Spain nears end game
The request by Spain for eurozone assistance to recapitalise its waterlogged banking sector was inevitable.
It’s been coming for the last year at least. The denials up to the very last minute were absolutely in keeping with the manner in which the eurozone typically goes about the business of patching up the balance sheets of its banks and — umbilically connected to them — its crisis-stricken economies.
The epicentre of Spain’s difficulties is much the same as in Ireland: An unsustainable boom in its construction/real estate sector, much of it funded by wholesale deposits from international markets that have now dried up.
It should be said that over the last year, the Spanish government has implemented wide-ranging reforms in the public sector, in pensions, as well as in the labour market and, crucially, its banking sector.
The real challenge — exactly the same as in Ireland — has been the unrealistic time-scale imposed by the eurozone authorities; ie the ECB, the Commission and, especially, Germany (with little help from the now departed president Sarkozy).
The time-scale has been far too ambitious and has actually exacerbated the problems it is directed towardsresolving.
The IMF, in its analysis of Spain’s problems just a year ago, pointed out that “unwinding imbalances accumulated during the long boom and reallocating resources across sectors, will take years”. The IMF pointed out that it is one thing to turn off the flow of credit but quite another to deal with the ‘stock problem’: the overhang of real estate, as house prices continue to fall and possibly by as much as one third more.
An adjustment on this scale for the fourth largest eurozone economy would be challenging enough if it were in the whole of its health: it is simply impossible for an economy caught between the rock of a continued severe contraction in growth and, on the other hand, the hard place of uniquely high unemployment rates.
So, Spain is following the trajectory marked out by Ireland. The eurozone authorities simply do not get it: that adjustment on the scale we are confronting requires growth in order to develop an economy to the state where it can realistically begin to deleverage.
Instead we are seeing overly optimistic forecasts and attempts to resolve uniquely challenging macroeconomic imbalances within an impossibly short timeframe.
In terms of the conditions that may be imposed on Spain, two things need to be said. The first is that Spain has undertaken significant measures to reduce its structural deficit. But its targets are slipping. With all of the heavy lifting done so far — and in a politically difficult environment — the deficit has now risen to 9% of GDP. The target is to reach 3% by 2014. Not going to happen. The markets know this.
A second issue is the impact of what is happening in the economy at ground zero — that is the lives of people and the difficulties of businesses on the banking sector itself. Spain is well into a major reform package: nConsolidating the capital savings banks (which are a large part of the problem);
* Raising core capital requirements; nRequiring banks to recognise bad loans and to make adequate provisions. But this itself raises a major problem. It is extremely difficult to meet much more stringent prudential requirements, and regulatory standards, while at the same time continuing to function effectively. In fact, with much lower interest margins, difficulties in accessing deposits and a collapse in the demand for low-risk credit, the banking crisis is feeding upon itself.
All of the efforts to date simply haven’t been enough. The banks now need external help in the order of €80bn-€100bn — compared with previous estimates of up to €30bn.
That is a measure of the magnitude of the problem and helps to explain the downgrading of Spanish bonds to just three notches above junk status. It’s very hard for an economy with such strong fundamentals and which has undertaken such significant efforts to date to seek to navigate its way through this. But the banking problems are only the start. Spain’s fiscal position is strained even though, like Ireland, it entered the crisis with relatively low debt-GDP ratio.
An economy going further into recession, and embedded within a eurozone that is chronically indecisive and dysfunctional, has spookedanalysts and the markets. It is almost inevitable it will need external assistance. And this is the problem. At a recent bond auction, the yield on Spanish 10-year bonds was over 6%. This can only rise and, according to some analysts, by up to 10%. The economy, under the present eurozone orthodox, is simply not strong enough to be able to pay these kinds of yields.
The real risk is this. The IMF pointed out last year that Spain’s large negative international investment position creates potentially serious vulnerabilities. That was a year ago. The strains now evident within the economy cannot be confined within national borders.
What we are looking at is a significant systemic event pulsing across the eurozone and into global markets. The biggest impact will be felt by German and also French banks who have the largest exposure to Spain.
The real question is why Spain — and Ireland — should be put through so much in terms of managing an already difficult adjustment process because German and French banks didn’t do their homework. And the question has to be asked whether it is moral or even fair for the burden of adjustment to fall so hard on the shoulders of Spain (and Ireland for that matter) in order to save the skins — certainly the balance sheets of German and French banks. Spain at least is negotiating hard to steer clear of the kind of conditionality imposed on Ireland and in which we have acquiesced. Sometimes it is more important to stand up for what is right than to be “nice” and just hope that the guys who are giving you a hard time “see the light”. They usually don’t.
Spain is just the first of the core countries to crack. It is unlikely to be the last. Policy responses from the eurozone authorities remain wholly unconvincing. Every summit — and there have been a lot — is a crisis summit. Still, the crisis continues to widen. The credit rating of France was downgraded at the start of the year. Now, so too has Spain’s. Equally, it is difficult to see in bond yields anything other than a safe haven effect.
At the heart of the crisis, the ECB has subverted its own constitution by flooding the banking system with cheap credit — so that banks can buy up their own countries’ debt. That’s not how it’s supposed to happen.
Equally, the role of the ESM — to whom Spain looked for help — is to assist countries not their banks. Even the financing system which is intended to underpin the ESM is highly problematic. Spain wants to access it directly. The ECB, and Germany, say that’s not what it’s there for. In the middle of it all Chancellor Merkel is now pushing full political union.
The institutions aren’t in place. Nor is there a democratic mandate. There is no conviction about political union — it is simply the last card in the deck. This does great disservice to what the European vision is about. In fact the disfunctionality within the eurozone is threatening all that Europe is and it has achieved since 1950. What looks like the end game in Spain may well prove the start of an unravelling within the eurozone’s core.
* Professor Ray Kinsella is on the Faculty of the UCD Michael Smurfit Business School.
