Spain economy: Tick tock
FROM THE ECONOMIST INTELLIGENCE UNIT
Time is running out for Spain. The economy has plunged into its second recession in little more than two years. Unemployment is at a record high above 24%, and expected to rise further still. Thousands have taken to the streets to protest against austerity, as the government launches yet more cuts to try to contain the spending deficit. The cost of government debt is rising dangerously. And then there is the banking system, broken by bad debts from a popping property bubble. Struggling to cut spending, the state continues to cast around for ways to make the banks pay for their own mistakes. Few believe this is realistic, meaning that the question is increasingly when, not if, Brussels will need to step in to avoid a meltdown of the financial system.
Figures for the first quarter of this year released yesterday (April 30th) were actually slightly less bad than feared, with the economy shrinking by 0.3% over the three months for the second quarter in a row. However, this is hardly a cause for optimism. Exports held up better than expected, offsetting to some extent a tumble in domestic demand as austerity bites and bank credit dries up. That is not sustainable, with a spending crunch across Europe expected to dent euro area demand, hitting Spanish exports. The Economist Intelligence Unit expects the economy to tumble by 2.2% this year, and then to remain flat in 2013. Unemployment of 24.4% (and 50% for young people) will rise.
The Spanish government is slightly more optimistic, expecting a contraction of 1.7% this year. But even on its own sums it will struggle to honour a promise to Brussels to cut its spending deficit below 3% of GDP next year (from a remarkable 8.5% in 2011). It recently admitted that renewed recession would keep the deficit well above 5% this year (compared to a now-scrapped target of 4.4%) and few believe its promise to cut the spending gap below 3% next year. With public debt levels surging, yields on government debt have surged above 6% at some points over the past month, worryingly close to the 7% cut off point that the markets regard as unaffordable for the state. Standard & Poor’s (S&P, a ratings agency) slashed Spain’s credit rating by two notches to BBB+ on April 27th, only just above investment grade.
The spiral
All of which means that Spain is caught in the classic euro zone debt spiral. It has been forced into austerity to reassure the markets even though the cuts will destroy growth, and any chance of reducing its debt burden. In fact, it will be hard for the country to force through any more spending measures. The centre-right government of Mariano Rajoy introduced a series of spending cuts and tax hikes in late March. Just one week later it announced another €10bn worth of measures (chiefly cuts to education and health spending) when increasingly dire economic data made it clear that it would miss its spending targets otherwise.
In late April and then again in early May thousands of Spaniards took to the streets to protest against the most recent cuts. With more mass demonstrations planned further austerity measures look implausible, politically and economically. Certainly, the government itself accepts that increasing the level of (relatively low) value-added tax to hike revenues, or cutting public-sector wages to crunch spending, could be counter-productive. Such moves would simply depress the level of consumer spending still further, wiping out any possible benefit to the budget.
We expect the spending deficit to remain above 6% of GDP this year as the economy wilts, meaning that Spain will have missed its spending targets for the second-consecutive year. Market funding will remain tricky, therefore. However, the country has already met a good chunk of its funding needs for this year, making a liquidity crisis unlikely over the next six months. That makes the more immediate worry a banking sector that it is already in trouble, and which will be in a lot more trouble as the economy deteriorates. A state bailout is likely, and given the lack of money at national level that probably means action at a European level.
Hidden problems
As the IMF noted recently, one of the biggest concerns is that no-one is quite sure of the extent of the problems bubbling away beneath the stated figures. Officially, bad debts already tot up to more than 8% of the total. Many of them stem from property loans, following a decade-long housing boom up to 2008. Prices have crumbled by close to a third since then which, with high unemployment, means a big hit to the banks: forced to repossess houses from often jobless non-payers, they must then sell them on for a big loss. Industry analysts assume that things will get far worse, with 800,000 empty homes in Spain.
House prices have still not fallen by anything like as far as in Ireland, another country whose banks needed rescuing after the property bubble burst. Irish home prices have crashed by 50%, suggesting that Spanish prices have further to fall. Add on rising unemployment making more people unable to service their debts, and the banking problems will get worse. S&P recently downgraded 11 Spanish banks including the two biggest, Santander and BBVA. Industry analysts say that another €100bn needs injecting into Spanish banks to bolster their battered balance sheets, on top of a big increase already planned by the government (such is the uncertainty over the figures that we expect the final figure to be anywhere from €80bn-160bn).
So far, the cash-strapped government has concentrated on forcing the industry to mend itself. It has ordered banks to increase their bad-debt provisioning and hike their capital by more than €50bn in total. And it has forced industry consolidation, with smaller banks that can’t afford the hit taken over by bigger and supposedly stronger banks. Now, there is talk of setting up a private bad-debt agency, which will take over the problem loans from the banks. However, many doubt that this scheme will do much to mend the banks. In contrast to Ireland, where the bad debt bank bought problem loans outright at a discount, private lenders in Spain will only offload loans that have already been fully provisioned, thereby avoiding a capital hole after the assets are transferred. But the doubts about asset quality extend beyond the construction and developer loans that would presumably make up the bulk of assets transferred to a bad bank.
Unaffordable
If the problems turn out to be as bad as expected then there is no chance that the banks will be able to fund their own rescue. The national government could step in, but a rescue looks unaffordable: a €100bn state bailout would hike public debt from below 80% of GDP to nearly 100%. With the spending deficit so high, market funding for the country would dry up amidst fears of a default. That means that the banks will need to be rescued by Brussels.
Existing euro zone bailout funds can comfortably handle a rescue of this size, but the manner—and timing—of the package will be crucial. If Brussels follows the same course it took over countries such as Ireland and Greece, giving money to the Spanish government to dole out to the banks, markets would perceive this as another euro zone country in need of a rescue. That threatens a panic among private investors that could quickly spread to countries such as Italy and even France.
Alternatively, the EU could inject money directly into Spanish banks, bypassing the government and the perception that this was part of a much wider problem. That would be a big shift away from national banking regulation within the euro zone, and the mechanisms to do this do not exist yet (the talk is of a dedicated fund being spun out of the existing ones). But if Brussels wants to avoid Spain’s problems infecting the wider region, it probably needs to be done—and soon.
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