Spain’s Waning Reserve Fund Risks Undermining Bonds: Euro Credit

Spain’s Waning Reserve Fund Risks Undermining Bonds
The Kio towers, the headquarters of Bankia SA in Madrid. Spanish banks, which had been using emergency European Central Bank loans to increase their holdings of national debt, lowered their share to 28.7 percent of bonds in May from 29.6 percent the month before. Photographer: Angel Navarrete/Bloomberg

Spain’s social security system risks falling deeper into deficit this year, eroding the ability of its 67 billion-euro ($85 billion) pension-reserve fund to prop up the Spanish bond market.

The reserve account has almost doubled its holdings of Spanish debt since 2008 as declining demand for the country’s bonds led the fund to start replacing German, French and Dutch securities with national debt. As the welfare system posts a loss, the fund’s ability to soak up new issues will diminish, adding to pressure on 10-year Spanish bonds, which yielded 476 basis points more than German bunds today.

The reserve fund’s assets, built up since 2000, is equivalent to about 11 percent of the central government’s estimated outstanding debt for this year, and more than 75 percent of the planned bond issuance for 2012. Its waning firepower comes as foreign investors shun Spanish bonds and as domestic banks, which had been picking up the slack, begin to reduce their holdings.

“Domestic demand in Spain isn’t sustainably sufficient to take all the supply and any slowdown in social security investment would only worsen that,” said Luca Jellinek, head of European interest-rate strategy at Credit Agricole Corporate & Investment Bank in London.

Spanish bonds have fallen more than 3.5 percent this year, making them the biggest decliners in Europe after Greece, according to indexes compiled by Bloomberg and the European Federation of Financial Analysts Societies. The yield on the country’s 10-year bond fell 9 basis points today to 6.29 percent, down from a euro-era high 7.29 percent on June 18.

Foreign Exodus

Spain saw the biggest outflow of foreign investment in April since the start of the euro, Bank of Spain data show. Non-residents cut their holdings to 37.5 percent of the total in May, from 38.1 percent in April and 51.5 percent at the end of last year.

Spanish banks, which had been using emergency European Central Bank loans to increase their holdings of national debt, lowered their share to 28.7 percent of bonds in May from 29.6 percent the month before. Public entities, including the social security fund, boosted their holdings to 15.8 percent of the total from 14.4 percent in April, according to Treasury data. Spain faces 32.8 billion euros of bond repayments for the rest of 2012.

“The Spanish bonds that mature in the second half are 90 percent held by domestic investors, so local demand remains key to the ability of the country to roll over its debt without hurting the government cash reserves,” said Ralf Preusser, head of European rates research at Bank of America Merrill Lynch.

Rising Joblessness

Spain’s social-security system is being weighed down by the highest unemployment rate in the European Union at 24.6 percent, which has drained contributions at a time when the number of retirees is on the rise. The system recorded a deficit equal to 0.1 percent of gross domestic product last year, the first shortfall in at least 15 years.

The government got some good news on employment today when the national statistics office announced that jobless claims in June, before the start of the peak tourism season, had fallen by more than 98,000, the biggest decline in the month since the series began in 2005.

New Measures

Those gained may be short-lived as the government prepares to unveil further austerity measures to try to make good on its pledge to bring its budget deficit within the EU’s 3 percent of GDP limit next year from 8.9 percent last year.

“We need to see in the coming weeks which components of the administration need to make further efforts,” Economy Minister Luis de Guindos said today in Madrid.

While the government seeks to balance the system’s books this year, economists including Ignacio Conde-Ruiz, a professor at Complutense University and the Fedea research institute in Madrid, and Javier Diaz-Gimenez, a professor at the IESE business school, forecast another deficit. Before the crisis, they estimated the system wouldn’t face a shortfall until about 2015 or 2017.

“They are going to start having to use the reserve fund in July” to cover pension payments, Diaz-Gimenez said in a telephone interview. “There is going to be a deficit for certain this year unless a miracle happens in the next six months.”

Workers, Retirees

Spain has 8.09 million retirees, who together receive about 7 billion euros per month, more than twice the 3.84 billion euros of expenditures in 2000. The ratio of workers per retiree paying into the system has fallen to 2.43, the lowest since 2003, Tomas Burgos, the deputy minister for Social Security, said on June 5.

As the system falls deeper into deficit, the government will be forced to change pension rules, reducing the risk to the reserve fund, said Juan Rubio-Ramirez, an economics professor at Duke University in Durham, North Carolina. The government, led by Prime Minister Mariano Rajoy, has pledged to keep reforming pensions and to reduce the deficit during its four-year term. The European Commission said in May that Spain should accelerate its timetable for raising the retirement age.

Rajoy has been expanding the government’s pension liabilities. He raised benefits in December at his second cabinet meeting after winning power. Rajoy, who opposed the previous administration’s increase to the retirement age and its freeze on pensions, increased retirement pay by 1 percent to meet an election pledge, even as he broke other campaign promises by raising taxes.

Fund Diversification

Before last year, the social-security reserve had grown every year since its inception. In 2005, with Spain running a budget surplus, the fund diversified into German, French and Dutch debt to prevent its purchases undermining the liquidity of the Spanish bond market, Burgos’s predecessor, Octavio Granado, told Parliament in May 2009. As the crisis started pushing up Spanish borrowing costs in 2008, the fund replaced maturing foreign securities with Spanish equivalents and then accelerated the switch into domestic debt the following year, according to a transcript of Granado’s comments to Parliament.

By the end of 2011, 59.1 billion euros was invested in Spanish debt, and 6.7 billion euros in foreign securities, the fund’s annual report showed. That compares with 32.2 billion euros of domestic government debt and 24.9 billion euros of foreign debt at the end of 2008.

The concentration of domestic debt may pose a dilemma for Spanish authorities when they need to tap the fund, said Diaz-Gimenez of Complutense University. The fund held 2.2 billion euros, or 14.8 percent, of all of Spain’s 4.2 percent 2013 bonds in circulation at the end of 2011, according to the reserve fund’s report to parliament.

“Nearly all of it is Spanish debt and if you want to sell that in the secondary market, you’ll push up the spread,” he said. “You’ll pose a serious problem for the Treasury.”

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