The severity of the Spanish financial crisis can be most vividly seen through the balance of payments data. March data shows net financial inflows of €533 million, but that includes ECB funding for the Spanish banks. When excluding the ECB funding, i.e., mostly private sector flows, the data shows €66 billion in outflows. In the past 12 months, €193 billion in private capital has left Spain, a whopping 18% of GDP. In March, about a third of these outflows came from the Spanish banks taking money out, while the rest primarily came in the form of foreigners liquidating portfolio positions and foreign banks exiting the country.
From an accounting perspective, what this means is that without the ECB support, the current account deficit in Spain would have had to adjust dramatically due to lack of financing. Without the ECB’s support, the resulting swing would likely have been so violent and so sudden that it could have triggered a series of bank collapses and corporate bankruptcies. When some say LTRO (the long-term refinancing operation) has been ineffective, they should think twice. The extent of the capital flight in Spain is mirrored outside the country in multiple ways, from Target 2 balances in the Eurosystem, to an increase in errors and omissions in the Swiss balance of payments or, and most obviously, through the level of Bund yields in the market.
While this transfer of wealth between the private and the public sector – with the ECB de facto funding capital flight – delays a much-needed current account correction, it provides some breathing space to the Spanish economy to smooth out the adjustment. The question is how much more foreign private capital is still left in Spain. The best guide here is the country’s net international investment position (NIIP), and the news is not particularly encouraging: As of the fourth quarter of 2011, the NIIP was still running at -92% of GDP, or -85% of GDP when excluding ECB funding. Since the data were published, however, the NIIP net of ECB funding has very likely gone through a further adjustment – possibly down to -60% to -70% of GDP, considering that current account data through March show 10% of GDP in ECB inflows during the first quarter of the year on the back of the LTRO. Remember, though, when excluding the ECB, Spain will continue to have total gross (not net) foreign liabilities of the order of 220% of GDP.
The NIIP data above tell us that the potential for more capital flight in Spain remains significant even after all that has taken place so far. The good news, though, is that when all is said and done, we expect a big share of Spain’s NIIP, possibly up to a third, will end up being owed to the public sector. Because of that, Europe needs to end its policy of “constructive ambiguity.” A pre-commitment to a credible and overwhelming policy response is necessary to crowd private capital in. The ECB needs to signal on a forward-looking basis how it would respond to an intensification of the crisis and European governments need to quickly agree how they will move toward greater fiscal integration. By crowding private capital in, an overwhelming policy response can actually save the official sector money on a prospective basis. Without this, private capital will continue to use the provision of official sector liquidity to exit Spain and this reduces risk appetite, credit and growth prospects for the Spanish economy.