8/2/2019 oeabril2012

1/13

8/2/2019 oeabril2012

2/13

1

CONTENTS

Executive summary 2

1) Will Spanish banks withstand the dramatic drop in house prices? 3

House prices have further to fall 3

Current provisions fall short of covering banks potential losses 4

Why is this of such a concern? 5

Recommendations 6

2) Can the regions stop spending? 6

3) Will Spains supply-side reforms deliver? 8

What reforms has Spain introduced so far? 9

Will these deliver the desired results in time? 10

Recommendations 11

Spains success could mean Portugals downfall 12

8/2/2019 oeabril2012

3/13

2

Executive summary:

Given its size, the fate of the Spanish economy will also largely decide the fate of theeuro. 80bn of 396bn (1/5) in loans that Spanish banks have made to the bustconstruction and real estate sectors is considered doubtful and potentially toxic,meaning at serious risk of default, with the banks only holding 50bn in reserves tocover potential losses. Already dropping, house prices could potentially fall another35%, meaning that Spanish banks will almost certainly face hefty losses as morehouseholds default on their mortgages.

In such a scenario, the Spanish state is unlikely to be able to afford to recapitalise itsbanks, meaning that the eurozones permanent bailout fund (the ESM) would have tostep in, shifting the cost to eurozone taxpayers.

As domestic banks are currently the main buyers of Spanish government debt, thiscould also lead to major funding problems for Spain. The chances of a self-fulfillingbond 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 itsbooks. The level of unpaid debt on the balance sheets of local and regionalgovernments has risen by 10bn (38%) since the start of the crisis (now topping36bn). This will likely be paid off by the central government, increasing the countrysdebt and deficit.

Spains various reforms, particularly to the labour market, are welcome, but arethemselves not enough to stop a bond run, as it will take time before they bite. Thecountrys long- term unemployment has now reached 9% of the economically activepopulation, and youth unemployment reached 50.5% last month. This is threatening

the long term productivity of the economy and whether Spanish society can sustainthis level is unknown.

A Spanish bailout is far from a forgone conclusion, but more work needs to be doneto avoid one. Open Europe recommends:

o Spanish banks double their provisions against souring loans and commit tothorough stress tests

o Strengthen labour market reforms, particularly to relieve the welfare burdenon state finances, including: end wage and pension indexation to inflation,reduce size and duration of benefits, limit collective bargaining, reduceredundancy costs and improve the business climate.

However, these reforms will only stand the test of time if they enjoy political buy-infrom across society in Spain, rather than being imposed from outside.

8/2/2019 oeabril2012

4/13

3

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 realestate and construction sectors in Spain. Currently, Spanish banks have 396bn inconstruction and real estate related loans on their balance sheets. The potential problemswithin 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 inSpain are yet to fully adjust. This is particularly stark when compared to Ireland, whichexperienced 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 thedecline picked up substantially at the end of last year (annual fall of 11.2%). The massiveoversupply of housing and collapse in demand, means prices have much further to fall.2 Inall likelihood, given the similar situation, house prices will have to fall as far as they did inIreland, that is, another 35%. Due to the greater flexibility in wage costs and output costs inIreland (thanks to its flexible labour market and open economy), the sector was able toadjust after the bust much more quickly than in Spain. A similar adjustment must and willtake 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 Theincrease in the number of mortgage cancellations per month suggests this is alreadyhappening, particularly when considering the number of mortgages which are issued permonth:

1Tinsa 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.html2

The Spanish Ministry for Housing said in 2009 that there were around 1 million unsold houses (20% of the totalhousing stock), this is only likely to have increased. The fall in demand is directly related to the fall in availabilityof 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-slumping4 House prices are here taken as an indicator for broader trends in the value of real estate and constructionrelated assets which banks hold. As the value of these assets fall banks will see losses pile up on their balancesheets, particularly those which mark to market on these holdings.

8/2/2019 oeabril2012

5/13

4

Source: INE

5

The number of mortgages cancelled per month relative to the number issued has reached85% 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 7

The level of doubtful loans on the books of Spanish banks has sky-rocketed since the startof the financial crisis and now stands at 136bn.8 This means that, of all their loansdispersed, 7.6% are now judged as doubtful, and can be seen as potentially toxic and at

5Instituto 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=16

This percentage measure is used to highlight that the cancellation increase isnt just down to more mortgagesbeing issued.7

Bank of Spain, Statistical Bulletin, Section 4: Credit Institutions, see:http://www.bde.es/webbde/en/estadis/infoest/bolest4.html8 The definition we use for doubtful loans is the same as the Bank of Spain which is: Those in respect of whichsome amount of principal, interest or any other contractually agreed expense is more than three months past-dueor exceeds 25% of total debt (unless these loans are specifically classified as written-off assets).

8/2/2019 oeabril2012

6/13

5

serious risk of default. Looking at just the real estate and construction sectors, the figuresbecome even more concerning:

Source: Bank of Spain, Statistical bulletin

Taken together, there are currently 80bn in doubtful loans to the real estate andconstruction sectors - equal to 20% of all loans to these sectors. This results from around a20% 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 evenlarger share will become viewed as uncertain.

This means that the 50bn (shown by thin red line on graphs above) that the governmentrecently ordered banks to put aside to cover potential losses is far from adequate.9 Thecurrent provisions cover only 37% of total doubtful loans and 62.5% of doubtful loans to theconstruction and real estate sectors. This seems inadequate even in the current position, butwill be woefully short if the conditions worsen.10

To instil the confidence which the Spanish banking system needs, the government mustinsist on tougher provisions and a fuller assessment of potential losses if house pricesdecrease 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 takessignificant losses or sees a massive deterioration in banks balance sheets, the

9Bank of Spain, Statistical Bulletin, Section 4: Credit Institutions, Table 4.7, column 12, see:

http://www.bde.es/webbde/es/estadis/infoest/a0407e.pdf10 Only last month, similar concerns were expressed by Moodys, in particular the rating agency expressedcontinuing concerns over the state of the cajas which it believes hold a capital shortfall of 50bn. See MoodysWeekly Credit Outlook, 28 February 2012.

8/2/2019 oeabril2012

7/13

6

Spanish state may be forced to bail out these banks or provide a large capitalinjection. Spain may not have the cash to perform such action, so may need to turnto the eurozone bailout funds. Even in the best case scenario, without a eurozonebailout, it would result in Spains already large deficit growing massively and its fiscalconsolidation and reform programme being thrown completely off track. At this pointmarkets 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 LongTerm Refinancing Operation (LTRO), providing cheap three-year loans to banks,may have allowed Spanish banks to increase their purchases of Spanish governmentdebt. Since the first LTRO Spanish banks have purchased 39bn in eurozonegovernment debt, with most thought to be from Spain making them essentially theonly buyers of Spanish debt.11 If the Spanish banks got into serious trouble theywould no longer be able to perform this role. This would break the sovereign-bankingloop which has been holding up Spain and Italy.12 Without this, the chances of a self-fulfilling bond market run on Spain would increase massively, potentially pushing thecountry to seek a eurozone bailout.

There are plenty of other problems with Spanish banks, such as their overreliance on ECBfunding and the problems of consolidating the diverse and poorly run cajas (regionalsavings banks).13 However, the exposure to the bust real estate and construction sectorremains the most acute and threatening of the lot.

Recommendations:

Double provisions against doubtful loans: Provisions should be doubled to100bn. 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 liquidityand 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 ableto find the scope for these extra provisions.

Thorough stress testing (using external organisations): As done in Ireland, testsshould focus on the real estate and construction sectors, which should help toprovide a closer estimate of the potential losses which banks face. Ideally, bankswould fully mark to market on doubtful loans, to fully represent the default risk ontheir balance sheets and allow them to provide adequate cover.

Precautionary loan from ESM preferable to threat of full bailout: If these are notachievable, despite the stigma, a precautionary loan from the ESM to help bankswould be preferable to the threat of another banking crisis which could create theneed for a full bailout programme for Spain, although the former is simply the lesserof two evils.

2. CAN THE REGIONS STOP SPENDING?

In Spanish regions enjoy a lot of autonomy, and roughly 50% of public spending flowsthrough the regions. It is positive that for the first time in this crisis the party running thecentral government actually has control in the majority of the regions. This reduces conflictand suggests that more progress can be made in terms of structural reforms and fiscalconsolidation in the regions.

11Cited by Reuters, Italian, Spanish banks continue to gorge on government debt, 28 March 2012:

http://www.reuters.com/article/2012/03/28/ecb-bonds-idUSF9E7L402N2012032812

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.pdf13

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

8/2/2019 oeabril2012

8/13

7

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

Source: Bank of Spain14

The graph above highlights the large level of unpaid debts held by local and regionaladministrations. 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 tellus. The most important fact here, though, seems to be that the unpaid debts held by regionsand local governments have been steadily increasing throughout the crisis. This highlightsthe continuing problems which the government has in controlling the regions and which theregions themselves have in cutting costs and reining in their spending. Rather thanrestructuring or reforming their spending programmes the regions simply seem to go intoarrears on current contracts. This trend seems unlikely to reverse over the next year asausterity begins to bite and budget cuts continue. All this makes the national 3% deficittarget in 2014 very unlikely.15

There are also additional hidden problems with debt related to public enterprises, estimatedto 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 isunfortunately likely to become a problem for central and regional governments since thesefirms have an implicit government guarantee. The central government is also explicitlyguaranteeing a range of other debt (such as those on bank bonds) which totalled 98bn atthe end of 2011.17

14Bank of Spain, Statistics, Chapter 2: Financial Accounts, see:

http://www.bde.es/webbde/en/estadis/ccff/cfcap2.html15

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.pdf17

Bank of Spain, Statistics, Chapter 2: Financial Accounts, Table 12.7, see:http://www.bde.es/webbde/es/estadis/infoest/a1207e.pdf

8/2/2019 oeabril2012

9/13

8

In an attempt to help tackle regional arrears and refinancing problems, Spain has created a10bn Instituto de Credito Oficial (ICO) credit line and a 35bn permanent fund. This isbroadly 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 willshow up in the national debt and deficit targets, probably making it harder for thegovernment to meet its deficit targets.18

Under the latest budget, the Spanish government is aiming to cut 3.2% of GDP from thegeneral government deficit, with regional governments expected to deliver 1.4% of GDP, or44%, of the planned deficit reduction in 2012. This is a large proportion considering that theregions 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 reformsaimed 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 andeurozone pressure, while monetary policy is as loose as the ECB will allow. That said, it isimportant to examine the credibility of these reforms and whether they can have the desiredimpact within a reasonable timeframe.19

The level of correction needed is huge; the graph below demonstrates the massive increasein 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: thegap in hourly productivity between Spain and Germany remains huge and the massive levelsof unemployment (23.6% total and 50.5% for young people) are widely documented.20

18Cited 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#axzz1oBTooxyl19

Bank of Spain, FISCAL POLICY, STRUCTURAL REFORMS AND EXTERNAL IMBALANCES: AQUANTITATIVE EVALUATION FOR SPAIN, 2011:http://www.bde.es/webbde/SES/Secciones/Publicaciones/PublicacionesSeriadas/DocumentosTrabajo/11/Fich/dt1107e.pdf20

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 inSpain. This is broadly a positive thing for the economy, but there are a couple of concerns. If more people areactually employed than suggested the state is likely missing out on some significant tax revenue while potentially

8/2/2019 oeabril2012

10/13

9

Source: Eurostat

As the graphs also show, labour unit costs climbed sharply over the last decade whileproductivity remained unchanged. Restoring a clear link between the two will be vital if Spainis 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 forpushing 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 ofgovernment;

Labour market reform: cuts to the level of compensation for fair and unfairdismissals, made easier to distinguish between the two and use fair dismissalprocedure. Reforms to encourage hiring of permanent workers and to tackle dualityof 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 whetherthey can help Spain out of its current crisis, specifically: how long will it take for the reformsto be implemented and return benefits, will the likely unemployment resulting from some ofthese reforms cause social unrest and even if the supply-side reforms work, where will thedemand come from to aid economic growth?

Reforms could take nine to twelve months to have an impact: Labour market reformwas initiated in 2010 and although it is an incremental process, progress has beendisappointingly 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 tacklethese 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/en-gb/Economic%20Outlook/120316%20Economic%20Reforms.pdf

8/2/2019 oeabril2012

11/13

10

extenuating circumstances, these delays drive home that it takes a significant amount oftime to pass many of these reforms, especially taking into account growing trade unionopposition and the difficulty of getting this implemented at the regional level. It could well benine to twelve months before the first benefits of the latest reforms are felt (if they wereimplemented today).

Spain may not be able to stomach any more unemployment: One well-known side effectof structural reforms, even necessary ones, is a temporary increase in unemployment. Thisis inevitable as the economy and labour market adjust and rebalance. Given the already sky-high unemployment in Spain it is unclear whether the population will be willing to stomachany further increases the political and social impacts are unknown. The recent wave ofprotests and strikes, although not yet on the level of those seen in Greece, does not bodewell on this front.

Source: Eurostat

Long-term unemployment could have a negative impact on the Spanish economy: Asof September 2011, 9% of the economically active people in Spain were classed as longterm unemployed. As the level of long-term unemployed increases there is also a concernthat the productive capacity of the Spanish economy could decrease permanently.Furthermore the negative social consequences and high welfare costs are more likely tobecome entrenched. Increases in unemployment will likely also lead to an increase in thenumber 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 boostcompetitiveness relatively quickly, there will still be questions over the level of demand in theeconomy (particularly with domestic demand crashing).22 Fernndez-Villaverde and Rubio-Ramrez (2011) suggested that in this instance (assuming monetary policy is seen to be asloose as possible) supply-side reforms could actually help to boost demand as people areencouraged to spend based on higher future wealth.23 This effect may take place to someextent but given the constraints on borrowing against future wealth (due to the lack of creditin the real economy) and the fact that many people have been running down savings for thepast year, this effect may be limited. The hope remains though that a more positive future

22CEPR Bulletin, Spanish Unemployment: Is There a Solution?:

http://www.cepr.org/pubs/Bulletin/meets/496.htm23

Fernndez-Villaverde, J and JF Rubio-Ramrez (2011). "Supply-Side Policies and the Zero Lower Bound", VoxEU, 11 November 2011: http://www.voxeu.org/index.php?q=node/7258

8/2/2019 oeabril2012

12/13

11

outlook in combination with the long term liquidity will eventually lead to banks lending moreto the real economy.24

These reforms are vitally important for Spain, but cannot alone guarantee that there will notbe a self-fulfilling bond run. As competitiveness improves and wages become morerepresentative of productivity, the countrys debt sustainability will improve, but this will taketime and could be knocked off course by the regional and banking problems highlightedabove. 25

Recommended reforms for Spain:

More reforms will be needed to speed up the recovery and boost Spanish productivity andcompetitiveness in the long term: 26

Move towards firm-level collective bargaining: Ideally firm-level collectivebargaining should be introduced across Spain, but this is unrealistic given tradeunion 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, particularlyabsent 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 Spanisheconomy. 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 throughpublic enterprises.

Support an EU patent and a pro-growth EU services directive: Completing thesetwo measures could boost the single market and will benefit Spain as well as the restof 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 disincentiveto work.

More labour market reform needed: The government has made a good start butmore can be done, for example lowering the costs associated with redundancy in thegraph below. There is significant scope to cut these further particularly relative toother EU countries.

24Speech 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.html25

Interestingly, even if exports grow quickly in Spain on the back of these reforms the Spanish current accountdeficit is likely to remain. This is because Spain imports a huge amount of oil and resources which are used toproduce its exports goods. This in turn highlights that Spain is incredibly open to the negative impact of an oilprice 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 Sickman of Europe2 to the New German Miracle, Konrad Adenauer Stiftung, Berlin, February 27, 2012.

8/2/2019 oeabril2012

13/13

12

Source: World Bank, Ease of Doing Business 201227

Obstacles to starting a business remain extraordinarily high: Spain still ranks133 in the World Banks Ease of Doing Business report in this area for 2012, andmore focus is needed on improving the business landscape. The new government isnot off to a great start with its latest budget which hits corporates hard (in a politicallymotivated effort to protect consumers). It is a tough trade off but a balance must bestruck 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 toSpain 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 therest of the EU and world. Secondly, it will also decrease the level of imports whichSpain takes from Portugal. The Portuguese current account would take a massive hitfrom a huge fall in exports, which could be a factor in pushing Portugal into a secondbailout.

27World Bank, Doing Business report, Employing workers data, see:

http://www.doingbusiness.org/data/exploretopics/employing-workers28

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