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European Debt Crisis

Spanish conservative landslide; plus ça change….


In spite of a “Socialist” rain storm over much of the Iberian peninsula, the Spanish voted overwhelmingly to oust the Partido Socialista after eight years of divisive and ruinous government. Alfredo Peréz Rubalcaba was not able to distance himself from the current government and policies of José Luis Rodriguez Zapatero, and indeed Rubalcaba was one of the top officials in the Zapatero Administration from the very beginning. He and his party were punished for 5 million unemployed, a stagnant economy and historically high risk premiums on Spanish debt by large-scale defections from the socialist ranks.

Mariano Rajoy, the leader of the conservative Partido Popular, rode that wave of discontent to victory, gaining an absolute majority in the Spanish Parliament in the biggest victory of the right since the days when Franco was alive and in power. His 183 seats in the Lower Chamber of 350 allows him to govern without the need of a coalition with regional parties and should, in theory, allow him to push through any reforms he deems necessary and appropriate. What, precisely, these reforms will be remains unknown, as Mr. Rajoy’s campaign was deliberately vague and uninformative, long on  “change” – which was certainly necessary – but short on the sorts of details that markets will need to assess the potential recovery of the Spanish economy over then next few years.

Mr. Rajoy’s task is of the same historic proportions as his victory. The laundry list essentially boils down to just two items: restart economic growth so that unemployment falls while simultaneously appeasing debt markets and austerity hawks in Germany and the ECB. Rajoy is on the horns of a dilemma and how he gets off them remains to be seen.

The Bull’s horns 1: Price of Spanish 10-year bonds on secondary market (1)


 The Bull’s horns 2: Unemployment in select markets as a % of labor forces (2)


 Mr. Rajoy has promised unequivocally to meet the targets for deficit reduction: 4.4% of GDP by the end of 2012, down from 6.0% in 2011. He is in the unenviable position of inheriting a larger than hoped for deficit this year: Spain will miss the target of 6.0% by as much as 60 basis points (3). This is partially due to lower than expected (or shall we say “hoped for”?) growth in the economy; but it is also due to the insufficient application of the government’s reform measures. Given that the Spanish economy is moribund, the new Administration cannot hope to grow its way out of debt: the debt-to-GDP ratio will only fall due to spending cuts. While Mr. Rajoy is not going to be blamed for missing this year’s target, it remains unclear how he plans to stimulate economic growth while applying ferocious austerity measures.

Another problem that Mr. Rajoy faces is the fragmented and decentralized nature of the Spanish government. The various regions and municipalities in Spain account for approximately 50% of general government spending and 70% of public employment (4). This devolution of critical social services including education, health care and sanitation means that controlling public spending is more difficult than it appears. The Populares have the advantage of controlling most of the regions: this may backfire on them, however, as a too rigorous application of austerity at the local level, in accord with instructions from the Calle Genova, might provoke more social unrest. There are autonomic elections in Andalusia in early 2012 where greater austerity might damage the incumbent Populares in this hardest hit region of Spain.

On the other side of the equation, stimulating the sluggish Spanish economy faces numerous and daunting challenges of its own. One of the first goals of Mr. Rajoy’s government must be to convince Spain’s banks to start lending again. The Spanish economy is suffering from a massive and extended credit crunch, which limits the ability of established businesses to grow and prevents new businesses from getting access to critical credit facilities.

Credit Crunch: Total Financing for Households and non-financial entities continues to shrink (5)


 Credit Crunch: Business activities and Consumption are being starved (6)


 The credit crunch is partially driven by the increasingly high risk premium on Spanish public and private debt, as many Spanish banks depend upon international credit markets for much of their day-to-day financing needs. Another motive is the increasing number of defaults, as consumers lose their jobs, as savings run out, and as public administrations delay payments to providers.

Credit Crunch 2: Non-performing loans have doubled since the crisis began (7)


The other impediment to new lending is the enormous drag created by the portfolio of non-performing real estate assets that the bank’s took over beginning in 2008. During the height of the property bubble, financing was available for almost any project involving construction: with or without an economic business case. The result is that vast sums were lent to project that are not only incomplete, but which will never be completed and are essentially worthless.

  • Spain has 1 million new homes that remain unsold. Between 35% and 45% of these are deemed “unsellable” as they are located in developments far from current population centers. The housing stock is not expected to clear before 2017; (8)
  • Spanish banks have already foreclosed on 200,000 homes and may have to foreclose on as many as 600,000 more as the crisis continues. (9) These foreclosures are part of the estimated €100 billion in non-performing loans Spanish banks currently have on their books. If these assets were “marked-to-market”, as they are in the United States, the Spanish banks would have to write-off potentially hundreds of millions of euros;
  • These write-offs will necessarily prompt another round of bank consolidations as balance sheets at smaller and mid-sized national banks were pummelled.  Spain’s financial sector has already been consolidated from 45 savings banks to just 15 at a cost to the public of €17 billion euros. An additional wave of consolidation could significantly increase the amount of public money needed to sanitize the banking system.

Credit Crunch 3: The Spanish banking system must consolidate more and increase capital (10)














Job Creation: More than just financing

Assuming Mr. Rajoy can reform the banking sector while keeping markets happy with his austerity plans, the Spanish economy may still not grow. One reason is that it is highly uncompetitive. While Germany was investing in productivity enhancing reforms and keeping down wages through agreements with labor, Spain (along with most of the rest of Western Europe) was moving in the opposite direction. Automatic wage increases tied to inflation and iron-clad contracts for priviledged workers have driven up the factor costs of Spanish labor to the point that it is far cheaper to import from Germany than to produce in Spain.

Unit Labor Costs in Major EU economies (11)


This indicator hides the fact that Spain and Germany produce different things, and that therefore unit labor costs are not necessarily directly comparable, but the trend is nevertheless clear. In those areas where Germany and Spain compete, Spanish labor is at a disadvantage. This is borne out by the current account data.

Spain’s Balance of Trade: Total Current Account Deficit and Geographic distribution of trade (12)

Spain’s current account looks better than it has in years, mostly because of the collapse in imports, but also because the rest of Europe is buying Spanish goods at pre-crisis levels. Spain needs to continue this trend if the export sector is to lead the way for the rest of the economy. A the probability of a European recession limits the upside potential of exports to Spain’s principal markets, however, while Spain continues to run current account deficits with the United States, Latin America, Germany, China and OPEC. The last three are particularly worrying: there is little room for Spain to reduce her OPEC energy imports in the short-term, while the terms of trade in manufacturing favor Germany and China. These structural impediments indicate that until and unless nations like France, the UK, Italy and the other EU27 members start growing again themselves, Spain will not be exporting her way out of the growth trap.

Nevertheless, there are reforms Mr. Rajoy can begin to implement without waiting for a major bank reform or for Europe’s recession to subside. Spain has a lot of room to improve both its business environment and the ease of starting a new business, upon which Mr. Rajoy is pinning much hope. Spain is among the worst of it major market competitors in both of these rankings.

  • In the World Bank’s Ease of Doing Business rankings, Spain is 45th – behind Cyprus, Peru and Colombia, and only slightly ahead of Rwanda, Tunisia and Kazakstan (13);
  • Spain also is a costlier, more bureaucratic and more time consuming market in which to start a new business than comparable markets (14).

 Ease of Starting a New Business in Spain and select comparable markets (2011)


A tough row to hoe

Mr. Rajoy is left in the unenviable position of needing to solve a difficult and complex dilemma without any guarantee that his success will keep Spain solvent and in the euro. He must not only succeed in applying austerity, restarting the economy and reducing unemployment – he must hope that his counterparts in Italy, Greece, Portugal and Ireland are equally successful. Markets today are signaling that they expect several defaults in Europe and it is upto Germany and the ECB to ensure that they don’t. Whatever Mr. Rajoy plans to do with Spain, his success will ultimately hinge on decisions being reached in Berlin and Frankfurt.



(1) Wall Street Journal
(2) Banco de España
(3) http://www.bloomberg.com/news/2011-11-11/spanish-third-quarter-economy-stalls-as-borrowing-costs-surged-to-record.html
(4) “Monitoring Sub-Central Government Spending in Spain,” Banco de España, 2011
(5) Banco de España
(6) Banco de España
(7) Banco de España
(8) Bloomberg
(9) Report by Taurus Iberica Asset Management
(10) Banco de España
(11) OECD
(12) Insituto Nacional de Estadísticas
(13) World Bank
(14) World Bank

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