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Sunday, March 9, 2008

Spain's Looming Economic and Financial Crisis

by Edward Hugh: Barcelona

Manuel in his accompanying post calls today's election in Spain "Zapatero's election to lose", meaning by this that the opposition scarcely seems credibly poised to win, and the best chance they have is if Zapatero somehow or other manages to clutch defeat from the jaws of victory. But there is another sense in which one might think that this was Zapatero's election to lose, since given the scale and importance of the economic problems which are steadily arriving, I sometimes find it hard to understand how anyone would actually relish winning this one. There really are occasions when discretion is the better part of valour. Wolfgang Munchau effectively made a similar point in a recent Financial Times Op-ed where he suggested the the winner, whoever that should be, "will spend the next four years cleaning up an economic mess of a scale not witnessed in Spain in modern times".

I thoroughly agree. I also agree that Munchau more or less hits the proverbial nail directly on the head when he suggests that "the twin engines of the coming Spanish economic crisis are a collapsing housing market and a current account deficit, now at 10 per cent of gross domestic product". As he also points out, these two are related since it has been the inflow of investment which has funded the lending associated with the property boom which has enabled Spain to finance its current account deficit. But now that this flow of funds has all but come to a halt (and the lending with it, see what happened to new bank credit last December in the chart below) it is by no means clear how the deficit is going to be financed.

Financial AND Economic Crisis

Perhaps the first thing to get absolutely clear in our minds from the outset is that the economic correction which is currently taking place in Spain is very unusual one in terms of what we have become accustomed to in developed economies in modern times, since the transmission mechanism for Spain's current difficulties does not run in simple one-way-street fashion from problems which have their source in the real economy (a correction in house prices for example, or a downsizeing of the construction industry, although both of these undoubtedly form part of the picture), nor does it run from an attempt by a central bank to "burst" some sort of perceived asset bubble or other (Trichet and the ECB's tightening of interest rates), rather the mechanism operates via a direct blow-out in the cylinder-head-gasket of the global financial system, a blow-out which has produced an immediate and direct change in global credit and lending conditions, and in the level of risk appetite which prevails in the securitised mortgages/covered bonds sector of the wholesale money markets (leading to a situation where these markets are now effectively closed to Spanish banks) , and it is this change in financial and credit conditions which is now making its impact felt on the real economy in Spain, with the actual and present danger that these negative consequences for the real economy may then in their turn feed back into the financial sector, in the process creating some kind of ongoing lose-lose dynamic.

As I say, such a phenomenon is certainly unusual in a modern European context, although some may wish to point to parallels with what happened in Japan in the early 1990s, and the subsequent "lost decade". I wouldn't go so far at this point as to suggest that Spain is facing a lost decade, although the situation is very very serious (as I hope to show in the charts that follow), and at the very least Spain now faces several "lost years" and a massive macroeconomic structural adjustment.

A Slowing Real Economy

So first of all lets have a brief look at some chart which can give us an idea of what has been happening to the Spanish "real economy" in the last months.

Unemployment is up, and substantially so. Unemployment in Spain has now risen from something over 1.9 million in June 2007 to something over 2.5 million in February 2008. The figures were up year on year by some 9.9% in February.

Regional differences area also imortant, with the year on year rises being very strong in some costal areas, like Valencia (20%) and Murcia (30%). As we can see from the comparative chart, the labour market moved in a positive direction from January 2006 to May 2007, then it turned in June 2007, since which point what we have had has been essentially a one way street of pretty bad news.

Strangely, while the economy has been slowing and unemployment rising, prices have continued to rise, and inflation has accelerated with the latest flash estimate for CPI inflation in February issued by INE, the Spanish Statistics Office, coming in last week at 4.4% for the second month running.

In this context of rising prices and unemployment it is hardly surprising that consumer confidence is taking a big hit, and if we look at the confidence index, we will find that despite registering some very slight improvement for the first time since April last month the general index, which stood at 76.8 in February was still very near to plumming all time historic lows.

The European Commission have also recently reported a continuing decline in its eurozone “economic sentiment” indicator in February, with the composite number for the whole zone reaching its lowest level since December 2005. The indicator, which gauges optimism across all economic sectors and is regarded as a reasonable guide to likely future trends, fell to 100.1 points in February from 101.7 in January.

While the picture across the eurozone shows considerable variation at this point with France holding up better than most, and Germany (as explained here) is hanging on in better than I personally expected, but Italy is very much in the doldrums already, and the two "construction driven" eurozone economies (Spain and Ireland) are - as can be seen in the chart below - now in strong downward retreat.

But it is when we come to the real data that things start to get decidedly hairy. Eurostat have, for example, just published the January retail sales data, and the Spanish numbers do not look good at all. Basically retail sales have now contracted in 5 of the last six months. In January they were down 1.1% on December (seasonally adjusted of course) and 2.4% on January 2007. If you look at the chart there is now a very clear downward line (which resembles more what we have been seeing in Latvia or Hungary in recent months that the kind of data output we are accustomed to from Western Europe), and the only real question is where this will now stop. The slide is evident. Basically this is a reflection of construction and banking sector issues gradually arriving and making their presence felt on the real economy.

Spanish manufacturing activity contracted again in February, posting its weakest performance in over six years, according to last Monday's NTC Purchasing Managers Index (PMI). All five component indices of Index (PMI) pointed to worsening conditions as both production and new orders fell in February following the modest growth reported in January.

The headline PMI, which measures the general health of Spanish manufacturing, fell to 46.7 -- its lowest since December 2001 -- from 49.8 in January, pushing it further below the 50.0 mark separating growth from contraction.

The data from the manufacturing PMI is pretty consistent with the latest industrial production data released by the Spanish Statistics OFfice (INE). Accoring to the release the Spanish Industrial Production Index - when adjusted for working day effects increased by 0.7% in January when compared with January 2007. Uncorrected the Index was down 0.2% year on year.

Activity in Spain's service sector also fell to a record low in February as costs surged while business gave few signs of any kind of bounce back, according to the NTC Purchasing Managers Services Index (PMI) published las Wednesday. Though the headline PMI figure recovered to 46.1 from January's 44.2 (see the chart above), the figure was still well below the 50 mark which divides growth from contraction and was the second weakest reading in the survey's 8-1/2 year history.

"Clearly there's a lot of downward pressure on growth," Chris Williamson, Chief Economist at NTC Research is quoted as saying. He added that the survey's forward-looking indicators emphasised the risks of a sharp slowdown in Spain after a long economic boom. A measure of confidence in the business outlook slipped to 59.2 from 59.8 in January (achieving in the process a fall of 14.2 points in a year and a new low for the survey) with respondents stressing their apprehension in the face of increasing economic uncertainty.

The new business index recovered somewhat to 45.9 from 43.5 but showed demand still falling. As firms continued to work their way through backlogs of business, employment showed the most marginal growth in 4-1/2 years.

And Then There Is Construction

I take it that it goes without saying that one part of this problem is now deeply ingrained in the contstruction sector, and even if in this post I want to concentrate attention in two of the more neglected areas of Spain's current embarassment - the real economy and the financial sector - I obviously can't let all this pass by without some mention of what is happening in construction. One small data point here really says it all, and that is the estimate from the IPE business school that in March there some 500,000 unsold new homes in Spain - more or less the equivalent of one year's residential construction output at the old pace. And of course the old pace is now history. Spain's economy is not going to be able to get the old uplift by producing anything like 500,000 new housing units a year anytime in the foreseeable future.

We could also look at the December mortgages data, which, as was to be expected, saw a decline in both the value and the number of new mortgages (and it should be remembered that mortgages and construction were still being driven to some extent by the competion of old orders, ie those that predated the advent of the credit crunch in August 2007). The average value of the new mortgages created in December was 161,142 euros - down 1.9% on December 2006, although this number was in fact up 1.4% on November 2007. Perhaps more significantly the number of new mortgages (102,976) was down in December by 26.87% on November and 14.6% on December 2006. As a result of the reduced numbers of properties being newly mortgaged the total value of mortgage loans (16.59 billion euros) was down in December by 25.88% on November and 16.24% on December 2006.

We could also try looking at what Wolfgang Munchau calls his favourite current chart (although why anyone would call such an appaulingly depressing picture a favourite is beyond me) - the one originating with Bank of Spain data which shows how building approvals and permits have (and I quote Munchau) "fallen off the edge of a cliff since the end of 2006".

As Munchau points out, at their peak in March 2007, house building permits were rising at an annual growth rate of 25 per cent. In the autumn of 2007, their annual change had dropped into the region of minus 20 per cent. The situation in terms of approved starts is even more dramatic, since these rose at an annual growth rate of close to 28 per cent in March 2007. By September the annual rate of change had fallen to minus 66 per cent. House prices have not fallen significantly in Spain yet, but this is surely only a matter of time, and especially when we come think about the large stock of unsold new homes (estimated as I say at 500,000 as of March 2008) waiting on the books, and the drop in the number of mortgage loans mentioned earlier in this post.

Systemic Financial Crisis?

So now for the cherry which is currently perched smartly on the top of our Spanish election Sunday pudding: the problem of how to provide suffient liquidity to the banking system to square off the monthly balance of payments deficit. Now Wolfgang Munchau correctly ties-in the capital inflows which have been needed to finance the Spanish housing boom with the huge balance of payments surplus Spain currently runs (Spain needs in the region of 9 billion euros in external finance a month to keep this afloat), but I'm not sure he has yet fully appreciated just what a problem for the Spanish banking sector - and indeed for the whole eurosystem - this financing problem can become, since while he correctly points out that in the Spanish case "there can be no currency crisis....since Spain does not have its own currency", he omits to ask himself the equally pertinet question as to whether or not there could be a (euro-) systemic banking crisis? As I try to argue in some depth in this post the answer to that question is that there most certainly can.

Perhaps another data point would be useful here. The Spanish banks currently attend the weekly liquidity auctions at the ECB to raise something in the region of 48 billion euros of funding (a figure which is double the 24 billion euro number they needed before the summer). However, as Jean Claude Trichet insistently points out, "there is no question that the Spanish - or any other - banks are being bailed out" at this point. This, like so many of Trichet's statements is entirely true. But it is not the whole truth. That is, there is a bigger picture. And herein lies the problem.

It is, for example, also true that the ECB has not changed its rules to accept mortgage backed securities (like the US Fed had to under pressure last August), but this apparent constancy in rules also stands alongside the fact that a banking system which didn't need much recourse to the facility in question has now doubled its use of it, and in a very short space of time.

It is also true that Spanish banks were not allowed by the Bank of Spain to set up special purpose vehicles to finance their lending, but again, they set up the cedulas hipotecarias to find another way to do something which, at the end of the day, is not that disimmilar. The argument against SIVs is that off balance sheet lending is likely to be more risky, but in a certain sense (and as I try to argue and explain in my post here on the cedulas system) the cajas regionales have played the role of off balance sheet entities for the principal banks, and since we still don't know how far down the value of the entire Spanish mortgage pool is going to fall, we have no way at this point of making a valid assessment of the level of risk that has been actually taken on board.

It is also the case that the level of mortgage defaults in Spain is at this point comparatively small, but then again the whole process is only just starting, so it is far to early to say at this point whether or not cover will prove adequate in the longer term, but then again, the problem for the Spanish banking system may not originate in defaults in the first place, but rather from a perceived rise in their risk rating if the value of the entire pool of mortgages on their books starts to decline significantly.

So Where Is The Problem?

Well if we want to get a first measure of what kinds of problem are looming in the Spanish banking system we could take a look at the activity level of incoming bond purchasing into Spain over the last several years (thanks to the monthly balance of payments data made available by the Bank of Spain).

As we can see, on a rough and ready basis the bonds boom really took off sometime in 2002, and it came to a sharp and rather unfortunate end in the middle of 2007 (I would say on or around the 9 August). In any event the height of the boom was in 2005, 2006 and the first half of 2007. Now before going any further with my line of argument, lets just look at one more piece of rather important evidence, the refi interest rate set by the ECB (and which of course regulated 1 year euribor) and the rate of inflation in Spain.

And as we can see here, the take of date for the bonds boom is hardly coincidental, since it more or less coincides with the arrival over a sustained period of time of negative interest rates in Spain, a fact which to a large extent explains the intensity of the housing boom, since under these conditions borrowing money does not seem especially onerous, and indeed it might even be considered illogical not to do so.

Now if we return to the task in hand, lets take a close-up look at the most recent years for those bond inflows.

As we can see, the last few months is not the first time that these flows have "wobbled", but this time the wobble is much more sustained and, since the wholesale money markets are at this point effectively closed to the Spanish banks to raise money in this way, there are good reasons for imagining that this time the change will be a more permanent one.

Now, why, apart from the implications for the banking system, is all this so important for Spain? Well lets now take a look at another chart, the one for the current account deficit. And as we can see, the growing consumer boom associated with the construction one had a long term and pretty disastrous impact on Spain's trade balance (and in particular its energy component, all those extra houses use energy remember). And this deterioration in the external trade position has remained, and arguably even gotten slightly worse, even as the economy has started to slow down.

Now normally this deficit has been offset by the sum total balance of funds coming in as part of the financial account, but as we can see in the chart below this has also dropped off somewhat since August last year.

The consequence of this is that Spain's banks are increasingly having to find the money they need to make the books balance via the eurosystem, and this is basically the significance of that increase in borrowing that the Spanish banks have had to undertake at the weekly ECB auctions (referred to in this post ). If we look at the chart below, which shows the net asset and liability position of the Spanish banks vis-a-vis the eurosystem, those months when the bars are above the zero line indicate there has been an increase in the amount of money borrowed by the Spanish banks from the eurosystem (presumeably largely or exclusively at the ECB weekly auctions), and this money is essentially needed to settle the monthly deficit in the balance of payments account.

As we can see, prior to August 2007 these quantities showed no particular trend, but since August, and for every month for which we currently have data, the Spanish banks have needed to raise additional money at the ECB. This is really a direct result of the fact that the banks have been unable to sell their cedulas for cash in the global markets. What the Spanish banking system lacks right now is a way to generate cash on a stable basis to meet the needs of the current account deficit.

Now as I have been regularly pointing out, another of the very specific characteristics of the way in which the property boom was financed here was the ability of the Spanish banking system to provide very low interest (variable) rate mortgages. Curiously, many commentators imagined that this (variable) component was the greatest rsik element in Spain. That is, they imagined that it was Spain's mortgage borrowers who were assuming the greatest part of the risk here. They were wrong. The risk at present has almost all been inadvertently assumed by Spain's banking system, and this decidedly odd situation has arisen (I'm sure this was never the intention) due to the recourse of Spain's banks to the widespreased use of securitised (or covered) bonds - the so called cedulas - and the provision of variable mortgages at very narrow margins (lets say around 0.75% or 1% over 1 year euribor). Now the banking system considered they were onto a sound bet here, since they in their turn could borrow (thanks to the investment AAA grade often assigned to these bonds, which made them virtually equivalent to government paper) at very favourable rates themselves (normally three month euribor), which meant they thought they were onto a very safe bet. Again they were wrong, since it is just this very global repricing of risk appetite I mentioned earlier, and the reassessment of the AAA rating which was assigned to their mortgage bonds which goes with it, which has produced the problem.

Oh, yes, and there's a third little detail which makes all of this just that little bit worse. The different term structures of the lending and the borrowing. Basically the Spanish banks, and especially here the regional cajas who undoubtedly have the lions share of the problem, borrowed short and lent long. The majority of the mortgages issued between 2000 and 2007 were for between 20 and 30 years. Indeed during the last two years of the boom it even became fashionable to offer mortgages over 50 years, so sure did the banks feel of themselves.

But they borrowed short. Not the very-short-liquidity type borrowing that we are increasingly seeing Spanish banks having to resort to as they stand in line at the ECBs weekly money auctions of course, but rather the lions share of the borrowing, which was done using cedulas, and normally over a ten year term or even less. That is to say, while the vast majority of the mortgages issued will still be outsanding come 2025, almost all of the bonds which go with them will need to be refinanced, between 2012 and 2017. And here is where we hit the snag, since the money markets which the Spanish banks need to do the refinancing are currently closed to them. These money markets can of course be reopened, but at a price (ie the price of a risk premium), and that is really the bigger half of the snag, since while the debtors are on "variable" mortgages , these are effectively fixed (at 1 year euribor plus something, euribor can of course go up, but it can also go down, as I think we are about to see in the next moves at the ECB), so the borrowers, it turns out, really do have a yardstick that lets them know what they are into. This is not the case with the lenders (the banks) however, since while we do not know what eventual risk premium will be built in to fund Spanish banks (this in part depends on how far and how fast property prices fall, and how much difficulty they have maintaining their mortgage pools), we do know that the days when they could fund them at a simple euribor 3 month rate (y punto) are now well and truly over, and we could even contemplate the possibility that if bad goes to worse, and even worse, and then worse again, then they could be asked to pay even more than they are recieving from their mortgage paying clients!

And the amounts of money are not small. One good recent estimate put the total quantity the banks will need to "roll over" in the space of about 5-7 years at some 300 thousand million euros.

And cash may well not be that easy to find since, while money may be attracted by offering higher interest rates, it is not clear what the funds would be needed or used for (rolling over existing liabilities should be more or less neautral here) and the rate of increase in bank lending has been slowing steadily all through 2007.

A country with a large and sustained current account deficit - as we can see in the case of the United States - can do one of two things. It can tighten money and credit conditions in order to try and use an indirect method to slow internal demand, or it can allow the value of the currency to slide (as we have seen with the dollar) in a direct attempt to reduce the deficit. Well, as Munchau poinyted out, Spain has no autoctonous currency of its own to let slide, so the only real alternative is to squeeze internal lending to try and reduce the deficit, and in the meantime lean on the ECB for money. The contraction in lending needed to reduce a deficit of this magnitude might be very large indeed, and the consequences for the real economy would be substantial, so it is to be anticipated that in the short term some other alternatives makeshift will be sought. What these alternatives might be are currently a complete mystery, since for reasonably obvious reasons little of the discussion which must currently be taking place behind the curtains has found a public airing at this point, even though we are in the midst of an otherwise heated electoral debate. All we can do is watch, stupefied, and wait, as the organisers of the concert prepare to emerge from the cabal to let the public know what gets to happen next.

So as Spaniards go to the polls today they might like to reflect on this thought. Given what we have seen in the course of this post, Spain currently runs the risk of being the first modern developed economy to suffer the twin issue of a sudden-stop in the credit system and a dramatic slowdown in the real economy at one and the same time, yet in the interminable election debates which have taken place over the last month or so this singular and intriguing little detail has scarcely been mentioned. Of course there has been plenty of talk of the "construction slowdown", and finger pointing about who exactly is responsible, but the full measure and extent of the problem has been scarcely aluded to, even in the faintest whisper.