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Friday, October 02, 2009

Spain's Current Account Deficit Folds In On Itself

Spain's current account deficit fell to 2.064 billion euros in July from 7.752 billion euros a year earlier as imports tumbled, according to the latest Bank of Spain data. This is a very sharp and dramatic fall, and my guess is that at this rate the gap will close in six months or so, which will be a very strong correction, and potentially very painful for Spanish living standards.

In fact the Spanish current account deficit ballooned in the "good years" - from around 3% of GDP at the turn of the century, to around 10% in 2008 on the back of large external borrowing to acquire housing units and land, and the inevitable imports which were sucked in to fuel the consumption boom.

The main reason for the fall was the reduction in the trade deficit, as imports plummeted an annual 29.5 percent amid weak domestic demand, while exports fell a lesser 15.8 percent. As Dominic Bryant, Chief European Economist at PNB Paribas puts it - "The 4.2% fall in GDP tells only half the story. Final domestic demand has dropped by about 7.5% – the only reason GDP held up was because the collapse in domestic demand led to a 22.3% fall in imports" (Quarterly data from Q2) . That is, the drop in living standrads is actually much sharper than headline GDP numbers actually show. And this is with a government running a fiscal deficit of 10% of GDP plus this year. Heaven knows what the fall would have been without this.

The figure compared with a 4.2 billion euro current account deficit as recently as May.

Also included in this series is one of the key charts of the present spanish crisis, gross external debt - now at roughly 158% of GDP, and of course rising as GDP falls.

But the really important data point is net external debt which is currently around 83% of GDP, and again rising.

The net debt chart illustrates quite clearly why the ability to issue debt denominated in your own currency is one of the most treasured possesions of any sovereign state. Basically Spain's debt is in euros, and since the Spanish treasury and central bank have no capacity to create euros, or to devalue the currency, the only way to correct Spain's distortions is via and long slow and hard process of ideflation (also known by the more politically correct title of internal devaluation, which doesn't make it any easier or less painful as we can see now in Latvia).

But this is just the problem, since with deflation the external debt to GDP ratio will rise - that is Spain will become MORE indebted, and this is just one of the unfortunate consequences of having gotten to where Spain has now arrived.

I estimate this internal devaluation can be in the order of 20% (see Real Effective Exchange Rate chart and the comparison with Germany).

Basically, as the trade deficit has persisted and the current account deficit has grown so the financing to square the account, which was basically the funds needed to fuel the mortgages, also grew. Of course, now that Spanish people are saving rather than borrowing, there is no accounting item to offset the negative CA balance, the external position becomes unsustainable, and the whole Spanish economy folds in on itself, valiantly as the government may try to keep the bicycle moving by borrowing and borrowing.

Also of note here is the way the deficit on the income account has simply grown. This is the outflow of interest on all the borrowing, and now runs at nearly 3 billion euros a month, although it has been falling slightly as interest rates have come down. This item is the first thing that will need covering once Spain has a trade surplus. And of course the cost of servicing the debt will go up, as interest rates rise, which is one of the reasons that the greatest threat to the Spanish economy comes at the moment from a recovery elsewhere which leads to a sharp rise in interest rates. Remember also that over 85% of Spanish mortgages are variable, so the cost of servicing these will rise, even as salaries and the capital values of the homes which go with them fall.

What a total, complete, utter and absolute mess!

Chief IMF Economist Oliver Blanchard said yesterday that the Fund now expect Spain to return to growth in 2011. I'd like to know where he thinks the growth is going to come from, quite frankly I really would. I don't see any sustainable return to growth till Spain's export industries become competitive again. In the best of cases we will simply sink to the bottom, and stay there in an "L" shaped recovery, while the banks steadily blow up one after another under the weight of the mounting pile of non performing loans.

And of course, we may not get the best of cases, since the worst thing about a financial crisis, is that when a country enters one the cost of servicing the debt (interest payments) also rises, as credit downgrades come, and investors demand more risk premium. This is what normally sends a country spiralling out of control once a critical threshold has been triggered. Spain, of course, can't be that far from this threshold at this point, which is why it would be better that those in Brussels and Frankfurt who can see this should be doing something now to grab Spain's administration firmly by the scruff of the neck in order to move things in another direction before the inevitable happens. Or does the ECB plan to keep vitual quantitative easing - Japan style - running as far ahead as the eye can see?


pacomer said...

The most realiable index I would take to foresee the very next future for the doomed spanish economy, it would come from Andrew Hugh himself:

Andrew, have you given for granted that you will have to leave Spain?

Anonymous said...

Hello Edward, I think a drop in living standards is responsible for the decreasing trade deficit, not the other way round, though I expect that is what you meant. We currenty have a strong Euro which makes imports cheaper, I suspect that will change and lead to a further decrease in imports, though it is unlikely to increase exports much..Spain's economy not being industry based, housing investment to continue downwards etc. , and it will not decrease the cost of visits for Eurozone tourists. How does Spains net and gross external debt compare with other EU states ? The ECB is raking 1% and Spanish banks a further 2% in public lending, citizens will pick up that tab through tax and vat increases etc. .. to refinance the banks.


Edward Hugh said...

Hello Pacomer,

No. I have no intention of leaving. This is now my home and my life, and I will fight to try and help protect what I have.

I don't think crew members will ever desert a ship in difficulty, especially those of us down in the engine room. It is not part of our professional code.

My home is Catalonia, rather than simply Spain, although I am not trying to make any special issue out of this. But, as I say in the sidebar, I am Catalan now, and when your country is in danger you work to try and save it. At least that is how I see things.

If the rest of my new fellow countrymen see things like I do we will see this one off, it will be hard, and with a lot of sacrifices, but together we can do it.

btw, it is Edward, not Andrew :)

Edward Hugh said...

"Hello Edward, I think a drop in living standards is responsible for the decreasing trade deficit, not the other way round, though I expect that is what you meant."

No, I meant it that way round. This is what I have been observing all over Eastern Europe - that when the money is not there to finance the deficit, then imports collapse and this is what leads to the fall in living standards. This is what the credit crunch is all about.

The last holdout was government borrowing, and as that is now forcefully being wound down from Brussels, so there is no correlative balance sheet item to correspond with the imports, so there is no way to pay for them. And down to the bottom we go.

This is not an easy point to see, but I think it is an important one, since this is the core of the whole mechanism.

With government, households and corporates all now deleveraging, who would be doing the borrowing to finance the deficit. You can only import either by:

a) exporting to pay for them (the best solution); or
b) By borrowing for some other purpose, and then paying with the incoming funds (what Spain was doing, and how we got into this mess).

"How does Spains net and gross external debt compare with other EU states ?"

Spain has the second highest absolute gross external debt in the world after the United States, and one of the highest per capita, along with Ireland. Other EU states with high esternal debt to GDP would be Greece, and Eastern Europe countries like Latvia and Hungary. Basically, the way you run up external debt is by having a CA deficit, so it is the large deficit people who have the debt.

Anonymous said...


Thanks. Though I have seen the deficit that way in terms of future reduction of wealth (i.e. repayment costs) , I was also thinking failure in the home economy would have led to that deficit. This is obviously mostly not the case (unless you count over-endebtment as an economic failure - many tend to see accessing borrowing as a success (!) , rather it is investor confidence in a country that allows it to build a deficit), with available borrowing to failing economies tending to be limited and with many strings attached. This point also outlines how interdependent the global economy is now - to reduce imports
automatically denies a population of much that it is used to and cannot make up for at anything near the price by home production.
I suppose much of the external deficit is owed to foreign banks, having passed through Spanish banks into the local market, could this be one reason Spanish banks have expanded into the US and Europe recently - as a form of intertwining themselves in these markets, which presumably they owe to, both as a present favor there and future leverage (political, social, administrative) if/when they run into dificulty ? There is a huge power play going on, the only thing which isn't happening is a serious restructuring of the economy into deflation/deleverage mode, it is being left to fall to pieces at ground level, while governments tout renewed expansion. This cannot happen for a long time for several good reasons - in fact the whole model is unsustainable as is....and no one is presenting a new one, I suppose it will impose itself.


Carlos said...

Hello. I would like to ask some questions.
First, if it is possible that ECB authorice to the Bank of Spain to issue a higher amount of euros.
Second, if it is possible that even, if it is considered necessary, they set temporarily a different rate of interest for Spain.
Will this, if they make it, have some positive or negative effect?
I suppose that although this would have a lesser global effect, it would have a more inmediate and greater impact in Spain.
Finally, is it not the main problem how the Goverment is using the available resources?
I hope you excuse if I made grammatical or lexico mistakes.

Anonymous said...

Hello Edward,

I would like to return to the relationship between foreign debt and the reduction of living standards to enlarge the topic some. I haven't the figures or charts at hand but from that I have read the story seems the following. In the west we have had massive monetary expansion over the last decade, mostly through credit and fractional reserve lending. This was introduced into the western economy mostly in the form of consumer debt, property mortgages, and credit released on equity (mostly houses). This is helped fuel the economic bubble we are in. If I remember correctly base money supply increased way beyond current account deficits. Much of the trade surplus from the likes of China or Saudi was also funneled back into lending to the west too . Exotic insurance vehicles , default swaps etc. enabled lending to continue way beyond acceptable economic levels. The crisis started when economic reality did not match that hoped for in the west, credit was tapped out, exposure to losses was revealed in the financial world. By this time the real western economy was already deteriorating, peoples wealth was diminishing (available wealth - and much of that borrowed to experience 'wealth' was only a mirage of debt that was unreturnable from the economy and actually represented financial impoverishment).
The stimulus provided by central banks/governments is also very much funded by surplus countries, it lacks the multiplier effect of being relent endlessly as banks have decided to sit on it to boost their reserves for the coming debt failures, or have lent it safely for government spending. The show is going nowhere.
Apart from credit being tapped to the limit in the west, so ending the fuel boosting the bubble, we have to look at various other reasons as to why the economic model in the west has failed. World comodity shortages and hence their high prices, speculation, lack of competitive production in the west etc and many more come into play. The scene is very complex and I would not point to any one factor as being decisive. The main responsibility though must go to the unrealistic debt bubble that fuelled expansion, and that was not just a current account event. The transfer of manufacturing, fx pegs and games etc. must all come into play somewhere too, as should China's economic and political direction. It is very complex. No one however seems to be adressing the most basic of issues, such as restructuring existing debt and readjusting forecasts to realistic parameters within which to shape policy. Instead we have the larger banks and government frameworks protected financially and the rest of the economy is left to its peril. This is no good, it is a downwards spiral of failures , which will cost all much. The markets are trying to revalue the economy upwards, reality is and will be the opposite. It is not a bubble that can be reinflated. Maybe it is one way to redistribute wealth in a model that is very unbalanced. It is the younger generations that will be picking up much of the tab though...or are we mostly all spoilt ? If so, at who do we point a finger ?

Regards, Bran.

Anonymous said...

Edward and Pacomer,

I agree with you Edward, in that I live in Spain (but not Cataluña) by choice, I love this country, and refuse to play ostrich to the problems facing my chosen country. We must stand up to the facts in order to solve the problem. By waving our hands and insisting every thing is fine is much like Nero fiddling while Rome burned. This behaviour by the current government is a big part of why the problems are so deep.


Anonymous said...

Hi, Edward et all

Difficult to see your point that it is the decreasing deficit that leads to a reduction in living standards, I am tempted to see it the oher way round, like Br.

Spain´s main cmmercial partners are France and Germany. How do you think this "spanish export" of its demise will affect them?


Pacomer said...

Thanks for your answer, Edward

The managers like you, can try, indeed, encouraging their fellows to face together the storm, to figure out which could be the painless way out of this havoc. Nonetheless, the problem always lies before us, namely, to find out a robust economic plan that leads the spanish economy to grow around the required 2% to add up new jobs.

The "internal devaluation" is just only the ongoing way up to the Golgotha, but not a final solution, the silver bullet, if there is such a thing. Frankly, I dont currently see anyone who can show up a troubleshooting guide, some kind of economic commandments to fulfill in order to get out of this nightmare, and that is really what should get us scared.

Sorry, Edward, not Andrew, you are right ;)

Anonymous said...

I have a doubt about the internal devaluation. We are in a monetary union. I think we should consider this the same way as the case of regions with different development in the same country. For example, catalonia and extremadura. We dont say that extremadura is poorer beacuse she can´t devaluate. We know there is other reasons.
In fact, the wages are lower in that place, and that does not seem to help. I think taht if we want be a exporting country, we must have something to export, and I do no see that a pure internal devaluation is decisive. Perhaps only to the extent that it atracts foreign capital indirectly.
So that is my doubt. Thanks.

Anonymous said...

Hello Carlos, I will try to reply to your question, hopefully someone will correct me if needed. The ECB lends money to Spanish banks, most recently was an over @ 400 billion issuance to European banks at 1% for one year, presumably Spanish banks took up a fair amount of the offer. They have relent much of that to government at 3%, propped up their investments , used it to expand internationaly even etc. They have not relent it into the base economy (ie business and private debt levels are more or less neutral, not expanding as previously). Taxpayers later repay that lent to government and interest on it. The ECB can lend at its choice I presume, I know they make comments regarding specific countries (e.g. Greece where they commented they would not withdraw help too fast from that country) so I imagine they may choose to lend more money through banking channels to one particular country, and they may even be allowed to authorize this at lower interest, though I suspect there would be an outcry over unfair competition within the EU if this were done.There is little room to lower interest rates from the current 1% it offers money at, interbank rates use their own mechanism also which will price money according to market conditions. At the end of the day public finance may reach bankruptcy like any other business . In Spain Tax Revenue has shrunk over 32% year on while public spending has increased by over 7%. There may be a point where a country defaults on its debt. When this happens it finds it even harder to borrow money and larger international organizations tend to step in with help (ECB, IMF) , while insisting on taking partial control of how that economy is run.
The resources provided are being used to create a temporary welfare state, not the worst idea if you consider several million people without income whatsoever, cash subsidies to boost sales are ultimately useless and unfair to taxpayers however. In other words government business tends to be inneficient and corrupt, money does need to be spent to help those in difficulty however.


Edward Hugh said...

Hello everyone,

Sorry I have been "missing" this week. Between have the flu, a lot of my own work to do and the demands of Catalan radio and TV I have simply not had the time.

Thanks for all the comments, I am now back in action with a long weekend ahead and will reply to the interesting points raised tomorrow (Saturday).

Edward Hugh said...

Hello everyone,

Sorry I have been "missing" this week. Between having the flu, a lot of my own work to do and the demands of Catalan radio and TV I have simply not had the time.

Thanks for all the comments, I am now back in action with a long weekend ahead and will reply to the interesting points raised tomorrow (Saturday).

lagarto juancho said...

Hello Edward,

I don't know if you had the chance to watch "banda ampla" a week ago. This is a new debate program on TV3 which includes many more participants than a usual tv debate. I guess they are trying to get as many diverse opinions as possible on the selected topics.
The other day they were discussing la crisis, and during the 20-25min. that I was watching, 6/7 participants spoke. Each of them explained different causes for this crisis (labour market deficiencies, lack of moral values, ecological unsustainability of the system...). The excess of liquidity and credit was briefly mentioned, obvioulsy only to blame financial entities and how they have shut el grifo (tap) off, implying that easy credit is almost a constitutional right.

If most people do not admit that our living standars are artificially too high, how are we going to accomplish internal devaluation? How is it going to be imposed and by who and to whom? Wages are not being lowered, but companies are pushing each other to lower their prices. Combining lower sale prices with lower demand causes more company bankrupcies, therefore increasing unemployment even more.
Not taking into account the unmeasurable underground economy, I think this is going to create an economy where those (few) employed will have higher living standards (same income, but lower costs due to deflation), while those unemployed will struggle to get a job.
And all this without considering the stinky balance sheets of our banks and cajas.

Not only the emperor still has clothes on, it seems everyone is wearing the same clothes and no one is interested in breaking the illusion.

Sorry, I'm a bit pessimistic...

James Baker said...

I thought AH's article was a chilling piece of analysis and posted a link on a Spanish expat forum. I got a lot of abuse about scaremongering and not wanting "to scare people". Unless people and especially governments have their eyes opened to the especially parlous state the Spanish economy is in, it will continue to languish. Special measures are needed - like carlos said - but I'm not sure what.

Anonymous said...

For those looking to find the reasonings behind the current economic downturn I would suggest you follow Mike Shedlocks blog which gives a very reasoned and detailed view of macro economic workings in a very readable manner.


The above link is one good overview, you would have to follow his blog for a while to catch up with much of the info, which he readily links through to in pertinent articles.


EstrellesLlunyanes said...


I pretty much agree with your arguments. But let me take them one step forward: it was more or less unavoidable for the Spanish government to take over the spending of the private sector, and as you said in another post, they pushed the G button.

In principle, it is not clear at all this is a bad solution. The final outcome will depend on how productive is the use of the funds the government to invest or spend.

I made an analysis, taking into account the overall spending of the Spanish government in each of the subsidies/investments/... it had decided to extraordinarily put into place since 2008, and I used the best estimates from European institutions for the fiscal multipliers for each of the activities (government investment, social spending, ...).

The stylized results were that even though these funds had a meaningful influence on output (about +2/3% if I remember correctly), the allocation of funds had not been optimally selected, since the highest multipliers were accomplished with subsidies to private investment, and the lowest, for social activities. But most of the spending has been directed into social activities, and little to private investment (with the main exception of railways).

The tipping point whereby financing costs become more and more expensive when more and more debt is issued by the government is probably close. Unfortunately, the tipping point is difficult to recognize ex-ante, but it is triggered suddenly and abruptly when it is reached.

We are still on time to do something about it, but first we have to recognize the problems and to reach an agreement for the solutions. I do not see this taking place in the near future, unfortunately.