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Tuesday, April 11, 2006

This Is One To Keep An Eye On

2003 was a good year for the Spanish banks, with interest rates at historic lows, lending boomed. News has it today that net profits at Santander Central Hispano, Spain's largest bank, rose 29.6 per cent in the fourth quarter to ?681m ($857m) mainly on strong mortgage lending in Spain and growth in its consumer finance business in Germany and Portugal. Net profits totalled ?2.61bn for the full year, a 16 per cent increase over 2002 and the best year on record, while credit inside Spain was up 16.2 per cent as the housing boom continued on its relentless path hence generating strong demand for mortgages.

So good luck to the bank, and that's it. Well again, not exactly. Why is there a boom in consumer credit and mortgage lending right now in Spain? That really should be the question.

Well the prime suspect here has to be the rate of interest. Spain as a member of the eurozone has been having the luxury of enjoying a rate of interest lower than the rate of inflation for some years now. In this situation the real rate of interest (that obtained by subtrating the inflation rate from the actual interest rate) is clearly negative. The consequence of this is that no-one wants to leave money lying idly around in the bank, and since opportunities for profitable investment have reduced substantially (here in Catalonia we are currently living through a wave of factory closures as industry - unable to work in the new high cost Spain - moves out). Incidentally whilst people are talking extensively of the way the job creation machine is moving down the value chain in the US, little comment is being passed on this in the European context: yet a staggering 91% of all new contracts in Spain last year were temporary ones. And the people entering employment are now earning significantly less than those they replace, as companies in all sectors struggle hard to maintain profitablility.

Now normally running an economy in this way would be regarded as extremely bad practice, but in the context of the euro 'experiment', what was once deemed to be undesireable may now be seen as a virtue. However does it occur to no-one that the impact of a systematically lower than optimum interest rate (and a correspondingly artificially over-valued currency) might not have been having serious detrimental effects on economies like Spains?

Let's put it this way: you need to divide the Eurozone countries into two camps, those who - broadly speaking - need a higher, and those who need a lower, rate of interest. (In fact virtually none of the economies needs the rate you actually have).

Now the latter group have certainly experienced a loss in GDP in relation to what might have been achieved with an appropriate rate of interest, and Germany is obviously the principle casualty here. They could have run more efficiently, although they have perhaps been able to sell more to the former group, so this offsets the loss somewhat.

The second group, which of course includes Greece, Spain and Portugal appear at first sight to have gained GDP, since they have run a lot hotter than would otherwise have been possible. It is here the biggest problem lies in my opinion. Because this short term growth has only been obtained at the price of longer term problems, being achieved as it is by borrowing more than would otherwise have been advisable.

The consequences of this folly are sometimes extraordinarily clear. Again speaking of Spain, which is the country I know best, we have the most horrendous housing boom. Property prices have risen at around 20% per annum during the last three years. 40% of all residential property built in the eurozone was built in Spain last year. Now put bluntly with an ageing and mid-term declining population, Spain simply doesn't need all those homes. But since they are assumed to be rising in value for ever, and since the interest rate makes them seem so attractive, the typical middle class investor has gone on a shopping spree, just like when they open the doors on 1 January. Here in Barcelona I don't know anyone in this category who has not bought at least one extra property, and normally it's two, three or more.

Has nobody else seen this? Well the IMF, the Commission and the Bank of Spain have been repeatedly warning, but of course, what can anybody do. It is a by-product of the euro. Interestingly enough, the UK which has had its own housing bubble in recent years considered this disadvantage decisive in the recent 'tests' exercise.

So what will happen when this finally bursts? I dread to think. Certainly we will leave a generation of young Spanish people horribly indebted - and even more so if the global environment turns deflationary. In addition two large questions also loom in the background. Most industrial enterprises have seen themselves inexorably converted into what are effectively property companies as the balance sheet impacts of the upward spiral have made themselves felt. So what will be the consequence of the deindustrialisation process here in Spain's industrial heartland, in Catalonia.

Secondly, just around the corner lies another headache. The centres of Spain's big cities have been converted into zones packed with high value office premisses, where again the projected rise in the property value may, paradoxically, have been an incentive for the location decision, and even a prime motive force in the final decision to set up the business in the first place. However out there in front lies another big social transformation: home working. Most vulnerable to this is every kind of office work as employers look for ways to reduce costs as an alternative to outsourcing in India or Argentina. And the 24 billion dollar question is: what happens to city centre property prices when the offices are no longer required as offices?