Pimco Sees Deflation Risk as Rajoy Hails Spain Price Drop

What Spanish Prime Minister Mariano Rajoy hails as a success when it comes to keeping a lid on consumer prices, investors are seeing as a risk.

Spanish inflation turned negative in February, adding to pressure for the European Central Bank to act when the Governing Council meets tomorrow as Pacific Investment Management Co. deputy chief investment officer Andrew Balls and International Monetary Fund Managing Director Christine Lagarde highlight the risk of price declines for the euro area.

Rajoy, 58, has shrugged off concerns about slowing inflation, which he says has helped boost the competitiveness of the euro region’s fourth-largest economy. Yet falling prices will make it harder for the government to pay back debts approaching 100 percent of gross domestic product.

“Spain risks falling into a deflationary trap as it’s operating at very low levels of inflation,” said Gizem Kara, a senior euro area economist at BNP Paribas in London, in a telephone interview. “Also, the lower inflation you have, the lower nominal growth is and the higher the debt-to-GDP ratio.”

Spain plans to sell as much as 5 billion euros ($6.9 billion) of bonds maturing between 2017 and 2024 before the Frankfurt-based central bank announces its interest-rate decision.

Borrowing Costs

While analysts estimate the likelihood the ECB may cut interest rates has declined, other options might include issuing fresh long-term loans to banks or ending the absorption of liquidity created by the ECB’s crisis-era bond purchases.

That last option may reduce borrowing costs of so-called periphery countries including Spain, especially in five-year maturities, because an increase in excess liquidity may be used by banks to buy bonds, Paris-based Natixis analysts Cedric Thellier and Cyril Regnat wrote in a note on March 3.

The deflation risk is important, Pimco’s Balls, who is buying Spanish debt among about $2 trillion in assets he helps manage, said in Feb. 28 interview on Bloomberg Television’s The Pulse. Weakening prices are “a significant challenge for the central bank,” he said.

Maintaining Spain’s advantage over its single currency peers is becoming more difficult as inflation throughout the region was at 0.8 percent in February, compared with a pace of 1.8 percent a year earlier. In Germany, the euro area’s largest exporter, the rate last year sank below 2 percent and stood at 1.2 percent in February.

Bonds Rally

The yield on Spain’s 10-year benchmark bond today fell as low as 3.39 percent as HSBC Holdings Plc recommended investors buy the debt at its auction tomorrow. That yield was the lowest since 2006, before the end of a real estate boom triggered a downturn. The yield on Spain’s two-year bonds touched a record low 0.68 percent.

The Spanish Treasury has sold 34 billion euros of mid- and long-term debt, a quarter of its 2014 needs, in less than two months amid a rally that has enabled it to place record amounts of debt.

The decline in funding costs has eased the pressure on Rajoy even as the country’s debt load rises to a record. The premier on Feb. 28 cited the low inflation rate as a sign that his policy recipe is succeeding.

“Our inflation is at a historic low,” Rajoy said. “We are gaining competitiveness and that means growth and jobs.”

Spanish consumer prices fell 0.1 percent from the year earlier period in October and February, the first declines since global markets collapsed in the aftermath of Lehman Brothers Holdings Inc.’s 2008 bankruptcy. According to European Union methodology, February’s prices were unchanged.

Don’t Boast

Spanish households have seen their average income decline 10 percent since 2008 as the government raised taxes, cut public pay and changed labor laws to make it easier for private companies to lower wages in a bid to help the economy grow.

“A low CPI number, such as 1 percent, isn’t to boast about, unless growth is at 2 percent,” said Georg Grodzki, who helps oversee $515 billion as head of credit research at Legal & General Investment Management in London.

Rajoy is aiming for a 1 percent growth rate this year after contractions of 1.2 percent in 2013 and 1.6 percent in 2012. While household spending last year recovered after a year of declines and exports hit a record, growth accelerated to only 0.2 percent in the last quarter as the government extended the deepest budget cuts in the nation’s democratic history.

Spain’s “very high stock of private and public debt, both domestic and external, continues to pose risks for growth and financial stability,” the European Commission said in a review of macroeconomic imbalances published today. Reducing government debt in the medium term will require “sustained fiscal efforts,” it said.

“Weak inflation, not necessarily deflation, would be enough to weaken debt dynamics materially in the periphery,” Ruben Segura-Cayuela, a former Bank of Spain economist who works at Bank of America Merrill Lynch in London.

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