Subordination is not the main issue in Spain

Many commentators have recently argued that sub-ordination of Spanish debt to the official assistance is the main driver of Spanish bond yield increases. Default on Spanish debt supposedly is becoming more likely because the new debt coming from the ESM is senior to the old debt. In this column, I argue that this is not the case. The main driver of the yield increase is the increase in the absolute debt level due to the assumption of private sector debt by the government.

The new programme is Spain has two outstanding features for the question at hand. First, it increases Spanish debt by around 10% of GDP. Second, this 10% of debt is treated senior to the 70% of exisiting Spanish debt. To illustrate what is driving the increase in yields, let’s do some simple arithmetics. Suppose that Spanish debt has a face value of 100 but a market value of 70. This means, markets expect that only 70 of the 100 will be repaid. The ability to pay of the Spanish government thus amounts to 70.

With the new programme, debt is increased by around 14%. If the ability to repay stays constant and the programme is providing finance without subordination, then the value of the outstanding debt should fall from 70 cents on the euro to 61 cents on the euro. If the 14 units of additional debt are given a senior status and we assume that the Spanish government will repay them in full, the capacity to service the old outstanding debt will be reduced by 14 and will amount to 56. This implies that market price of debt will fall to 56. The table illustrates the simple numbers.

Subordination thus indeed lowers the market price of outstanding debt. However, this effect amounts to around 1/3 of the problem while the fact that new debt is put on top of old debt drives 2/3s of the yield increase. The seniority effect is thus of second order compared to the actual increase in debt.

The key for Spanish solvency is thus not that assistance is given seniority or not. The key question is whether banking sector assistance as such will mean an increase in Spanish net debt. To the extent that private creditors of banks shoulder the largest part of the burden, the equity injections into the Spanish banking system should not negatively affect Spanish government solvency. In fact, becoming a shareholder of banks that have been restructured at the expense of old creditors of banks should not imply a net financial liability. On top of this, a significantly lower interest rate on the programme debt will contribute to debt sustainability. Moreover, sorting out banking sector problems should increase the ability to repay debt as credit provisioning to the dynamic export sector gets improved. On the downside, imposing losses on private creditors of banks may dampen consumption as well as investment depending on who are the main creditors to banks. It is therefore of central importance that the public authorities investigate carefully who are the creditors of banks and how losses would affect their behaviour. Overall, imposing losses on private creditors of banks will be a possible way of improving solvency of the Spanish government.