A 70 percent surge in oil prices over the past year - the price of crude oil touched $100 a barrel for the first time in New York yesterday - together with a global surge in food prices is driving up inflation across Europe even as the euro's gains against the dollar make imports cheaper. The "strong, short- term'' increase in inflation is a source of concern to the European Central Bank, the Bank of Spain said yesterday. It certainly is, since
Adverse weather conditions in food-producing countries and increasing demand from rapidly growing emerging economies, where food consumption composes a significant proportion of household expeniditure, are also pushing up food prices, increasing the inflationary pressure. Droughts in Australia, Canada and Ukraine pushed the price of wheat to a record in December while soybeans touched a 34-year high.
Inflation across the euro region accelerated to 3.1 percent in November, the fastest pace since the currency was introduced. Meanwhile consumer confidence is plummeting, touching historic lows for three months in succession in December according to the index compiled by the Instituto de Credito Oficial.
The cost of borrowing - as measured by the British Banking Association's three-month Libor rates has been falling during the last couple of weeks as central bank measures to relieve a year-end logjam in money markets continue to show signs of success, but they are still way above where most people would like to see them.
The three-month euro interbank offered rate, or Euribor, dropped almost 2 base points to 4.67 percent, the European Banking Federation said today. It was 4.93 percent Dec. 17, the day before the European Central Bank injected a record $500 billion into the banking system.
Short-term borrowing costs have fallen since policy makers in the U.S., U.K., Switzerland, Canada and the euro region announced plans Dec. 12 to counter a credit shortage threatening to undermine global economic growth. Up to the present time ubprime-mortgage defaults in the U.S. have forced the world's financial institutions to write down about $100 billion in fixed-income securities.
But these measures have yet to achieve their underlying objective of pushing borrowing costs back down to the levels of July, before the collapse of the U.S. subprime-mortgage market caused banks to stop lending to all but the safest borrowers. The three-month euro rate is still 66 base points above the ECB's key financing rate of 4 percent, and this is up considerably on the average difference of 25 base points during the first half of 2007. The comparable dollar rate is 43 basis points more than the Federal Reserve's benchmark rate, up from 11 basis points in the first half.
Basically Libor rates for one-to-three month funding in dollars, euros and sterling are global bellwethers for interbank lending.
Three-month euro Libor was fixed down again yesterday at 4.661313 percent having fallen at eleven out of the last 12 fixings and marking a second consecutive week of declines. Although still well above the 4 percent ECB base rate, this was the lowest fixing for three-month euros since November 22. So what we can say is that while the massive easing operations have reduced the spread, the underlying difficulty is still there, and this is very important in a country like Spain, where an estimated 80% of mortgage holders have variable rate packages which are normally related in some form or other to the Euribor rate.
So really what we should note here is that Spain is facing a very strong tightening on nearly all fronts - interest rates, inflation, credit conditions, and, last but by no means least, exchange rates. The euro simply rose and rose against the dollar throughout 2007 in a way which, I must admit, certainly surprised me.
So what we are faced with is a Spanish economy which is entering its most important "correction" in many years - certainly since 1992, but quite possibly the most important one in its entire history, with all the policy indicators set on tightening. This, it seems to me, is very serious indeed.
As I have pointed out on numerous occassions in the past, this is the downside for Spain on euro membership, since it means that Spain will not have anything like the policy mix that is appropriate to its current needs (the upside was, of course, the property boom, which was in part produced by having negative real interest rates - ie interest rates which were below the actual inflation level in Spain - over a considerable number of years.
The underlying situation in Spain is also highlighted by the shifting pattern of employment and unemployment, and a comparison between 2006 and 2007 is pretty revealing. If we look at the chart below we can see that in the early months of this year the employment situation was generally up over 2006. Then the situation turned (around July), and since then it is "down hill all the way" unfortunately, with unemplyment rising (as it might well do for seasonal reasons anyway, but in every case the increase is significantly more pronounced than in 2006. Spain's ever productive labour market has, unfortunately, now turned.
Also if we look at retail sales we get the same picture. Retail sales across the entire 13-nation euro region fell in November according to the most recent eurostat data, dropping by 0.7 per cent from October to a level which is just 0.2 per cent higher than the Novemeber 2006 one. Of course this average hides considerable variance, with the weakest performances coming from Germany, Italy and Belgium.
But of particulr of note is the performance of retail sales in Spain (the zones 4th largest economy) since strong growth in Spain has previously offset weaknesses in Germany and Italy at previous critical junctures. But this time it will be different, since Spanish retail sales have fell in both October and November 2007, and while the year on year readings are still in positive territory, they will not remain there for long since the earlier strong readings will eventually drop out of the data.
Also manufaturing industry in Spain may well now be contracting. Euro zone purchasing managers surveys for the manufacturing sector confirm the economy is likely to have slowed down in the fourth quarter despite pockets of resistance in some countries. The Royal Bank of Scotland purchasing managers index for the euro zone manufacturing sector eased to a final 52.6 in December from 52.8 in November, a figure was revised up slightly from the provisional reading of 52.5 issued in mid December. The Spanish manufacturing PMI fell to 49.5 from 50.7, dropping below the critical 50 dividing line between expansion and contraction. Since it was also below 50 in October this means that in 2 out of the 3 months in Q4 2007 Spanish industrial output may have been contracting. When we add this to the decline in retail sales and construction, and take into account that with a large trade deficit foreign trade is a drag not a plus for Spanish GDP, it is hard to see where the growth is going to come from in the last quarter, except of course from an expansion in civil engineering projects financed by the government. With elections looming in March, my guess is that they are deficit spending as much as they can at the moment.
The Spanish services sector purchasing managers index (PMI) stood at 51.0 in December, up from 50.7 in November, according to market research group NTC. "Commercial activity continued expanding... even though recent calculations suggest that the growth will not be maintained in 2008," Nathan Carroll at NTC Economics commented. In particular new orders fell for the second month in a row, coupled with moderate additional declines in pending orders, all of which point to a continued slowdown in activity. Basically services - which constitute the lions share of the Sanish economy - continued to expand in December, but - as can be seen from the chart below - at a much slower rate than earlier in the year. Looking at the chart it is not difficult to imagine that we will enter negative growth in services in Q1 2008, and I imagine that at that point the Spanish economy will enter recession.
7 comments:
Congrats for your excellent blog. Only one question: most spanish mortgages (>90%?) are variable, and referenced to 1 year Euribor, so the 3-month euribor/libor
"crunch" is inmaterial for setting interests rates. (1 year Euribor has barely moved through the "troubles").
This said, personal finances are NOW suffering the effects of last year increases in interest rates (because mortgages adjust with a lag) and spanish bancs and cajas are clearly reigning in their lending spree.
Hello Eddy, and thanks for the comment. In particular, the point about Euribor and variable rates. I hadn't picked up the one-year part of the story, I suppose because I hadn't been paying attention sufficiently. Basically this problem has been so obvious, and yet has been so long in coming that I was largely bored by it all. Predictable things don't really interest me too much.
So the squeeze on the inter-bank rates won't hit the mortgage holder directly, but it will hit somewhere, since the banks themselves are paying this to finance their day to day operations. I don't have any real data on the banking sector in Spain, this would seem to be the key area in the whole Spanish story. Most authorities (eg the Bank of Spain) are busy denying there are any issues, but I don't really see how there can't be.
Essentially it would be interesting to know the proportion of mortgage lending in the 2004 - 2007 period which was taking place on the basis of "own bank deposits", and how much of the financing was being outsourced by the banks. This measure would give you a vulnerability indicator for the Spanish banking sector. Basically, taking your point about euribor - this basically insulates the borrowers, and passes all the additional costs on to the banks, since they need to keep rolling-over borrowing on a three month basis (or to some significant extent they do). So their margins and liquidity must be being squeezed at this point. We will see how long they are able to accept the pain before someone says "ouch".
My guess is that Spain must have one of the highest quotas of home grown sub-prime problems (ie not derivatives from the US situation) on the globe. I would say these issues will come in 2 areas: a) second-home owners from outside Spain who have been very extensive in areas like Almeria and Valencia. Basically if prices tank and their debt exceeds there asset then they can just walk away from underneath, leaving the keys with the bank as they go. Secondly immigrants. As it happens I don't consider myself an expert on the Spanish economy - I know a lot more about Italy, Japan, Germany and Hungary (for eg) - but I have lived here for 15 years now, and I do talk to a lot of people, and I do listen a lot.
Now here in Barcelona we have whole "barrios" - like Santa Coloma de Grammanet - where the locals basically sold their homes in what were traditionally poor areas and moved to larger and relatively cheaper properties in housing estates outside Barcelona (Olesa de Montserrat, for example, seems to have been popular in the case of Santa Coloma, Spanish consumer behaviour is very much of this nature, with people tending to look at what others are doing and folloing trends). So basically Santa Coloma now has a significant immigrant population - with large groups from China and Romania. Now immigrants tend to be badly paid, but they do work long hours, and they do save, and banks were accepting four or five "nominas" (paychecks) as backing for a single mortgage, so a lot of migrants have bought-in.
Young Spanish people represent less of a risk to the banks, since - as Caruana cynically noted when he was governor of the BoS - through the DNI and paycheck link up to the banking system it is very hard for them to just walk away. The only thing they could really do is emigrate, and again as Caruana noted there is very little tradition of this in Spain due to family ties etc. So they will be faced with significant distress.
Essentially I think the whole property sector is seized up, and for many years to come, due to the change in the "lending conditions" more than any interest rate effect. What do I mean by this? Well banks were lending over 50 years, interest-only for the first 3, and with 100% (or even 110%) of valuation mortgages. These days are now over, and permanently. Banks now won't shift above 80%, so this means that young people need to find a minimum of 20% of the asking price, plus notary fees and furniture. So if we take a bottom level flat at say 300,000 euros, they need to find 60,000 plus expenses. Maybe 100,000 in total. And they have very little savings, since in the past they weren't necessary.
Worse, mummy and daddy don't have savings either, since the low interest rates encouraged them to take the money out of deposit accounts and sink it in second homes. So for the children to buy the parents now need to sell one of their properties, and this is one of the first points were we can see downward pressure on prices. Also the children will need to start to save that 60,000 plus, so immediate consumption will also be affected.
A second area which is going to seize up the works is the behavioural shift which is taking place from buying first and selling second, to selling first and then buying. Most people who bought new properties in recent years in order to move "up market" from an old one bought on the basis of architect's plans (which is why construction is still ticking over, since all the property that was bought up to August still has to be built), and only selling their current home at the last minute. This made sense while prices were rising, but now they are falling.....
I think it is important to realise just how much in the avant-guard the Spanish banking sector were in introducing the so-called "financial efficiencies" which made the boom possible. Now some of these efficiencies are real and permanent (like some of the benefits of financial globalisation, you can borrow cheap in yen, eg), but some - like raising the % of the loan, lending to risky individuals, lending on the basis of issuing paper rather than deposits - were most definitely not efficiencies, but "irrational exuberance". As I say, the Spanish banks - especially BBV, Santander Hispano, Sabadell Atlantico - seem to have been in the forefront of all this. My feeling is that the caixes have been rather more conservative (at least here in Catalonia) but that may vary from region to region (and remember many regional cajas are involved with local political institutions who may now be seeing property boom related income drying up, and hence some of the institutional indebtedness may now become unsustainable. I would also be thinking about corporate balance sheets, if the value of the urban office "park" starts to fall, some of the major companies may be widly over-leveraged in this context, think of all the euphoria at the time of E-On/Endesa).
One measure of the issues raised by financial globalisation can be obtained by looking at the contributions to a recent Bank for International settlements conference on the topic (2006) Basically the whole conference is interesting, but in particular the Panel on "Review of recent trends and issues in financial sector globalisation" session and in especially the presentations from Christine Cumming (Federal Reserve Bank of New York), José Luis de Mora (Banco Santander Central Hispano) and David Llewellyn (Loughborough University) are of interest. De Mora is fascinating, since he gives us an indication of just how the Spanish banks were taking their new "methodology" to the UK (think Northern Rock).
Basically I am interested in demographic processes and construction booms. That is why I have been following Germany, Japan and Italy, since these are the oldest societies to date. My feeling is the nearest comparison we have to what just happened in Spain is Japan 1992. The most worrying aspect is this sharp spike in inflation. With demand falling all over this can't be sustained, so Spain does have, IMHO and especially given the lack of a sensitive interest rate policy from the ECB, a real risk of falling into deflation in the mid term, which I never would have imagined possible only a year ago, but you need to look at the above trend growth in prices we have seen over the last six or seven years, and think how an economy can correct for these in a common currency zone, and with global factors (the fall in the dollar, the disintegration of Bretton Woods II) maintaining the euro at possibly very high levels.
Demographic factors are important here. Basically the 25 to 50 age group just peaked in Spain, as it did in Germany in 1995. This means that natural demand for housing, and home loans, is likely to trend down from here on in. The only unknown is immigration. Spain just sent its estimates for 2007 migration in to Eurostat (and they must have a pretty good idea from the Padron Municipal) and we have yet again had a record year it seems, with the estimate pushing the 700,000 mark. But the big question is what is going to happen to all these people during the downturn.
In conclusion I would say I have three large questions in my head:
1/ What happens to the immigrants and inward migration?
2/ What level of distress will we see in the banking sector going forward?
3/ What will happen to all these young people who are mortgaged up to their eyeballs on property whose value may now enter a protracted period of secular decline. Will there be political pressure in Spain - as in the US - for the situation to be eased (possibly by adjusting downwards the book value of the debt). If any such political measure is taken, who will pay the bill? Basically Spain's "broken plates" will need to be paid for by some apportionment between the young people themselves, the banks, and the taxpayer, but the big question is in what proportions?
As you can see, I don't anticipate that this is going to be a short term affair. This all started on 9 August, we are now in January, and things have hardly started.If we go back to Spain's last real recession - after 1992 - then property prices needed till 1995 at least to recover their earlier values. This time I think the situation is much, much more serious. Japan really still isn't out of the problem that started in 1992 even now. So I would say a conservative estimate on this one is a five to ten year window of problems, and that is imagining we get a "soft" landing, which may well not be the case.
So basically, while I don't have time to comment on Spain's issues on a day by day basis, I will try a more or less monthly report as new data comes in.
"Only one question: most spanish mortgages (>90%?)"
I'm afraid I don't have exact data on this, but institutions like the BIS quote 75%-80%, which is probably a conservative estimate, but I am quite happy to be conservative here, since this is still massive.
Incidentally, there is this in the FT this morning:
Sweeping powers to intervene in failing banks are to be given to the Financial Services Authority as part of a regulatory shake-up by Alistair Darling, chancellor of the Exchequer, to avoid a repeat of the Northern Rock crisis.The new measures – which echo those in place in the US – would allow the FSA to seize and protect depositors’ cash when a bank gets into serious difficulty, heading off the risk of a run on the bank. Mervyn King, governor of the Bank of England, believes a special insolvency regime for banks is vital because it would mean that a badly run bank could be allowed to fail without fear of a systemic crisis caused by a loss of public confidence.
The question is, how far are we away from seeing something like this in Spain. My guess is that everyone is trying to avoid this till after the March election, but will the elastoplast hold? There is such a tradition of secrecy in Spain, when just what you need to restore confidence is complete transparency. Of course, maybe the problems are now so bad that this last possibility is excluded till it can't be put off any longer.
Also this one from S Korea this morning. This is the kind of "bail-out" I am suggesting is going to be necessary in Spain. The only real question is who is going to pay, and how is the "distress burden" going to be distributed. Remember, Spain's fiscal situation is not bad at this moment, but they are just about to enter the rapid ageing stage as far as the domestic population is concerned, so fical pressure is going to mount and mount. That is why maintaining the large part of the migrants who are currently in Spain is going to be important.
South Korea’s incoming government is planning a huge bail-out covering 7.2m consumer debtors behind on loan repayments or with poor credit ratings in an effort to spur consumption and prevent a repeat of a 2004 consumer credit crisis.
President-elect Lee Myung-bak, an ex-Hyundai executive, promised help for consumer debtors during the campaign leading up to last month’s presidential election. Economists have warned that South Korean households and small companies are facing a growing risk of default amid rising interest rates and a credit squeeze at the country’s banks.
But South Korea’s top financial regulator, the Financial Supervisory Commission, took things a step forward on Thursday when it outlined a bail-out plan to Mr Lee’s transition team. Under the plan, credit delinquents with a small amount of debt will have their interest payments reduced and repayment deadlines extended. Their credit records will also be cleared.
“Basically I am interested in demographic processes and construction booms.”
Congrats. You are in the right place at the right time.
1/ What happens to the immigrants and inward migration?
Many immigrants will lose their jobs (construction, services etc). This is already happening. Many will return home or will seek greener pastures in Europe.
See for example http://www.tt.mtas.es/periodico/laboral/200801/diciembre%2007.pdf
Page 22-Foreign unemployed total increased by 24,5% y/y
Foreign unemployed in construction increased by 53.5% y/y
2/ What level of distress will we see in the banking sector going forward?
Although data is disperse, my hunch is that the problems for the financial sector will come short term from the immigrants (where a lot of shoddy financing has been going on, without adequate income history) AND the R.E. firms, who are clearly overexposed.
But the main threat for the banking sector short term IMO, is not an increase in delinquencies but the inability to roll over their debts in the European Inter bank Market or to sell their mortgages (cédulas) abroad at all, or at least, to do it in profitable terms.
Margins for the Spanish banks in their mortgages are razor thin. A typical mortgage with Euribor 1Year +0,50% is paying now around 5,25%.
(There is a market failure here, cause they are using short term rates to finance long term credits, with a very low margin, anyway, great for borrowers)
A flattening of the curve is causing clearly pain for the banks (and they have convinced a lot of clients to sell their “fondos de inversion” and transfer the money to deposits as a short term remedy)
http://www.expansion.com/edicion/exp/mercados/es/desarrollo/1073740.html
In the same manner as the crash in US mortgage providers
http://ml-implode.com/ , Spanish banks could very well be soon unable to sell the mortgages they originate, or roll over the existing debts.
A la Northern Rock, but much, much bigger.
This would be a text book “sudden stop” in external financing …and with a 10% c.a. deficit this year, something to worry A LOT.
3/ What will happen to all these young people who are mortgaged up to their eyeballs on property whose value may now enter a protracted period of secular decline.
For me the main problem now is not “negative equity” , but the effects in general activity of a housing recession. Of course a lot of people will become house-slaves (unable to sell or to move away).
But barring any financial accident, the could cope with their debts if Mr Trichet doesn’t increase rates.
The problems will come later, with a general recession (given the oversize weight of housing in Spain’s economy), unemployment etc. Of course a general recession would decimate public finances
4) Variable/Fixed Mtgages
Well, I don’t have the total numbers, but my hunch is that 90+% of the mortgages originated in the last 10 years are variably type.
Take the numbers for last month, for example, here http://www.ine.es/daco/daco42/daco426/h1007c.pdf
( October 2007)-97,6 % of mortgages where variable (incidentally, notice the fall in total volume for residential –7.32% y/y and –5,67% m/m)
Hello again Eddie,
First off, thanks for your most interesting and useful comment. I mean I think we are both in the same ballpark here.
My speciality is really macroeconomics, so I may be looking at this in a slightly different way from those who are largely focused on the financial sector direct.
The thing is - as you obviously recognise - Spain is simply a local part of what is now a big global problem - housing starts have been down between 30 to 40 percent every month since August, check the Japan blog out if you are interested. But Spain is one of the focal points due to the intensity of the boom, and the number of migrants which were sucked in. Proprtionately all of this is world champion of something dimensions (the only other one who comes close is Ireland, and then of course the UK, with all the Poles) but the UK doesn't have the same scale of distortion, since Mervyn King did have some control over monetary policy, so he was trying to apply the brake, were no brake was applied in the Spanish case until it was already much too late.
So we are in for big things in Spain, if you have the stomach for them.
Now you say:
"Many immigrants will lose their jobs (construction, services etc). This is already happening. Many will return home or will seek greener pastures in Europe."
Yes. I agree. But the details will matter here. Remember the atmosphere is likely to be recessionary in many eurozone economies in 2008 (not as bad as Spain, but still) and the immigrants who come from Lat Am don't normally come from the countries (Argentina, Chile, Brazil) who may survive the coming storm best.
Eastern Europe is another cup of tea altogether, since Romania and Bulgaria have similar problems looming to Spain, basically their economies are overheatinmg fast due to shortage of labour, since much of it is in Spain and Italy, yet people are sending money home to finance deposits and morgages to build houses. Take a look at my arguments on the Romania blog. So asll of this is linked in in some way which is yet to be precisely determined. But if the geyser does blow in Romania and Bulgaria too - and it looks like it probably will IMHO - then this will be a double whammy for some Spanish financial interests, since some people clearly took money out of Spain to put it in Eastern Europe. This was part of the tale at this years Barcelona Meeting Point construction fair.
So we need to get some sort of measure of how many migrants exit Spain and how many stay before we can really assess the long term structural damage here. Remember, fertility has been around 1.3 for years, so there aren't that many native born coming up behind to buy up excess houses with the passsage of the years. Spain needs those migrants, and more of them.
"But the main threat for the banking sector short term IMO, is not an increase in delinquencies but the inability to roll over their debts in the European Inter bank Market or to sell their mortgages (cédulas) abroad at all, or at least, to do it in profitable terms."
Yes! I think you have hit the nail on the head here.
"Margins for the Spanish banks in their mortgages are razor thin. A typical mortgage with Euribor 1Year +0,50% is paying now around 5,25%."
Exactly. My feeling is that the most ridiculous part in all of this is that they used the mortgages business as an excuse to sell secondary financial products like life insurance, funeral arrangements, pension plans etc etc etc. So, from a banking point of view, all that cement was moved around just to pick up crumbs, even if they did seem to be very tasty crumbs at the time. The thing is there was no perceived risk.
But as we are finding out now, there is risk, and a lot of it. Basically everyone has been playing moral haxard - there's safety in numbers - and now we are about to find out that central bankers and commissioners don't control and manipulate everything - far from it.
I had long felt that the big difference between the way the low interest environment which the eurosystem made available was working out between Spain and Italy was that in Italy it was the government which was getting hopelessly in debt, while in Spain it was the private individual and the banking system, but before August 9th I couldn't see how the Spanish think could unwind. Now it is blindingly obvious.
(I think Italy's public debt issue will gradually unwind as the gentlemen over at Standard and Poor's and Moody's steadily turn the screw).
"Spanish banks could very well be soon unable to sell the mortgages they originate, or roll over the existing debts."
Both probably.
"The problems will come later, with a general recession (given the oversize weight of housing in Spain’s economy), unemployment etc. Of course a general recession would decimate public finances"
Yes, but if you look at the data I am presenting, we may be heading for recession quite - indeed alarmingly - quickly. Retail sales are going down month by month, construction is weakening steadily, industrial output started to contract this month (going by the PMI) and services are now barely growing. Given that foreign trade is a drag rather than a boon, my guess is that we will be in negative growth in th 1st quarter of 2008, and that we will stay there for some time.
Basically I am also going to put up some more charts on Spanish GDP since the early 1990s. There hasn't been a recession since 1993. Basically cheap interest from the ECB put it off and off. I mean they haven't had one quarter of negative growth since then. So now we shoudl expect downside underperformance to follow all the upside overperformance. That is what my macro instincts tell me.
"Of course a general recession would decimate public finances"
Exactly. Theyb have the juice in the tank for a short term boost, and then they start to get near the 3% deficit level. If you looka t Japan again, you will find that the government attempt to consume cement on civil engineering projects was what lead the national debt to ballon up towards the 150% of GDP or so level it is at now. But Spains health and pensions crunch is coming from the native population, so the EU Commission won't allow them to go very far down this road.
"( October 2007)-97,6 % of mortgages where variable (incidentally, notice the fall in total volume for residential –7.32% y/y and –5,67% m/m)"
OK, thanks for this. As I say, apart from putting a few more charts and some of these arguments up - and a running widget so we can see where we are - I will only be doing brief posts with bits and pieces of data as we get them. But I will do a monthly report, so please stay around and keep throwing in your point of view.
Edward
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