Costs of rescuing Spain’s savings banks should be manageable but more information is urgently needed

Outside of Greece, the most worrying developments in the ongoing euro zone crisis have been in Spain. Although it must be hoped that Greece will find a way of  stepping back from the brink of default, financial collapse very likely forcing an exit from the euro zone, it is clear that preparations must be made for the possibility that Greece does leave and the contagion implications for other countries. Since Portugal and Ireland are covered by euro zone and IMF rescue packages with whose conditions they are expected to continue to comply, the most vulnerable country looks like Spain

It should be remembered that unlike Greece and Italy, the Spanish crisis is not to do with poor management of public sector accounts. On the contrary up to 2007 Spain was a model with a debt less than half of Germany’s and an annual surplus. Spain’s problem like Ireland’s originates from private sector imbalances fuelled particularly from a housebuilding boom leading to over-supply and consequent problems for banks which had lent to builders and property companies. In Ireland virtually the whole banking sector collapsed in 2010 and the costs to the state of rescuing the sector forced it into asking for a loan facility from the euro zone and IMF. In Spain by contrast it is less than half the banking sector that is severely affected and Spain has not so far needed outside financial assistance. But the news on May 12th that a medium sized bank, Bankia (formed from a merger of seven regional savings banks), needed to be provided with capital by the government and that the government had instructed banks to increase provisions on property loans not already regarded as distressed from 7% to 30% has engendered fears that further bad news could be expected from the property exposure of banks. The problems of some of Spain’s regional savings banks have been known for at least two years, but action to tackle the problems has been slow and reactive rather than proactive. Given the sensitivity of financial markets to bad news and continuing uncertainty the need to draw a convincing line under the matter is urgent. At last on May 21st, the Spanish government  appointed two independent auditors—Roland Berger (a German consultancy company) and Oliver Wyman (a US consultancy)—to assess the scale of the problem posed by property loans throughout the Spanish banking sector. They are expected to produce preliminary reports in a month and more detailed ones in three months. It must be hoped that the report within a month provides a fairly clear indication of the scale of further support that the Spanish government may have to provide. According to most unofficial estimates (official estimates are still much lower) this should not to be than €100bn or about 10% of Spanish GDP. With the Spanish debt to GDP ratio at 68% of GDP at the end of 2011 and likely excluding bank refinancing to amount to about 75% at the end of 2012 this would put the ratio up to 85% which should still be manageable. Even the much higher €262bn estimate by Nouriel Roubini should not itself make Spain unsolvent but anything substantially over €100bn would be alarming given the worries about the euro zone as a whole and the continuing decline of the Spanish economy.

It should however be pointed out that, despite recent downgradings by Moody’s, the two large international commercial banks, Santander and BBVA, still look robust with capital ratios comfortably above those required and continuing profitability in first quarter 2012 of €1.6bn and €1bn respectively, despite the deep double-dip recession in Spain.  While more information is urgently needed, the evidence so far available does not suggest that the Spanish banking sector is in such a bad position as to require an external rescue in the short term. In the longer term the key question is whether the economy is near to bottoming out or whether job losses on a large scale will continue. The losses of Spanish savings banks have been almost entirely to property and building companies. There is also an estimated €656bn of individual mortgage debt in Spain. At present the rate of non-performing loans in this sector is below 3%, but it is not likely to immune should the Spanish economy deteriorate further.

Hollande and Merkozy have no time to get to know each other

Not for all, but for a great deal, of the time since General de Gaulle brought in France’s Fifth Republic, the European Union and its forerunners have been dominated by the personal relationship of the French president and the German chancellor. With the EU having expanded from six to 27 member states, there has been much discussion as to whether this tandem would be superseded. But this has not happened other than for temporary intervals. The institutions of the EU to which their effective founder, Jean Monnet, gave so much emphasis, are also important, but if the franco-German relationship is not working, the institutions have been unable to do much more than tread water, preventing disintegration of the EU but not able to tackle major problems. This is the situation today. While previous French presidents and German chancellors have always built strong personal relationships over a period of time, President Hollande and Chancellor Merkel have no time.

They have to act urgently on two fronts. They must restore confidence that the euro zone as a whole can find a path out of its debt-recession quagmire at a time when there are fears that a weakening economy and failing banks will undermine Spain’s ability to restore control over its public sector finances, and when the situation in Italy which has an even higher public sector debt than Spain is only slightly better. The policy levers available, such as enhancing the capital and role of the European Investment Bank, more effective use of EU structural funds and project bonds, are limited and certainly no single measure is on its own going to transform the situation, but that is all the more reason why the levers available should be harnessed with urgency.

Even more urgent is how to tackle the political, social and economic crisis in Greece. At the general election on May 6th, the Greek electorate did not give a parliamentary majority to the traditional parties, Pasok and New Democracy, which, albeit with equivocations and extreme reluctance, had in principle accepted the principle that in order to continue to receive financial support in the form of loans to the Greek state and liquidity to Greek banks, they had to put into effect deficit reduction and other reform measures insisted upon by Greece’s creditors as represented by the troika of the European Commission, European Central Bank and IMF. Both in opinion polls and in the parties they voted for at the election, the majority of the Greek electorate voted against the austerity measures but in favour of staying in the euro. This is despite the fact that EU leaders, including Chancellor Merkel and the outgoing French president, Nicolas Sarkozy had insisted in October 2011 that, if a referendum were held as proposed by the then Pasok leader, George Papandreou, a vote against austerity would in effect be a vote against continued membership of the euro. President Hollande and Chancellor Merkel must now decide if this is a position they will hold to ruthlessly confronted with the high possibility that Greece will reject the conditions of the financial rescue again, and decisively, in a second general election in June.

A willingness openly to negotiate an easing of conditions does not seem an option. The troika, backed by France and Germany, firmly told the Pasok leader, Evangelos Venizelos, and ND leader, Antonis Samaras, that the conditions could not be substantially altered. If they had been more flexible, Pasok and ND would not have had to go into the April election on such an unpopular policy platform. To change stance now or after the June election in order to appease parties competing with Pasok and ND, would therefore be a betrayal of Mr Venizelos and Mr Samaras and would also indicate that populist politicians, in any country in need of financial assistance, could alter the terms of such assistance by simply demanding better terms.  Therefore, it will almost certainly have to be made clear that the new financial rescue programme agreed in March would be null and void if a Greece’s parliament after the June election, rejects the conditions. The stance is not something that Germany could agree to change if President Hollande were to request it.

However, there remains a question as to whether to threaten Greece with a withdrawal of any support linked to staying in the euro if the election again produces an anti-austerity result. The unpredictable sequence of events which would follow a refusal of further loans and an enforced default would be very likely to lead to a degree of economic and social breakdown against which the only possible palliative would be a decision by the national authorities to re-introduce a national currency. But no country can actually be expelled from the euro so it is questionable whether to threaten a country with being cut off from the euro would be proper and to do so might also precipitate crises of confidence in continued euro membership in other vulnerable countries.

What can and should be done is that the new emphasis on growth measures that President Hollande is insisting be added to the fiscal treaty be applied with urgency to Greece. There are substantial unused funds available for Greece in the 2007-13 EU budget. They should be used for immediate high-profile projects such as youth training programmes and investments in export or import-substituting food or other manufacturing facilities and such plans should be given high publicity so as to counter the despair which has spread and is particularly affecting young people. The situation in Greece is already one of social and economic disaster with shops and tavernas closing all over the country and those that remain open nearly empty, while tenants with little or no income are being evicted with nowhere else to go and dependence is increasing on soup kitchens and other charitable measures not associated with Europe since shortly after the Second World War.

Are Greek voters pushing the country inadvertently to an exit from the euro?

Following the indecisive election of May 6th, it seems likely that another election will have to be held because it will prove impossible to form a government with a majority in parliament. The two parties which have alternated in power for most of the period since 1974 and which reluctantly were willing to work with the troika of the European Commission, European Central Bank and IMF on the basis of the Memorandum of Understanding for the second financial rescue package agreed in March 2012, received about a third of the popular vote. Because of the Greek voting system, which deliberately rewards the leading party with extra seats, the two parties very nearly achieved a majority of seats in parliament (Vouli). In fact they won 149 seats out of 300, but a small victory would have been very fragile given the frequent occurrence of party defections, and the two parties might not have been able to work together. Although they have supposedly worked together during the last five months, in practice the interim government, which was led by the non-aligned Lucas Papademos, has just done what it was told to do by Greece’s creditors, with ND indicating that it would attempt to adjust policy after the election. Very reluctantly ND was pushed into agreeing that such changes could not alter the broad thrust of the Memorandum.

Democracy has an inherent flaw in that to be elected parties in government have an incentive to spend more or tax less than is needed to prevent debt rising while parties out of government are more likely to be elected by making promises to spend even more or tax even less. Given these inbuilt incentives it is surprising that it is only recently that government finances in democracies in many countries have deteriorated to an extent that investors have begun to shun them.

The situation in Greece has now reached a condition where it is putting strains on the country’s democracy. This is not because of voting for extreme parties. Although the rise of the neo-Nazi Golden Dawn is cause for concern, the vast majority of Greece’s recently elected members of parliament are committed to democracy within the Greek constitution.

There are two problems. First that there is a high degree of disillusion with politicians, which seems only likely to get worse. The two main parties have lost support because they are seen to have led the Greek people into the present dire situation but the other parties are all saying that there is an alternative to the current austerity policies when no such alternative exists. Even if Greece renounces all its debt servicing it would still have to carry out the present austerity plan or one equally severe or end up unable to pay salaries or pensions.

Secondly, the Greek electorate does have a choice but does not seem aware of what the choice is. The choice is between following the conditions attached to the new financial rescue agreement, with only a modest room for negotiation and interpretation, or rejecting the Memorandum in which case it could no longer expect the financial support provided by euro zone partners, the ECB and the IMF to continue. If this happens Greece’s banks would be likely to collapse making normal economic life only possible if Greece reinstates its own currency.

In other words the Greek electorate has to decide whether they want to remain inside or outside the euro. Opinion polls show that 70% want to remain inside the euro but the general election result suggests that two thirds of the electorate does not want to accept the necessary conditions to do so.

 

If another general election takes place, the choice must be spelt out more clearly. The EU (both its member states and the Commission and Parliament) should have a duty to help Greeks make that choice since the EU is partly responsible for the condition in which Greece finds itself by enabling it to join the euro. Leaving the euro should not be seen as entirely negative and should not be equated with leaving the EU. It is argued that there is no provision in the Lisbon Treaty for a country to leave the euro although there is one for a country to leave the EU but there is also no provision that a country forced out of the euro would have to leave the EU.

 

The truth is that economists have different views as to whether, of two evils, staying in the euro is better or worse than re-introducing the drachma. In the end no-one can foresee all the consequences of either. Reintroducing the drachma would mean that a bank accounts would be converted into a weaker currency so effectively being devalued and would be likely to make imported goods which provide most of Greece’s everyday needs from food to clothes and energy even difficult to obtain. Thus the consequences of leaving the euro would be likely to lead in the short term to a sharp further drop in living standards.

 

On the other hand Greek governments would have more freedom. On the economic side, the very scarcity of foreign exchange would provide a very strong incentive to exporters.   If exports were to boom as a result then Greece would be able to emerge from its predicament. Unfortunately Greece’s agricultural and manufacturing base is weak (manufacturing accounts for 12% of GDP) and would not be likely to grow rapidly even in these circumstances and its strengths in services (notably shipping and tourism) would be unlikely to be sufficient to make up for these weaknesses.

 

The choice is an unenviable one but the Greeks should have be enabled to make it rather than being misled into policies which lead to its unchosen departure from the euro.

Will Hollande victory influence euro zone crisis for better or worse?

The victory of Francois Hollande in the May 6th election for the French presidency is bound to have consequences for the previous approach, led by Germany and the European Commission, to resolving the euro zone’s crisis. For Germany it has been primarily a sovereign debt crisis and this is reflected in the treaty on Stability, Co-ordination and Governance that has been signed by all euro zone participants. For Germany tackling the sovereign debt crisis is a pre-condition for reviving growth together with structural economic reforms to foster business and employment growth. For M Hollande and for many others lack of growth is itself a large part of the crisis. The different viewpoints reflect both a tradition of fiscal and monetary orthodoxy in Germany and the fact that the German economy is in fact growing well and unemployment there is at its lowest for 15 years. President Sarkozy has tried to push for policy to be more growth-oriented amongst other demands but the imperative of maintaining unity with Germany—a key to French policy for many decades—meant that he had to give way.

M Hollande has the advantage of not being associated with the existing policy which in most of the euro zone appears not to be working; the French economy is stagnant with unemployment rising and much worse situations exist in the more vulnerable countries, particularly Spain, Portugal and Greece. If M Hollande does win, the result will be a major democratic indication of a desire for a change of policy coming from a country which, for the last 60 years, has played a decisive role in promoting European integration.

The German government will therefore be under strong  pressure to make changes to the austerity policy that it (and other creditor governments) are effectively imposing on the rest of the euro zone. Much of German popular opinion, particular that supporting the parties at present forming the German coalition, is in favour of fiscal and monetary orthodoxy so it is not surprising that the German chancellor, Angela Merkel, has already indication strong reistance to any concessions but a factor operating in the other direction is that the opposition Social Democrats are themselves calling for a more growth-oriented policy.

However, an even more difficult obstacle to a more growth oriented euro zone policy is the financial markets. Governments can only run an expansionary fiscal policy if the extra borrowing required can be obtained at reasonable interest rates from investors. Two major euro zone countries, Spain and Italy, are struggling to keep the confidence of financial markets so as to fund their needs. A factor which may now influence financial markets is that, since fiscal austerity exacerbates declines in economic activity, it will thereby push down tax revenue and so offset part of the improvement to government deficits that should normally result from fiscal austerity. It has even been argued that in an extreme case, which could include Spain in 2012, the economic impact of pursuing a harsher fiscal policy may actually drive down economic activity so much as to actually increase the budget deficit. The European Commission has in the situation conceded a slightly less severe target for Spain in its 2012 budget but the policy of expenditure cuts and tax rises will remain in place with the aim of reducing the general government deficit from 8.5% in 2011 to 5.8% in 2012.  But a halt to fiscal austerity would lose the confidence of investors so Spain and other countries will remain bound by the vicious circle of the need to reduce deficits at a time of economic recession, so exacerbating the recession and in turn reducing revenue.

The victory of the French Socialist, M Hollande, indicates a desire for a change in the imposition of austerity as the prime and almost only policy instrument of euro zone policy makers in response to the area’s financial and economic crisis. The trouble is likely to prove to be that the alternative options are very limited. One thing that could be done is to change the name of the treaty to Treaty for Responsibility, Governance and Growth as demanded by M Hollande, rather than Stability, Coordination and Governance. Some clauses of the treaty might also be changed but it is likely that such clauses will be those of a general rather than specific type.  Germany and other creditor countries will not concede on the key requirements for structural general government balances by 2017 or a compulsory reduction of debt  of countries with debts over 60% of GDP of a twentieth per year.  They regard a commitment to longer term fiscal stability as key to financial market confidence and nothing has happened to suggest that this view might be wrong.

Not only M Hollande but also President Sarkozy have called for a change in the statutes of the European Central Bank so that it balances the requirement of price stability with that of maintaining economic activity and employment as is the case for the US central bank. Such a change would in principle be desirable but it will face intense resistance from the forces of the establishment in Germany particularly the Bundesbank which only agreed to participate in monetary union on the basis that the new European Central Bank should have the same objectives that the Bundesbank—an organization seen as underpinning German prosperity and financial stability for 60 years—had had since its foundation. In any case the ECB has by no means in practice been only concerned with price stability. Despite inflation running above target, ECB interest rates are now almost as low as possible and a massive €1trn has in the last six months been been provided in 3 year loans at low interest to euro zone banks, supplementing the provision of shorter term finance since September 2007. In addition, the ECB has made highly controversial purchases of government bonds, against strong opposition from German members of the ECB board. Angela Merkel has already gone a long way by conceding that ECB independence requires not just independence in the face of political pressures from weaker countries wanting monetary easing but also independence from Germany which may have qualms that some ECB policies are too accommodating.

There is a possibility that Germany might be persuaded to agree a more symmetrical policy towards the resolution of foreign economic imbalances. Germany has in recent years been running large external surpluses while France and Italy have been running moderate deficits, while Spain, Portugal and Greece have had much larger deficits. Even though several years of cutting domestic demand has reduced the deficits of the latter three countries, they remain substantial and need to go into surplus if their overall debt is to be reduced. The deficits of these countries are the counterparts of surpluses of other countries, including China and oil exporting countries, but also Germany. If countries in deficit are to reduce their deficits those in surplus must reduce their surpluses. So far Germany has insisted that the main responsibility for adjustment lies with the deficit countries. In a world economic system based on competition Germany is not likely to be willing to reduce its competititiveness which would affect its ability to compete outside the euro zone and EU as well as inside. Nor is Germany likely to give up its hard won success in bringing down its own government deficit following years of overspending to finance German unification. It would however be reasonable to ask Germany to adopt policies to encourage household spending rather than saving, such as encouraging increased home ownership –which is very low compared to most other EU countries. Higher home ownership would be likely to increase spending both on homes and their contents, and also more generally, given that a home as an asset can substitute for financial assets.

More can also be done through the EU budget complemented by financing from the European Investment Bank (and its subsidiary the European Investment Fund). The EU budget is modest but still plays a significant role in Greece and Portugal and the poorer regions of Spain. The focus of the EU budget should be shifted from infrastructure, which is generally now good in most parts of the euro zone, to promoting business formation and development which if successful would generate more durable growth. This of course should be combined with the removal of bureaucratic obstacles to business formation and the removal of labour market regulation which inhibits employment growth by small to medium businesses. But this kind of deregulation on its own may not suffice in a depressed economy to stimulate growth. If successful cases of business expansion especially in the hardest hit countries and regions were given publicity they could act as examples of a positive nature to counteract the negative economic and social impact of austerity. Because of underspending so far in the 2007-13 budgetary framework period there could be scope to boost spending though the Commission would have to be persuasive and show that spending was likely to be better managed. This would require an increase in the annual budget and the Commission has indeed requested a 6.8% increase in budget funding for 2013. The case for a strong increase in funding for promoting growth in the hardest hit countries should be made, but the Commission should balance this by being willing to make cuts elsewhere in the EU budget, particularly on administration.

The Hollande victory includes risks. In theory his French deficit reduction targets are similar to those of President Sarkozy’s government but as he has made commitments to increase expenditure on education there will be doubts as to whether his tax increase proposals will raise sufficient money to make the deficit reduction targets credible. On the other hand, the Hollande victory brings hope of a shift of emphasis towards stimulating economic activity in France and elsewhere. Whether such a shift can be converted to better economic outcomes remains to be seen.

Is there more bad news to come from Spain?

The news from Spain seems recently to be only bad. Its deficit last year was significantly higher than expected, it is again in recession, government bond yields have been rising and there are renewed concerns over banks. On May 7th, the government was forced to announce that it would be using the agency for bank rehabilitation, FROB, to inject about €10bn into Bankia, itself a merger of a large number of savings banks including Caja Madrid and Bancaja, together with a management reorganisation including the departure of the former finance minister Rodrigo Rato. S&P had recently downgraded the two leading banks, Santander and BBVA. An article put on the Bloomberg website on May 2nd argued that unlike Ireland which has taken on board the full force of its property collapse since 2008 (with the consequence that the country was forced at the end of 2010 to ask for a financial rescue package from the EU and IMF) Spanish developers are continuing to build in denial of the collapse in demand since 2008 and still falling house prices (http://www.bloomberg.com/news/2012-05-01/madness-in-spain-lingers-as-ireland-chases-recovery-mortgages.html).  The article argues that Spanish banks are trying to prop up house prices by offering favourable 100% mortgages, a practice which in view of experience should have been discontinued. The article suggests there is a possibility of a widespread collapse of Spain’s banks having as disastrous an effect on public sector indebtedness as did the collapse of Irish banks on Ireland’s indebtedness.

However, while there are no grounds for complacency, the evidence available suggests that Spain’s other  larger banks, including Santander, BBVA and La Caixa, which are much more diversified in and outside Spain than the Irish banks, are still in reasonable good financial shape and that recapitalization of smaller banks can be managed. It is underway with the number of banks having been reduced from 45 to 11 but still has a way to go over the coming months. While it is likely to require intervention by the Spanish state, it is not likely to do so to the same extent as happened in Ireland. Between February and April 2012 the IMF conducted a major (five-yearly) review of the Spain’s financial system. It calls for rapid action to complete cleaning up the weak banks so as to avoid contaminating the stronger ones but states that “the largest banks appear sufficiently capitalized and have strong profitability”. It does expect further credit losses from the property sector but points out that loan-loss provisions have been increased. It carried out stress tests for 90% of the sector and concluded that most banks could withstand new shocks.

The public sector debt to GDP ratio of Spain, which was 68% at the end of 2011, is likely to rise to about 75% by the end of 2012 as a result of the ongoing deficit. If the government is required to step in to recapitalize the banks, because the private sector is unwilling to provide the funding—at present estimated at €53bn—debt could rise further. In a much worse scenario that the €53bn turns out to be only half the amount required and that it all has to come from the government, the impact on Spain’s debt to GDP ratio would be to raise it to around 85%, an amount which should still be manageable.  The weaker parts of the Spanish financial sector do indeed require careful watching but the probability is that they will be successfully rehabilitated over the next few months at a significant but manageable cost to the Spanish state.

In the medium to longer term, however, the health of the financial sector will depend on the health of the overall Spanish economy, which in turn depends on its ability to redress its economic imbalances, in particular the external current account imbalance which led too the accumulation of first private and more recently public debt. Substantial progress has been made in reducing the current account deficit from peaks of close to 10% of GDP in 2007 and 2008 to 3.5% in 2011, or €37.8bn. Merchandise exports increased by 16.8% in value terms and 15% in volume terms in 2010 and by 14.8% in value terms and 9.6% in volume terms in 2011, both well above the growth rate in markets and so representing recoveries in market share. These figures represent a substantial turnaround but the deficit remains significant and progress has stopped in the first two months of 2012. That is due to the weakness in Spain’s main EU markets but such an excuse is of little comfort. Unless Spain can move into current account surplus, either private or public debt will continue to rise, and they both need to start falling before Spain can be said to have turned the corner decisively. Until the debt dynamics change, domestic demand is likely to continue to fall so any growth will only come from the external sector.

While the new Spanish government, in office since December 2011, has been hesitant in addressing the country’s public finances, it has taken decisive measures to improve the performance of Spain’s labour market. Its measures include allowing companies to cut wages which some are reported to have begun doing this year following average wage growth of 2.7% in 2011.  Lower wages will further depress the domestic economy but should help companies gain competitive advantage. A second key reform to the labour market fixes 33 days pay  per year worked as the maximum compensation for “unjustified” dismissals. It is hard for companies needed to cut their workforce to convince courts that they need to do so, so 80% of dismissals are classified as “unjustified”.  This limit should provide conditions for companies to take on more employees in open-ended contracts rather than the short term contracts which characterize the majority of new employment.

These reforms give Spain a potential advantage over many of its partners. But unemployment is officially 25% and youth unemployment 50%. The Spanish unemployment statistics have for decades given figures which look higher than the reality and in comparison with figures in other countries a rate of 15% may be a better indicator. Nevertheless the labour market situation especially for young people is very serious. The government needs to continue to work to extend its reforms into liberalizing professions and trades and facilitating the start and growth of new businesses. The growth agenda at the euro zone or EU level which the governor of the European Central Bank has along with others began to talk about is certainly needed. More action such as boosting the capital of the European Investment Bank as he specifically suggested is urgently awaited. Spain should be able to reassure investors on their financial concerns this year but it is likely to continue to struggle to turn its economy for some time yet.