The Spanish Treasury No Longer Accepts Italian Government Bonds

The Spain Treasury announced last Friday that it was no longer willing to accept Italian government paper as collateral for short term loans. In part the move is a reflection of the deteriorating liquidity situation inside the Spanish banking system, and in part it reflects the rather negative outlook on Italian government debt as continuing lowest-low economic growth makes it difficult to see how Italy can possibly hope to balance its budget by 2011, thus making holding Italian government debt a progressively more risky decision as that deadline approaches.

Spain's Treasury has said it is nopw only willing to accept the highest-rated government debt as collateral for short-term loans, a move that will exclude Italian government bonds. As of July, Spain will only take AAA rated bonds registered with the Spanish clearing house Iberclear as collateral for overnight repurchase agreements, or repos, according to Enrique Ezquerra, deputy director of public debt at the Spanish Treasury. Since Italian debt has been systematically downgraded in recent years, and Standard & Poor's now rates Italy's debt at only A+, while Moody's Investors Service has it at Aa2 this clearly means that Italian paper no longer qualifies. Italy's debt rating was lowered by both Standard & Poor's and Fitch Ratings in October 2006 on concern that problems in containing the deficit would lead to further increases in what is already the EU's biggest debt by volume over the coming years.


Basically the Spanish Treasury lends surplus cash to broker-dealers to boost income from financial holdings and in return receives collateral. Following the sub prime crisis in the United States last August the Spanish government expanded the range of securities it would accept as collateral to include foreign government bonds and AAA rated private debt since the strong budget surplus Spain was running at the time meant in had plenty of cash on hand.

Now Spain's budget surplus is rapidly disappearing as government spending rises in the face of the rapid economic slowdown while income is decreasing. Also, the Spanish banks, for whom this measure was really intended are finding themselves in an increasingly difficult liquidity gridlock, hence whatever help, no matter how small, they can receive from the government is more than welcome. Thus this move needs to be seen more in a Spanish than an Italian context. It is however a warning shot for Italy, since Italian paper (after its Greek equivalent) is the most difficult to place of any European government (and particularly given its volume), thus the Spanish decision can also be seen as a desire for the little window they have opened to become a repository for unwanted Italian debt.

In a Bloomberg interview Enrique Ezquerra described the move as "a partial step back....We will continue accepting AAA corporate bonds listed in the Spanish fixed-income market. This includes asset-backed securities and covered bonds.'' Perhaps I would say rather than a step back it is an attempt to close a loophole and focus attention on the real problem which is how to fund the Spanish cedula hipotecarias (the local version of mortgage-related covered bonds).

I would also say that this relatively small and seemingly trivial decision is just one more symptom of the sort of strains the eurozone's "twin deficts" (Italy's public debt - circa 103% GDP 2007 - and Spain's current account deficit - 12% GDP Q1 2008) are likely to place on the smooth working of the eurosystem ten years after it was originally set in motion.