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Monday, October 4, 2010

Is A 6 percent 2011 Deficit Realistically Within Reach For Spain?

by Edward Hugh: Barcelona

Last Thursday Moody's Investor Service cut Spain's Sovereign credit - to Aa1 from AAA - thus removing the last of the country's highly-valued triple-A ratings. The move really surprised no one - in this case the Moody's rating could be regarded as a lagging indicator on the health of Spain's finances - since the two other "majors" (S&Ps and Fitch) had long taken the decision, and the market predictably shrugged off the news, as if to say "what else is new". But there was one small detail in the report which should have attracted more attention than it has: the agency explicitly stressed that it was the government's show of determination to reduce its very large fiscal deficit in the near term which influenced their decision to limit the downgrade to just one rating notch, and this was also the reason the rating had been assigned, for the time being, a stable outlook. Which means, of course, that should there be any slippage in that determination, any wearying, or falling asleep at the wheel, then the outlook would rapidly move to negative, and more downgrades could be anticipated.

This creates an interesting situation, since I am by no means as convinced as many conventional journalists seem to be that the present fiscal situation is entirely under control. And since I do think Spain is going to come under increasing scrutiny from all points of view as we enter 2011, especially if Ireland and Portugal are ultimately forced to seek some sort of financial rescue, then any "accidental" slippage this year will inevitably mean even deeper cuts and a lot more pain next year, since Elena Salgado and José Luis Zapatero very definitely have pinned their shirts to the mast on the question of getting the deficit down to 6% of GDP in 2011. If this target is not achieved, and in a way which satisfies reasonably close inspection, then I think the country really will face the wrath of the markets, and in this sense the destiny of the 46 million odd people who live in the country very much is harnessed to the credibility and realisability of the budget plan Elena Salgado is about to present to the Spanish parliament.

The Story So Far

According to most of the reports you read in the press these days market confidence in Spanish debt is rising based on the growing conviction that the Spanish government will be able to comply with its deficit commitments. I somehow doubt that this is the complete story (as I explained in this post), and think it is as much a case of markets being focused at this point on whether or not Ireland and Portugal will ultimately be forced to have recourse to the European Financial Stability Facility (EFSF), and that they are being detached from Spain as much as Spain is detaching itself from them. At this point in time Spain is simply in the waiting room, in a state of grace or being given one last chance, and if the opportunity is not clearly seized with both hands then downgrades and widening spreads will almost certainly follow.

Now, according to the "official version" what is happening if that Spain's fiscal deficit is steadily coming nicely under control as the economy returns to growth and the government squeezes its spending harder and harder. There are only two difficulties with this story. In the first place Spain's economy already appears to be moving back into contraction (the Bank of Spain is now talking of a "weakening" of GDP in the third quarter, and only last Friday the government itself revised up its unemployment forecast for 2011, from 18.7 percent to 19.3 percent to reflect the way the impact of the spending cuts is expected to hit growth). Indeed Moody's itself stressed their scepticism over the government's growth forecast. “Over the next few years the Spanish economy is likely to grow by only about 1 percent on average,” according to Kathrin Muehlbronner, a Moody’s vice-president and lead analyst for Spain. And this is more optimistic than S&Ps, who seem to think trend growth in the years to come will be more like 0.7 percent.

Secondly, and this is the important point at this stage, the part of the deficit which is apparently reducing at this point is the central government one: we are simply not being given the necessary information on the state of Autonomous Community and Local Authority finances to know whether their deficits are reducing, or even if they are increasing. Spain's central government has targeted a deficit of 6.9 percent of GDP this year, with the rest of the adminstration being supposed to limit themselves to 2.4 percent to bring in the 9.3 total promised to the markets.

So despite the fact that we only really have limited information at this point, here is how Reuters reported the news.

Spain's Jan-Aug govt deficit falls more than 40 pct

* Deficit down 42.2 percent from same period last year

* Higher tax take of 33.4 percent in period

* VAT hike from July having effect

MADRID, Sept 27 (Reuters) - Spain's central government budget deficit fell more than 40 percent for January to August compared with the same period last year, thanks to a higher tax take, leaked data from the Economy Ministry showed on Monday.

The January-August deficit, which does not include the balances of the social security system or provincial governments, would be equivalent to 3.3 percent of GDP.

Spain has promised to cut the public deficit to 6 percent in 2011 and to an EU-guideline of 3 percent in 2013 -- forecasts many economists have said they doubt are possible in a low-growth environment.

The central government deficit in the first eight months of the year totalled 34.85 billion euros ($46.50 billion), data from the ministry published on the website of financial newspaper Expansion showed. That was 42.2 percent lower than the same period last year.

The improvement was helped by a 33.4 percent higher tax take, buoyed by a 2 percentage-point rise in value-added tax from July 1.

Still, the January-August figure marks a smaller improvement than that logged in the January-July period, when the deficit came to 25.77 billion euros, down 48.2 percent from the same period last year. That data was welcomed by markets who saw signs that Spain was getting its fiscal house in order.

Now I am calling this the "official version", but I could, rather less charitably call it the "data engineered" one - since the people who are circulating it either don't understand how to read the official monthly updates on bugdet implementation, or they are intentionally trying to mislead. As I will try to show below, the sort of story being reported by Reuters represents a very tendentious reading on the numbers to say the least, since when you come to look at the fine print the real underlying deficit is not down over 40 percent from last year, the tax take is not up 33.4 percent on 2009, and the VAT increase is not having its effect (yet) since as the Agencia Tributaria (Spain's tax office) explain in their report, due to the August holiday period they haven't even processed the returns yet, and the only item they have data for is VAT paid on imports - which has brought in an estimated 100 million euros extra so far.

"Julio y agosto recogen los primeros impactos recaudatorios de la subida de tipos, pero sólo en el IVA Importación, que se valoran en unos 100 millones (0,8% del incremento total)." Agencia Tributaria - August report.

So, what we have is not a lie, or even a damn lie, but it is a very studied and judicious use of the statistical data available. Put politely, the data we have been served seems specifically designed to confirm the idea that Spain is, finally, getting its fiscal house in order. Unfortunately, this is not the complete picture. What we are getting is the truth, and nothing but the truth, but what we aren't getting (yet) is the whole truth.

As I say, the detail here, as always, is in the fine print, although the big point - that we don't know about regional government spending - really should be very obvious to anyone who is even vaguely aware that Spain is a fairly decentralised state, and thus it should stand out like a smoking gun that in all the articles you read about the deficit, the reference is to Spain's "central government" deficit, conveniently forgetting that a significant part of the total - and this year probably an even larger part than normal - comes from the regional governments and the municipal authorities - as I have already tried to explain in this earlier post. If we have leaned anything about Spain during the present crisis it surely is that nothing, but absolutley nothing that is to be found in a government press release should be accepted at face value without further checking. I don't think Spain's government simply blatantly and obviously falsifies its data, but I do think that data is often presented in a way which, if you don't follow all the methodological procedures which lie behind it, can give a totally misleading impression about what is going on, and I am not convinced that this outcome is completely unintentional.

Luckily for us however, the body which is responsible for following the progress of the annual government budget as it is implemented - a very austere sounding entity known as the Intervención General de la Administración del Estado (or IGAE) - publishes a fairly readable and easy to understand monthly report (latest issue available here), and if more journalists who wish to report on Spain took the trouble to read and study it for themselves, then perhaps they wouldn't be so easily taken in by the latest government press handout as they evidently have been up to now.

The first thing to note, as the IGAE themselves emphasise is that when it comes to following the annual execution of the budget it is important to compare like with like, and not, as it has become fashionable to say these days - apples with pears. In this case we need to distinguish between harmonised and non harmonised accounts. That is to say, when there has been a methodological change which influences the data the raw numbers (which you can find on page 9) can be very misleading, and you need to follow the harmonised data (which you can find in page 11). Thus, the raw data suggests that indirect taxes (impuestos indirectos) were up by 39.9% between January and August when compared with the previous year (seventh row, end column), while the harmonised (or adjusted) figure is 29.9% - meaning the real improvement is only 8.049 billion euros, and not 13.164 billion the raw number suggests.

But even this is not the complete picture, since if we now go to the latest monthly report (here) from Spain's Agencia Tributaria (the tax office), we find (page 16 in the acrobat reader), that one of the big differences in the VAT numbers between 2009 and 2010 comes from the much smaller volume of refunds in 2010.

Refunds fell from 43.525 billion euros in the first 8 months of 2009 to 33.087 billion in the same period of 2010, that is to say by 10.438 billion euros. In their methodological commentary the Agencia Tributaria (on page 5) put this reduction in refunds down to either money owing from previous fiscal exercises (4.4 billion euros) or refunds which had already been paid in 2009 (5.6 billion euros) due to a policy change which meant that refunds started to be made on a monthly basis. Be all that as it may, the real net increase in tax income from all sources so far this year is something like 6.9 percent according to the agency, and the net increase in IVA (adjusted for refunds) may be more like 5.4 percent, and not the splendid looking 47.5 percent figure which appears on page 11 of the IGAE report.

Las devoluciones de IVA Anual 2009 caen hasta agosto un -60,9% (en consonancia con el menor importe solicitado), y las de IVA mensual apenas crecen un 0,3% porque las mayores devoluciones realizadas este año del ejercicio 2009 (por la generalización del sistema de devolución mensual) se compensan con el menor importe solicitado del ejercicio 2010. La única novedad que aporta agosto en cuanto a los ingresos brutos es el IVA Importación, que registra un aumento del 18,0% hasta este mes en sintonía con la marcha de las importaciones de terceros no energéticas. En total y antes de empezar arecoger el impacto total de la subida de tipos, el IVA bruto ya acumula un incremento del 5,4%. Agencia Tributaria Report, my emphasis.

Now, if we move over to the expenses side, we see that staff costs are up (2.3 percent) in the first eight months of the year, but this number is a little deceptive, since salaries were originally increased 3 percent in January of this year, and then cut in the May measures by an average of 5 percent as of 1 July, so evidently as the year advances the total increase should fall steadily, and may even arrive below zero by the end of the year. More importantly (for next year) freezing salaries for 2011 will represent a real reduction in salary 2011/2010 since the base to be applied on 1 January 2011 will be the level of 1 July 2010, which means during the year their will be a commensurate drop in Spanish domestic consumer demand.

But the big reductions on the spending side for 2010 come in capital spending (infrastructure works etc) which is down 7.9 percent (or 500 million euros, about 0.05 percent of GDP), and in transfers to Spain's local authorities - which are down by around 1.3 billion euros (or about 0.13 percent of GDP). Transfers to the autonomous communities are in fact up, but interpreting this involves a complicated calculation, since there have been recent changes in the financing arrangements.

On the other hand, Spain's regional governments, far from reducing their deficits are in fact increasing them like never before. In fact total autonomous community debt hit 104 billion euros (0r 10.4% of GDP) in June according to the latest Bank of Spain data, up from 82.9 billion one year earlier. That is to say, the regional governments increased their debt by nearly 25% year on year, and there is no sign so far that they are putting the brakes on.

Of course, the regional governments only accounted for about 14% of last years deficit, so even if their deficit does shoot up, it won't be a determining factor, but it will make it much more difficult for the total deficit to fall within the targeted limits.

The local authorities, on the other hand, have things a lot tougher, since their revenue from central government is significantly down, and they find it very hard to increase their borrowing from banks, so their rate of new debt accumulation is definitely slowing.

Difficult Times Ahead For The Regional Governments

On 4 August 2010 Fitch Ratings placed four more Spanish autonomous communities on a Negative Rating Outlook, which effectively meant that all Spain's autonomous communities are now on Negative Outlook. According to the rating agency this move reflects their view that their budget balances will remain fragile in the medium term, while their debt will continue to increase. As they say, some indication of regional governmment intentions to curb expenditure have emerged, but in the majority of cases the measures still need to be detailed and implemented, a process which could take considerable time, and will certainly see us well beyond the 2010 fiscal exercise before their impact is felt. According to the terms of the recent Royal Decree the maximum deficit allowed for the Autonomous Communities during the 2010‐2012 period has been reduced by 0.5% of GDP. But this decision comes just one year after the Council for Fiscal and Financial Policy (CFFP) authorised the autonomous communities to exceptionally raise their deficits to 2.5% of the GDP for 2010, 1.7% for 2011 and 1.3% for 2012 in order to counterbalance the revenue shortfall being created by the crisis. So we can imagine some kind of chaos may well have ensued when those responsible for implementing their budgets learnt of the new targets.

What is worse for the regional governments, as Fitch point out, the smaller deficit allowances introduced in June 2010 do not take into account the negative tax settlements related to excess transfers made by the state during 2008 and 2009 to try to help the beleagured regional governments. Although the amount of this excess funding temporarily transferred to autonomous communities by the central government has yet to be confirmed it is clear that now having reduced entitlement to funding will only make an already difficult position worse.

What happened was that the 2008 and 2009 budgets’ tax forecasts were over‐optimistic and the autonomous communities received greater advance tax and sufficiency fund payments than warranted by the amounts actually collected, and the autonomous communities will now have to return the excess (see chart from Fitch below).

Fitch’s calculates that the excess allocated to autonomous communities in 2008 was something like 7 billion euros, and that in 2009 the number may have hit 21 billion euros. According to the new financing agreement with the central government, the regional governments can make repay in 60 monthly instalments starting in January 2011.

Fitch is of the opinion that the increased financial pressure all this will produce plus the stricter control over debt authorisations introduced under the new financing agreement will definitely create heightened liquidity pressure for the regional administrations. Most of the autonomous communities have budgeted for a deficit equivalent to 2.4% of their GDP for 2010, however, since the central government is now only likely to authorise them to issue new debt equivalent to a maximum of 1.95% of GDP, they will have to fund a gap equivalent to a minimum of 0.45% of GDP without new borrowing. The most likely scenario is that their cash reserves will decline and that delays in paying suppliers will increase.

In fact only this week, the Economist quotes Juan Bravo, who is in charge of finances for the city of Madrid, as saying that the city’s income will not return to 2007 levels until 2016, and in the meantime the only way he can survive is to delay payment. “Last year I paid bills in 60 days, now I am paying in six or seven months,” he said. (Or see this report in the WSJ)

And to make matters worse, significant doubt exists about the achievability of Spain's GDP growth forecasts. Finance Minister Elena Salgado said last Friday that she was confident the country's economy would grow in line with government forecasts but most analysts feel the forecasts of a 0.3% contraction this year,followed by growth of 1.3% in 2011, 2.5% in 2012 and 2.7% in 2013 are far too optimistic.

The bottom line here is that Spain's real commitment to meet its targets is still on trial. Pressure from financial markets may well mean that the fiscal effort made in the second half of the year will be much greater than that in the first, but all in all, achieving the 6% target for 2011 looks to be an extraordinarily difficult task, given everything we have seen so far. As one investor put it recently “We are still skeptical as to whether they will really take all the austerity measures or only go as far as the market forces them, and when pressure abates they’ll let the deficit slip again. It seems they want to do as little as needed to relax the markets.”

And, of course, if all this wasn't enough, even if the fiscal effort is made as the government is promising, this still doesn't solve the deep-seated underlying problem. Just what is the plan to put sufficient dynamism back into the Spanish economy in order to produce those lovely growth numbers that we would all so much like to see?