Spain Downgraded, Seen Asking for Bailout Saturday

China rate cut worries investors as more bad news anticipated

Fitch cut Spain’s credit rating by three notches late Thursday, leaving it two levels above junk, and Friday morning word circulated that the country would ask for a bailout on Saturday. Meanwhile, investors who had been elated over China’s rate cut on Thursday began to fear that the action presaged a host of bad news to come over the weekend.

Reuters reported Thursday that Fitch took the action on Spain and added a negative outlook, saying that the country’s banks would require approximately 60 billion euros ($75 billion) to recapitalize—with the total to go possibly as high as 100 billion euros if the situation escalated.

In a statement, Fitch said, "The negative outlook primarily reflects the risks associated with a further worsening of the eurozone crisis, notably contagion from the ongoing Greek crisis."

The country’s troubles were reinforced with the determination in an International Monetary Fund (IMF) report, to be published on Monday, that at least 40 billion euros would be required to cover the banks’ capital shortfall. The total needed to resolve the sector’s problems is about 90 billion euros, the report says, adding that healthy banks should cover much of the larger total.

An unnamed source discussing the contents of the report told Reuters, "The capital shortfall for the Spanish banks will be around 40 billion euros after taking into account the capacity from some of the entities to cover expected losses with their own resources."

European Union and German sources were cited as the origin of the news that Spain would at last seek a bailout. According to two senior E.U. officials, a conference call would be held Saturday among finance ministers of the 17-member eurozone to discuss the situation, and the Eurogroup would issue a statement at the conclusion of the meeting. No monetary amount had yet been determined, they said, although one was quoted saying, "The announcement is expected for Saturday afternoon." Later reports cited five officials as being aware of the planned call.

A senior German official said in the report, "The government of Spain has realized the seriousness of their problem," adding that the group had to reach an agreement prior to the next Greek elections on June 17.

However, the sources also said that it was unlikely that any additional conditions set for Spain would be tough, and that additions to austerity measures and economic reforms already mandated would likely not be made.

Two unnamed E.U. officials said that a final total for the cost of recapitalizing the country’s banks was still in flux. "You've got bad property loans that still haven't flowed through the system, and you have a recession. All the banks' balance sheets are going to be under increased pressure in the months ahead as a result," one was quoted saying.

He added, "When it comes to Spain, there would appear to be two ways to go: a minimalist approach in which only the bare minimum of banks are recapitalized, and a maximalist approach where you try to get ahead of the bad loans in the pipeline and recapitalize all the banks that need it."

Just prior to the downgrade on Thursday, Prime Minister Mariano Rajoy of Spain said in a Bloomberg report that he was discussing with E.U. colleagues how best to resolve the situation, and would wait till he received the results from consultants Roland Berger and Oliver Wyman on their evalution of the banks’ capital needs. The two are set to deliver reports on the state of the banks in the second half of June.

“After that I will give my figure and the government will say what the financial system needs to be recapitalized,” he was quoted saying during a Madrid news conference with the Dutch premier, Mark Rutte. “I’ve been talking to my European Union colleagues and to Prime Minister Rutte to take a decision on this matter.”

While Amadeu Altafaj, spokesman for the European Commission (EC), would not confirm that the Saturday conference call regarding aid for Spain was planned, and said that Spain had not requested aid, he did say that should such a request come there were structures in place to deal with it.

"If such a request were to be made, the instruments are there, ready to be used, in agreement with the guidelines agreed in the past, in 2011," he was quoted saying, and added, "We are not at that point."

Officials cited in the report said that the aid package in the works would focus only on the banking sector and not remove Spain from credit markets. Such a move would be aimed at preventing a bailout from overtaxing the rescue fund, since Spain is the fourth largest economy in the region and the twelfth largest in the world. Having to provide for Spain’s financial needs for the next three years in addition to the possibility of additional aid for Ireland and Portugal would strain the capacity of the rescue mechanism.

Vincent Chaigneau, head of rates strategy at Société Générale, was quoted saying, "I think they're trying to get a lighter support package, where the money is headed to the banks and not for financing the fiscal deficit. But you need to know the details, the size of the program and who participates."

A government spokeswoman in Madrid said she could not confirm any announcement on a pending bank rescue.

Rajoy has been pushing for aid to go directly to banks rather than being funneled through governments, but it is not known whether such a strategy is being considered for a bailout of the Spanish banking sector.

As the world worried about Spain’s plight, investors got jittery about China’s move to cut interest rates on Thursday, and some banks held deposit rates where they were in resistance to official policy.

Reuters reported that suspicious investors grew wary of the action taken by the People’s Bank of China (PBOC) Thursday and showed their concern by driving the market down on Friday. Worries that the Chinese economy could be weaker than expected, and anticipation of a flurry of bad news over the weekend, sent stocks tumbling.

"The rate cut should have been a positive but it comes at suspicious timing," Norihiro Fujito said in the report. Fujito, senior investment strategist at Mitsubishi UFJ Morgan Stanley in Tokyo, added, "It makes people think that really bad news is going to be unleashed this weekend."

Growth is expected to slow for the quarter, with falling figures anticipated in trade data and stabilizing numbers in fixed asset investment and industrial production. While in other countries those numbers would look good, for China they reflect a slowdown in a formerly booming economy that has proved to be vulnerable to the contagious slowdown in the West. Although exports and imports are expected to show an increase, both are thought to fall short of the 10% growth Beijing is aiming for in 2012.

China’s top five banks decided to break with official policy and keep deposit interest rates at their pre-Thursday levels, in an effort to win more savers and entice more deposits.

Industrial and Commercial Bank of China, China Construction Bank, Bank of China, Agricultural Bank of China and Bank of Communications all maintained a deposit interest rate of 3.5%. A few smaller banks even boosted their interest rates to 3.58%, in accordance with the wiggle room granted by PBOC on Thursday at the same time as its rate cut.

Deposit rates have driven would-be savers into riskier ways to invest their money, since they have often failed to keep up with inflation. Many of those savers have instead put their money into property ownership—and China could be sitting on a real estate bubble of its own as house prices have soared.

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