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.

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