Not so bullish now?

The short term prospects for Spain inside the euro

April 2012

By Raoul Ruparel

Copyright 2011 Open Europe Published by Open Europe 7 Tufton St London SW1P 3QN www.openeurope.org.uk

CONTENTS Executive summary 1) Will Spanish banks withstand the dramatic drop in house prices? House prices have further to fall Current provisions fall short of covering banks potential losses Why is this of such a concern? Recommendations 2 3 3 4 5 6

2) Can the regions stop spending? 3) Will Spains supply-side reforms deliver? What reforms has Spain introduced so far? Will these deliver the desired results in time? Recommendations Spains success could mean Portugals downfall

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Executive summary: Given its size, the fate of the Spanish economy will also largely decide the fate of the euro. 80bn of 396bn (1/5) in loans that Spanish banks have made to the bust construction and real estate sectors is considered doubtful and potentially toxic, meaning at serious risk of default, with the banks only holding 50bn in reserves to cover potential losses. Already dropping, house prices could potentially fall another 35%, meaning that Spanish banks will almost certainly face hefty losses as more households default on their mortgages. In such a scenario, the Spanish state is unlikely to be able to afford to recapitalise its banks, meaning that the eurozones permanent bailout fund (the ESM) would have to step in, shifting the cost to eurozone taxpayers. As domestic banks are currently the main buyers of Spanish government debt, this could also lead to major funding problems for Spain. The chances of a self-fulfilling bond run on Spanish debt would increase massively in this scenario, threatening to push the whole country into a full bailout. Containing spending in the Spanish regions is also key to Spain rebalancing its books. The level of unpaid debt on the balance sheets of local and regional governments has risen by 10bn (38%) since the start of the crisis (now topping 36bn). This will likely be paid off by the central government, increasing the countrys debt and deficit. Spains various reforms, particularly to the labour market, are welcome, but are themselves not enough to stop a bond run, as it will take time before they bite. The countrys long- term unemployment has now reached 9% of the economically active population, and youth unemployment reached 50.5% last month. This is threatening the long term productivity of the economy and whether Spanish society can sustain this level is unknown. A Spanish bailout is far from a forgone conclusion, but more work needs to be done to avoid one. Open Europe recommends: o Spanish banks double their provisions against souring loans and commit to thorough stress tests o Strengthen labour market reforms, particularly to relieve the welfare burden on state finances, including: end wage and pension indexation to inflation, reduce size and duration of benefits, limit collective bargaining, reduce redundancy costs and improve the business climate. However, these reforms will only stand the test of time if they enjoy political buy-in from across society in Spain, rather than being imposed from outside.

1. WILL SPANISH BANKS WITHSTAND THE DRAMATIC DROP IN HOUSE PRICES? Spanish banks face a series of challenges, the biggest being their exposure to the bust real estate and construction sectors in Spain. Currently, Spanish banks have 396bn in construction and real estate related loans on their balance sheets. The potential problems within these holdings are yet to be fully realised or prepared for. House prices have further to fall: The housing boom and bust in Spain is well documented. However, despite the massive increase in prices over the last decade housing prices in Spain are yet to fully adjust. This is particularly stark when compared to Ireland, which experienced a similar bubble but has seen prices fall much more steeply.1

Source: Eurostat

On the surface the lower reduction in house prices may seem positive for Spain, but the decline picked up substantially at the end of last year (annual fall of 11.2%). The massive oversupply of housing and collapse in demand, means prices have much further to fall.2 In all likelihood, given the similar situation, house prices will have to fall as far as they did in Ireland, that is, another 35%. Due to the greater flexibility in wage costs and output costs in Ireland (thanks to its flexible labour market and open economy), the sector was able to adjust after the bust much more quickly than in Spain. A similar adjustment must and will take place in Spain but due to wage stickiness it is taking much longer.3 A steep decline in real estate prices will in turn increase the number of residential and commercial borrowers defaulting on their loans, exposing banks to large losses.4 The increase in the number of mortgage cancellations per month suggests this is already happening, particularly when considering the number of mortgages which are issued per month:
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Tinsa February 2012 Index, House prices in Spain continue to reflect the macroeconomic decline: http://www.tinsa.es/en/2810/press-area/press-releases/2012/imie-february-2012.html 2 The Spanish Ministry for Housing said in 2009 that there were around 1 million unsold houses (20% of the total housing stock), this is only likely to have increased. The fall in demand is directly related to the fall in availability of credit and the fall in domestic demand. Both well documented phenomena. 3 Cited by Zerohedge, European Housing still slumping, 21 March 2012: http://www.zerohedge.com/news/european-housing-still-slumping 4 House prices are here taken as an indicator for broader trends in the value of real estate and construction related assets which banks hold. As the value of these assets fall banks will see losses pile up on their balance sheets, particularly those which mark to market on these holdings.

Source: INE

The number of mortgages cancelled per month relative to the number issued has reached 85% and the pace of cancellations picked up significantly during 2011.6 Current provisions fall short of covering banks potential losses:

Source: Bank of Spain, Statistical bulletin

The level of doubtful loans on the books of Spanish banks has sky-rocketed since the start of the financial crisis and now stands at 136bn.8 This means that, of all their loans dispersed, 7.6% are now judged as doubtful, and can be seen as potentially toxic and at
Instituto Nacional de Estadstica (Spanish National Statistics Office), Financial and Monetary statistics, Mortgage time series, see: http://www.ine.es/jaxi/menu.do?type=pcaxis&path=%2Ft30%2Fp149&file=inebase&L=1 6 This percentage measure is used to highlight that the cancellation increase isnt just down to more mortgages being issued. 7 Bank of Spain, Statistical Bulletin, Section 4: Credit Institutions, see: http://www.bde.es/webbde/en/estadis/infoest/bolest4.html 8 The definition we use for doubtful loans is the same as the Bank of Spain which is: Those in respect of which some amount of principal, interest or any other contractually agreed expense is more than three months past-due or exceeds 25% of total debt (unless these loans are specifically classified as written-off assets).
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serious risk of default. Looking at just the real estate and construction sectors, the figures become even more concerning:

Source: Bank of Spain, Statistical bulletin

Taken together, there are currently 80bn in doubtful loans to the real estate and construction sectors - equal to 20% of all loans to these sectors. This results from around a 20% fall in real estate prices. If a further 35% decrease is still to come, things could get a lot worse. Proportionately, we could expect the number of doubtful loans to double. In any case, with further falls in prices many of these currently doubtful loans will default while an even larger share will become viewed as uncertain. This means that the 50bn (shown by thin red line on graphs above) that the government recently ordered banks to put aside to cover potential losses is far from adequate.9 The current provisions cover only 37% of total doubtful loans and 62.5% of doubtful loans to the construction and real estate sectors. This seems inadequate even in the current position, but will be woefully short if the conditions worsen.10 To instil the confidence which the Spanish banking system needs, the government must insist on tougher provisions and a fuller assessment of potential losses if house prices decrease further. Why is this of such concern? There are two reasons why this is of concern to the eurozone: 1) Spain may need to bail out its banks: If the Spanish banking sector takes significant losses or sees a massive deterioration in banks balance sheets, the
Bank of Spain, Statistical Bulletin, Section 4: Credit Institutions, Table 4.7, column 12, see: http://www.bde.es/webbde/es/estadis/infoest/a0407e.pdf 10 Only last month, similar concerns were expressed by Moodys, in particular the rating agency expressed continuing concerns over the state of the cajas which it believes hold a capital shortfall of 50bn. See Moodys Weekly Credit Outlook, 28 February 2012.
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Spanish state may be forced to bail out these banks or provide a large capital injection. Spain may not have the cash to perform such action, so may need to turn to the eurozone bailout funds. Even in the best case scenario, without a eurozone bailout, it would result in Spains already large deficit growing massively and its fiscal consolidation and reform programme being thrown completely off track. At this point markets would surely question the stability of the economy as a whole. 2) Spanish banks are the only buyers of Spanish bonds: The ECBs so-called Long Term Refinancing Operation (LTRO), providing cheap three-year loans to banks, may have allowed Spanish banks to increase their purchases of Spanish government debt. Since the first LTRO Spanish banks have purchased 39bn in eurozone government debt, with most thought to be from Spain making them essentially the only buyers of Spanish debt.11 If the Spanish banks got into serious trouble they would no longer be able to perform this role. This would break the sovereign-banking loop which has been holding up Spain and Italy.12 Without this, the chances of a selffulfilling bond market run on Spain would increase massively, potentially pushing the country to seek a eurozone bailout. There are plenty of other problems with Spanish banks, such as their overreliance on ECB funding and the problems of consolidating the diverse and poorly run cajas (regional savings banks).13 However, the exposure to the bust real estate and construction sector remains the most acute and threatening of the lot. Recommendations: Double provisions against doubtful loans: Provisions should be doubled to 100bn. The aim should be to complete this within the next 12 months maximum. Markets in Europe are relatively calm and Spanish banks are flush with new liquidity and have covered the majority of their funding for the coming year. With the additional security of the Spanish bank bailout fund (FROB) the banks should be able to find the scope for these extra provisions. Thorough stress testing (using external organisations): As done in Ireland, tests should focus on the real estate and construction sectors, which should help to provide a closer estimate of the potential losses which banks face. Ideally, banks would fully mark to market on doubtful loans, to fully represent the default risk on their balance sheets and allow them to provide adequate cover. Precautionary loan from ESM preferable to threat of full bailout: If these are not achievable, despite the stigma, a precautionary loan from the ESM to help banks would be preferable to the threat of another banking crisis which could create the need for a full bailout programme for Spain, although the former is simply the lesser of two evils.

2. CAN THE REGIONS STOP SPENDING? In Spanish regions enjoy a lot of autonomy, and roughly 50% of public spending flows through the regions. It is positive that for the first time in this crisis the party running the central government actually has control in the majority of the regions. This reduces conflict and suggests that more progress can be made in terms of structural reforms and fiscal consolidation in the regions.
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Cited by Reuters, Italian, Spanish banks continue to gorge on government debt, 28 March 2012: http://www.reuters.com/article/2012/03/28/ecb-bonds-idUSF9E7L402N20120328 12 For an excellent discussion of the eurozone sovereign bank loops see this IMF working paper: http://www.imf.org/external/pubs/ft/wp/2011/wp11269.pdf 13 Cited by WSJ Heard on the Street, More Twists for Spanish Banks, 27 March 2012: http://online.wsj.com/article/SB10001424052702303404704577307910878289278.html?mod=djemheard_t

That said, it is not all smooth sailing between the central and regional governments. The government has failed to win Andaluca, Spains biggest region, while Catalonia (Spains wealthiest region) is governed by local nationalist parties, as is the Basque Country. It will be very hard to impose strict fiscal rules in these areas, especially when any rules from Madrid are not well received. Fighting against the largest and wealthiest regions in Spain could yet prove a bigger task for the central government than many had anticipated.

Source: Bank of Spain

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The graph above highlights the large level of unpaid debts held by local and regional administrations. The levels are similar to those seen in Italy (but also the UK and Norway) and proportionately similar to Greece meaning it is hard to judge just what these figures tell us. The most important fact here, though, seems to be that the unpaid debts held by regions and local governments have been steadily increasing throughout the crisis. This highlights the continuing problems which the government has in controlling the regions and which the regions themselves have in cutting costs and reining in their spending. Rather than restructuring or reforming their spending programmes the regions simply seem to go into arrears on current contracts. This trend seems unlikely to reverse over the next year as austerity begins to bite and budget cuts continue. All this makes the national 3% deficit target in 2014 very unlikely.15 There are also additional hidden problems with debt related to public enterprises, estimated to be around 56bn (5.2% of GDP) at the end of 2011. If recession is deeper or longer than predicted, financing this could be a problem for some of these institutions.16 This is unfortunately likely to become a problem for central and regional governments since these firms have an implicit government guarantee. The central government is also explicitly guaranteeing a range of other debt (such as those on bank bonds) which totalled 98bn at the end of 2011.17

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Bank of Spain, Statistics, Chapter 2: Financial Accounts, see: http://www.bde.es/webbde/en/estadis/ccff/cfcap2.html 15 For an excellent run down of the debt problems facing Spain and its regions, see: http://www.economonitor.com/edwardhugh/2012/03/06/homeric-similes-and-spanish-debt/ 16 Bank of Spain, Statistics, Chapter 2: Financial Accounts, Table 11.10, see: http://www.bde.es/webbde/es/estadis/infoest/a1110e.pdf 17 Bank of Spain, Statistics, Chapter 2: Financial Accounts, Table 12.7, see: http://www.bde.es/webbde/es/estadis/infoest/a1207e.pdf

In an attempt to help tackle regional arrears and refinancing problems, Spain has created a 10bn Instituto de Credito Oficial (ICO) credit line and a 35bn permanent fund. This is broadly a positive step since it will help move an unknown debt overhang onto the books. However, questions remain over the conditionality which will be applied to these funds. There is also the added drawback that once these funds have been tapped the arrears will show up in the national debt and deficit targets, probably making it harder for the government to meet its deficit targets.18 Under the latest budget, the Spanish government is aiming to cut 3.2% of GDP from the general government deficit, with regional governments expected to deliver 1.4% of GDP, or 44%, of the planned deficit reduction in 2012. This is a large proportion considering that the regions overshot their targets last year by some margin. 3. WILL SPAINS SUPPLY-SIDE REFORMS DELIVER? The new Spanish government has importantly embarked on a series of supply-side reforms aimed at making Spain competitive within the eurozone again. This is a vital step, since Spain has few tools at its disposal fiscal consolidation is a must due to market and eurozone pressure, while monetary policy is as loose as the ECB will allow. That said, it is important to examine the credibility of these reforms and whether they can have the desired impact within a reasonable timeframe.19 The level of correction needed is huge; the graph below demonstrates the massive increase in labour costs in Spain relative to Germany:

Source: Eurostat

Spain has made some progress since the start of the crisis, but there is a long way to go: the gap in hourly productivity between Spain and Germany remains huge and the massive levels of unemployment (23.6% total and 50.5% for young people) are widely documented.20

Cited by the FT, Spains public sector debt to be exposed, 26 February 2012: http://www.ft.com/cms/s/0/c020b7dc-6088-11e1-84dd-00144feabdc0.html#axzz1oBTooxyl 19 Bank of Spain, FISCAL POLICY, STRUCTURAL REFORMS AND EXTERNAL IMBALANCES: A QUANTITATIVE EVALUATION FOR SPAIN, 2011: http://www.bde.es/webbde/SES/Secciones/Publicaciones/PublicacionesSeriadas/DocumentosTrabajo/11/Fich/dt 1107e.pdf 20 Cited by Bloomberg View, Clive Crook, Why Europe Really Must Pursue Structural Reform, 1 February 2012: http://www.bloomberg.com/news/2012-02-01/why-europe-really-must-pursue-structural-reform-clive-crook.html It is likely that these official figures overestimate the actual level of unemployment due to the black/grey economy in Spain. This is broadly a positive thing for the economy, but there are a couple of concerns. If more people are actually employed than suggested the state is likely missing out on some significant tax revenue while potentially

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Source: Eurostat

As the graphs also show, labour unit costs climbed sharply over the last decade while productivity remained unchanged. Restoring a clear link between the two will be vital if Spain is to become competitive (as will a similar link with job security). What reforms has Spain introduced so far? 21 Despite the significant pessimism surrounding Spain the government deserves credit for pushing ahead with some extensive and important reforms: Minimum wage and civil servant wage freeze; Tax changes: a new programme to tackle tax evasion and temporary increase in personal income tax; Budgetary stability law: balanced budgets, expenditure ceilings, automatic correction of debts and deficits and enhanced surveillance at all levels of government; Labour market reform: cuts to the level of compensation for fair and unfair dismissals, made easier to distinguish between the two and use fair dismissal procedure. Reforms to encourage hiring of permanent workers and to tackle duality of labour market; Improved educational and training programmes.

Will these deliver the desired results in time? Looking at the extent and breadth of the reforms some key questions remain over whether they can help Spain out of its current crisis, specifically: how long will it take for the reforms to be implemented and return benefits, will the likely unemployment resulting from some of these reforms cause social unrest and even if the supply-side reforms work, where will the demand come from to aid economic growth? Reforms could take nine to twelve months to have an impact: Labour market reform was initiated in 2010 and although it is an incremental process, progress has been disappointingly slow after a promising start, partly owing to election season. Despite some
also paying extra welfare benefits to many of these people. It would be in the governments interest to tackle these undocumented earnings, although it might not be a priority. 21 Spanish Economy Ministry, Spains Economic Reform Programme, 22 March 2012: http://cdrtse.meh.es/SiteCollectionDocuments/engb/Economic%20Outlook/120316%20Economic%20Reforms.pdf

extenuating circumstances, these delays drive home that it takes a significant amount of time to pass many of these reforms, especially taking into account growing trade union opposition and the difficulty of getting this implemented at the regional level. It could well be nine to twelve months before the first benefits of the latest reforms are felt (if they were implemented today). Spain may not be able to stomach any more unemployment: One well-known side effect of structural reforms, even necessary ones, is a temporary increase in unemployment. This is inevitable as the economy and labour market adjust and rebalance. Given the already skyhigh unemployment in Spain it is unclear whether the population will be willing to stomach any further increases the political and social impacts are unknown. The recent wave of protests and strikes, although not yet on the level of those seen in Greece, does not bode well on this front.

Source: Eurostat

Long-term unemployment could have a negative impact on the Spanish economy: As of September 2011, 9% of the economically active people in Spain were classed as long term unemployed. As the level of long-term unemployed increases there is also a concern that the productive capacity of the Spanish economy could decrease permanently. Furthermore the negative social consequences and high welfare costs are more likely to become entrenched. Increases in unemployment will likely also lead to an increase in the number of doubtful and defaulting loans this will put further pressure on the banking sector. Questions remain over where demand will come from: Even if these reforms help boost competitiveness relatively quickly, there will still be questions over the level of demand in the economy (particularly with domestic demand crashing).22 Fernndez-Villaverde and RubioRamrez (2011) suggested that in this instance (assuming monetary policy is seen to be as loose as possible) supply-side reforms could actually help to boost demand as people are encouraged to spend based on higher future wealth.23 This effect may take place to some extent but given the constraints on borrowing against future wealth (due to the lack of credit in the real economy) and the fact that many people have been running down savings for the past year, this effect may be limited. The hope remains though that a more positive future

CEPR Bulletin, Spanish Unemployment: Is There a Solution?: http://www.cepr.org/pubs/Bulletin/meets/496.htm 23 Fernndez-Villaverde, J and JF Rubio-Ramrez (2011). "Supply-Side Policies and the Zero Lower Bound", Vox EU, 11 November 2011: http://www.voxeu.org/index.php?q=node/7258

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outlook in combination with the long term liquidity will eventually lead to banks lending more to the real economy.24 These reforms are vitally important for Spain, but cannot alone guarantee that there will not be a self-fulfilling bond run. As competitiveness improves and wages become more representative of productivity, the countrys debt sustainability will improve, but this will take time and could be knocked off course by the regional and banking problems highlighted above. 25 Recommended reforms for Spain: More reforms will be needed to speed up the recovery and boost Spanish productivity and competitiveness in the long term: 26 Move towards firm-level collective bargaining: Ideally firm-level collective bargaining should be introduced across Spain, but this is unrealistic given trade union power. Therefore getting as close to this as possible must be the aim. End wage and pension indexation to inflation: This is a practice which is being reformed across Europe, and will be a key tool in containing labour costs, particularly absent interest rates tailored for the Spanish economy. Begin a privatisation programme: The Spanish state has significant assets to sell, which would encourage greater investment and involvement in the Spanish economy. Revenues can be used to aid fiscal consolidation or pursue other reforms. This will also reduce the levels of hidden debt which the state guarantees through public enterprises. Support an EU patent and a pro-growth EU services directive: Completing these two measures could boost the single market and will benefit Spain as well as the rest of the eurozone. Spain has in the past openly opposed the former. Incentivise work: Attempts have been made to stagger the transition from unemployed to employed and encourage hiring of permanent workers. However, benefits remain far too high, presenting a massive cost to the state and a disincentive to work. More labour market reform needed: The government has made a good start but more can be done, for example lowering the costs associated with redundancy in the graph below. There is significant scope to cut these further particularly relative to other EU countries.

Speech by Jean-Claude Trichet, President of the European Central Bank, Supply side economics and monetary policy, at the Institut der Deutschen Wirtschaft, Kln, 22 June 2004: http://www.ecb.int/press/key/date/2004/html/sp040622_1.en.html 25 Interestingly, even if exports grow quickly in Spain on the back of these reforms the Spanish current account deficit is likely to remain. This is because Spain imports a huge amount of oil and resources which are used to produce its exports goods. This in turn highlights that Spain is incredibly open to the negative impact of an oil price shock. Supply side reforms will help the economy deal with this and other shocks more effectively. 26 Many of these reforms have been successful elsewhere, notably in Germany during the early part of last decade. As highlighted by: Jrgen Matthes, Senior economist IW Kln, Presentation - Germany: From the Sick man of Europe2 to the New German Miracle, Konrad Adenauer Stiftung, Berlin, February 27, 2012.

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Source: World Bank, Ease of Doing Business 2012

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Obstacles to starting a business remain extraordinarily high: Spain still ranks 133 in the World Banks Ease of Doing Business report in this area for 2012, and more focus is needed on improving the business landscape. The new government is not off to a great start with its latest budget which hits corporates hard (in a politically motivated effort to protect consumers). It is a tough trade off but a balance must be struck between the two groups, especially given the massive employment problems. Significant improvement could also be made in areas such as enforcing contracts, getting businesses access to electricity and protecting investors.28

Spains success could mean Portugals downfall If all these reforms succeed and Spain manages to achieve the necessary internal devaluation to become competitive again it could unfortunately be negative for Portugal. Portugal and Spain are each others main competitors, since they export similar products to similar markets. Therefore Portugal has to become competitive relative to Spain and vice versa. If Spain manages internal devaluation it could be doubly bad for Portugal. Firstly, because Spain will be relatively more competitive, harming Portuguese exports to the rest of the EU and world. Secondly, it will also decrease the level of imports which Spain takes from Portugal. The Portuguese current account would take a massive hit from a huge fall in exports, which could be a factor in pushing Portugal into a second bailout.

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World Bank, Doing Business report, Employing workers data, see: http://www.doingbusiness.org/data/exploretopics/employing-workers 28 World Bank, Doing Business report, Ease of doing business in Spain 2012, see: http://www.doingbusiness.org/data/exploreeconomies/spain

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