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European Debt Crisis

Spain: Ominous and Imminent


A friend of mine recently moaned over Facebook, “If I read one more article that starts with ‘the pain in Spain’ I’ll scream.” And justifiably so. Beyond the uncalled for alliterative abuse, there has been a flood of gloomy news coming out of the Iberian nation recently. After a calm first quarter, April has been a month of very dark clouds.

Dark Clouds Gather

Things actually began to sour on March 2nd, when Mariano Rajoy’s newly installed government unilaterally declared that it would not adhere to the debt target of 4.4% agreed by the previous Socialist government. Instead, he proposed to reduce the government’s deficit to 5.8% of GDP, a far more realistic goal given that Spain had completely muffed their 2011 target (8.5% instead of 6%).[1]

Needless to say, this did not go over well in Brussels or Berlin. Not only did the DAX miss a step[2] on news of the Spanish move, but Brussels promptly got on the phone to tell Mr. Rajoy what’s what. At a meeting of Euro zone finance ministers on March 12th, it was announced that Spain had agreed to a 2012 target of 5.3% of GDP.[3] So while Mr. Rajoy got most of the wiggle room he was looking for, it was clear that his pre-election pledge “not to take orders” from Brussels was – at best – hyperbole.

Markets were also listening. The Spanish 10-year sovereign bond benchmark fell to a 52-week low of 4.80% on 29 February. On 7 March, it peaked at 5.23% in intraday trading before settling at 5.07%.[4] Mr. Rajoy, in attempting to stand up for his government, only succeeded in calling attention to it. The rise in the bond price has been more or less inexorable since then, as bond traders and foreign investors have swung their baleful gaze full force on Spain.

Bad news now came in battalions.[5] On 25 March, after barely 100 days in power, Mr. Rajoy’s Popular Party failed to win a majority in the regional elections in Andalucía. Although the opposition Socialist Party has ruled this province for 30 years, it was widely expected that the Populares would be victorious[6]. The loss came as a shock to Populares and foreign investors alike, and increased doubts that regional spending could be curbed. It was uncontrolled overspending in the regions that caused Spain to overshoot the 2011 deficit target.

 The loss of this election (or the failure to win, since the Populares took a plurality, but the Socialists formed a minority coalition government) was a greater blow than it might at first appear. After all, the Populares remain in direct or coalition control of 15 of the 19 autonomous communities. The exceptions are Catalonia, Andalucía, the Basque Country and the Canary Islands. However, those four regions represent 42% of Spain’s economy and population. [7] Heavyweights Catalonia[8] and Andalucía have already indicated that they are not happy with Madrid’s austerity mandates. Given that the Spanish regions account for more than half of all public spending, investors are understandably worried by the central government’s ability to rein in the regions.

 On 29 March, the Spanish trade unions went on general strike. Tens of thousands of people took to the street in protest of the government’s planned austerity measures, and there were street blockages as well as fires, though little serious violence. Depending on who you listen to, the strike was either a great success or an unmitigated failure. The strike nonetheless paralyzed public transportation and a disruption of flights into Spain. It was the first major protest in a country with 23% unemployment, but it will not be the last.[9]

Off the Cliff

On April 3rd, Mr. Rajoy’s government published the details of his long-awaited austerity budget. The Populares were severely criticized for failing to publish the budget much earlier, in hopes of avoiding negatively influencing the Andalucía elections – a vain hope. Mr. Rajoy had good reason to expect a negative reaction from his countrymen: the budget is the most severe in Europe in the past 30 years.

Spain will cut 27 billion euros from the central government expenses, or 2.5% of GDP. The government also plans to raise an additional 12.3 billion euros in new revenues, another 1.1% of GDP. It is hoped that these two measures will close the gap in the government’s accounts. However, since the economy is expected to contract by 1.5% this year[10], the actual reduction in the deficit is only about 2.7% of GDP, which leaves the deficit at 5.8% of GDP – the figure Mr. Rajoy had initially announced – rather than the agreed upon 5.3% of GDP.

Every area of government is in-line for major cuts[11]: infrastructure investment (-2.5%), naval construction (-21%), public safety and penal institutions (-29%), housing and urban development (-31%), defense (-35%), public sector enterprises (-41%), road maintenance (-62%), funds for the mining industry (-80%), rural development (-86%), electricity subsidy (-100%).

Perhaps most disconcerting – as if the above figures were not enough to chill the blood – are the cuts that undermine Spain’s future: scholarships and educational assistance (-12%), non-defense research, development and innovation (-14%) and other research grants (-34%). For a nation that is struggling with issues of industrial competitiveness and worker productivity, these savings seem “penny-wise, but pound-foolish.” Mr. Rajoy is also cutting an investment subsidy for Catalonia of 950 million euros (-100%) agreed to during the Zapatero administration. This may also be storing up trouble for the future with the notoriously prickly Generalitat of Catalonia.

Some of these measures are a welcome and necessary reduction in Spain’s bloated public sector[12]. But no large economy has ever made such large and deep reforms during a time of recession, at least not successfully. That Mr. Rajoy should attempt it now under pressure from markets and European partners bodes ill. It should be noted that the Bank of Spain’s prediction of -1.5% was made before the austerity budget was published.  Spain’s economy will undoubtedly suffer an even worse contraction due to the fiscal retraction and increase in taxes, making the deficit shortfall even greater. Spanish and international economists agree that the budget is “unlikely” to achieve the deficit targets.[13]

Gloom and Doom

The day after the “budget from hell” was unveiled, investors reacted. Spanish sovereign bonds fell off a cliff: 

The Monday before the budget (April 2nd), the 10-year bond had opened at 5.33%. On Thursday, April 5th – markets were closed on Friday – the bond had gained 31 basis points to close at 5.74%. This began the slide that peaked on April 15th with the bond exceeding 6%, having recovered 62% of the 52-week high set in November. Given that debt servicing is now the largest single item in the Spanish budget[14], this increase in the cost of public financing is ill-timed and very painful.

Credit default swap rates rose in parallel, passing 500 for the first time ever.


The move in the CDS market is strange since foreign investors hold almost no Spanish debt anymore. They have been busy offloading their exposure onto Spanish banks, which have used the ECB’s LTRO funds to purchase these bonds and sustain the market.[15] Their capacity to continue doing so is nearing an end, one of the reasons why the bond price is steadily rising.

Meanwhile, every significant macroeconomic indicator reinforces the negative outlook on Spain.

  • GDP and Unemployment data significantly underperform Euro-area averages:[16]

  • Personal consumption and fixed capital formation have fallen off a cliff and show no signs of recovery.[17]


  • The Industrial Production Index is 30% below peak capacity and continues to trend lower[18]:


  • The Spanish current account deficit has fallen strongly but remains negative, and energy dependency is high.[19]


  • Long-term unemployment is putting massive pressure on the Social Security fund, which recorded a deficit of 668 million euros for the first time since 1996.[20]


  • The real estate sector continues to be the main lodestone on the financial sector.[21]


  • Higher loan losses and increased capital requirements are pummeling Spanish retail banking, hindering a return to lending activity.[22]


  • Total financing and private sector credit remain in the doldrums, with no desire on the part of banks to increase lending activities.[23]

Too Early to Go Long on Europe

Spain’s outlook is dire indeed. Mr. Rajoy’s government is trapped in a classic austerity trap. It must make ferocious cuts in spending and raise revenues to meet the market’s demand for deficit reduction; but every new measure causes the economy to shrink even faster and markets to grow more fearful. Truly damned if you do and damned if you don’t.

The solution, of course, lies outside of Spain, as it always has. Reducing sovereign borrowing costs and permanently damping market panic requires a collectivization of risk through Eurobonds or an explicit guarantee by the ECB to be the lender of last resort. Restoring growth requires a major adjustment of the northern tier countries towards internal demand. Germany – even more than Angela Merkel – has said “nein” loudly and repeatedly to both measures.

If politicians in Brussels and Berlin will not see sense, there remains only what Dr. Krugman calls “hoping for the austerity fairy to appear.” This elusive elf has failed to materialize for Greece or Portugal. Perhaps it is a leprechaun that refuses to leave Ireland.

Spain looks set for an anno horribilus in 2012 which may be without precedent in modern times. Whether the country can weather further external shocks, such as the French and Greek elections, as well as a fraying social fabric remains to be seen. There is no relief in sight for the Spanish worker or for Mr. Rajoy.

Sources and Notes:

[1] Gonzalez, Miguel and Sim, Andrew, “Spain defies Brussels by giving itself the leeway it was denied on the deficit”, El Pais, 2 March 2012
[2] Gretler, Corinne, “German Stocks Decline as Spain Raises Deficit Target, Retail Sales Drop”, Bloomberg, 2 March 2012
[3] O’Donnell, John and Strupczewski, Jan, “Eurozone okays Greek aid, demands deeper Spanish deficit cut,” Reuters, 12 March 2012
[4] Quotes from MarketWatch
[5] “When sorrows come, they come not single spies; But in battalions.” Shakespeare, William, “Hamlet”, Act 4, Scene 5
[6] Davies, Nigel, “Spain’s PM denied symbolic austerity boost in local vote,” Reuters, 25 March 2012
[7] Instituto Nacional de Estadística
[8] “La Generalitat protesta porque no ve suficiente la revisión al alza del déficit para las comunidades”, La Razón, 3 March 2012
[9] Tremlett, Giles, “Spain’s general strike shows first sign of rebellion against austerity,” The Guardian, 29 March 2012
[10] Ross-Thomas, Emma, “Spanish GDP to Contract 1.5 Percent in 2012, Bank of Spain Says,” Bloomberg Businessweek, 23 January 2012
[11] Sánchez, Carlos, “El Gobierno poda el sector público y lo deja  con un presupuesto de ‘guerra’”, El Confidencial, 04 April 2012 (Spanish)
[12] Central government spending equals 36% of GDP without counting the regional budgets and local public corporations. Contrast with the United States where total federal, state and local spending accounts for approximately 36% of GDP.
[13] “IMF see Spain missing 2012, 2013 public deficit goals,” Reuters, 17 April 2012
[14] Sánchez, Carlos, “El Gobierno poda el sector público y lo deja  con un presupuesto de ‘guerra’”, El Confidencial, 04 April 2012 (Spanish)
[15] Onaran, Yalman, “Spanish Banks Gorging on Sovereign Bonds Shifts Risk,” Bloomberg Businessweek,  17 April 2012
[16] Banco de España – Economic Indicators, Tables 1.2 and 2.2.
[17] Banco de España – Economic Indicators, Table 1.2.
[18] Instituto de Industria, Energía y Turismo. Logarithmic trend line added by Common Sense.
[19] Current account data from Instituto de Industria, Energía y Turismo. Energy imports from World Bank Energy Statistics.
[20] Registered workers from Instituto Nacional de la Seguridad Social. Total Spanish population from Instituto Nacional de Estadística. ¨La Seguridad Social registró un déficit de 668 millones tras 13 años en positivo,” El Mundo, 05 January 2012 (Spanish).
[21] “Spain’s Economic Reform Program,” Ministerio de Economía y Competitividad, 22 March 2012
[22] Banco de España – Economic Indicators, Table 8.10 and Statistical Bulletin, Table 4.3.
[23] Banco de España – Economic Indicators, Tables 8.5 and 8.9.

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