step of bank recapitalisations with the funds potentially coming from the EFSF (The European Financial Stability Facility).

Q: The bad loan data that came from Spain, that number has now hit 8.2% of the total credit portfolios of Spanish banks. Does the EFSF have enough fire power to be able to help recapitalise Spanish banks?

A: Spain has to be given a little bit of credit as they have made a lot of progress over the last couple of years with reforming its banking sector particularly with regards to the merging of the smaller savings banks where there are particularly significant problems and also its FROB (The Fondo de reestructuración ordenada bancaria) facility where it has actually been injecting capital into banks.

That has a limit to its size and it needs to happen on a much larger scale but with the increased size of the EFSF/ESM, there are sufficient funds to enact a recapitalisation of the Spanish banks.

Q: Are you expecting an IMF pitch to come in because the IMF is currently discussing raising more money from its member countries?

A: Any funds coming from the EFSF or ESM are likely to be associated with some funds also coming from the IMF. I think it will be a joint program.

Q: Many people when they spoke of what next in Europe after Greece they inevitably used to mention Italy. But we have seen in the last few weeks that the Italian yields haven’t caused as much nervousness as the rise in Spain. The 10-year yield in Italy had stayed well below 6% but Spain has been flirting with that 6%? Why is it that Spain seems to have exceeded Italy in the bad news situation? How are investors making this distinction between Italy and Spain currently?

A: With regards to Spain, the sort of nasties in the cupboard with regards to its banks is quite unknown. No one really knows exactly what scale of recapitalisations are required and what real estate loans affectively impaired and the severity of future house price falls. But I think the bond market feels more comfortable with what the issues are with Italy and that we know it has got a very large stock of sovereign debt which isn’t really growing significantly in size and we all know it has suffered from low economic growth over the last few years.

But I think there is confidence generally in the Monti government being able to push through some reforms. So it’s really with regards to Spain there could be skeletons in the cupboard which no one yet knows about whereas everyone knows the problems in Italy.

Q: What number does the Spanish 10-year yield have to hit for one to start getting alarmed and believe that this problem is now spiraling out of control?

A: It is going to be a similar story to last time around in November where perhaps the 6.5-7% level is when concrete measures start to be taken by the various European authorities. They have got a little bit of a wait. We are hearing the first murmurings of what potential steps might be taken but in order for anything to be enacted, I think we will have to see a bit more pressure so about 6.5-7% level.

Q: What are the other steps and when do you start expecting to see the ECB intervene?

A: I think it is possible. The difficult one to read at the moment is both the S&P and the LTRO ultimately failed in their aims and it is just the question of what tools they have left in their tool bag to deal with the crisis and that is why we think the likely first step is the bank recapitalisation in Spain.

Q: Are you at all expecting a third Long-term refinancing operations (LTROs)? If there was to be another S&P type of intervention, what would it take? When do you think that will happen where the ECB might be forced to intervene?

A: I think the LTRO is unlikely simply because the system is already over washed with liquidity. The LTRO is essentially something that provides liquidity. We view that as fairly unlikely. We know the S&P is not very keen on it but it is more likely than another LTRO being run.

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