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Saturday, September 26, 2009

Three Million Unsold Properties In Spain - Update

In my last post on this topic, I said the following:

My second observation is merely anecdotal, but the Acuña & Asociados report places a lot of emphasis on the coastal situation, which has, to some extent, already been “factored in” by most participants, however quite by chance I have talked with a number of people in recent days who have stressed with me just how serious the situation is in the satellite towns around Madrid, built as they have been for Ecuadorians who never arrived, or Romanians who have already left. I think this element is yet awaiting a proper accounting, and the cost is unlikely to be small.


Well, "Lo & Behold", Spanish property portal idealista.com have done a bit of digging, and here is what they found. Going through the official Ministery of Housing data they were able to locate 22 "black spots" (towns or cities with over 25,000 inhabitants) where the price of housing has already reputedly fallen by more than 30% from the December 2007 peak. This compares with the official average price fall of only 8% for the whole of Spain. And incredibly (see the chart below) no less than nine of these "black spots" are in the Autonomous Community of Madrid - that's roughly 40% of the most severely affected areas nationally are in only one community.



The areas affected are Alcalá de Henares (-37%), Alcobendes (- 47.6%), Alcorcón (-34%), Aranjuez (-35%), Colmenar Viejo (-33%), Leganés (-33%), Móstoles (-33%), Pinto (-37%) and Rozas de Madrid (-35.1%). By way of comparison, in Catalonia there are only two such areas, Castelldefels (-33%) and Sant Cugat del Vallés (-32%). Many of the worst affected areas in the Mardid area are in centres of high inward migration, but there are also some quite surprising names, like Alcobendas, one of the richest towns in the whole area, and home the famous neighourhood La Moraleja where so many of Spain's publicity seeking but camera shy elite seem to find shelter.

Of course, it isn't clear what level of reliability is to be placed on official government statistics, but on the other hand this data does put some flesh on the otherwise anecdotal evidence I have been hearing, or on those reports of trains which stop at stations where no one seems to get either on or off. We are talking about new building with large infrastructural projects to support it here, and of course, as I keep saying, if the immigrants simply walk, who is ever going to live in some of these places?

Monday, September 21, 2009

Three Million Unsold Properties In Spain?

Yes, up to three million. That was the conclusion reached in the 2009 annual report on the Spanish property market prepared by Madrid-based real estate analysts R. R. de Acuña & Asociados. The report is described by Sunday Times Spanish Property Doctor columnist Mark Stucklin as one of the most influential annual reports on the sector, so the conclusions are hardly to be sneezed at, indeed the assumptions made in the calculations appear on the surface to be entirely plausible. In fact, having read the summary of the report in this article here, Variant Perception's Jonthan Tepper wrote to me to ask whether I thought we were being "dire enough". Yep. Sufficient unto the day is the direness thereof.

So where does the 3 million number come from? Well, according to the estimates of R. R. de Acuña & Asociados - as outlined in the Expansion article - there are currently 1.67 millon flats and houses on the market and looking for a buyer in Spain. Roughly 1.1 million of these are new, while a further 518,000 second hand residential properties are now estimated to be languishing on the market. To this number we then need to add the 327,350 properties under construction but still unfinished - these will either need to be completed or knocked down, but in either case they represent a problem.

Finally we come to the 1.098 millon housing units for which planning permision has already been granted together with an allocated credit line of 52.947 billion euros courtesy of the Spanish banking sector. Of course maybe may say, well these properties will never be buit, and this may be true, but deciding whether or not to build them is a much more difficult decision to take than it seems, since any such decision would be equivalent to throwing the towel in on Spain's construction industry, and would constitute an implicit recognition that the policy pursued so far by the Zapatero administration of trying to soldier on through to 2011 had been a failure. Construction activity is still only down some 30% from peak, and if we think it will need to fall from nearly 12% to around 4% then it still has at least another third (or fifty percent of current output) to come down, and this is where all the issues start.

Deciding not to go ahead with these houses would basically mean very little construction activity in Spain during the next couple of years or more. Evidently this would push up unemployment even further, and here is where the problem comes, since this deterioration in the general economic situation would make it even harder for the property market to recover.

Any kind of bubble like the one we have had requires that everything feeds on itself, the moment this stops happening everything starts to deflate, and this is what is happening now. Simply not building - which I obviously think is what they have to decide - would mean another vicious twist in the screw, more construction company bankruptcies, and hence more bad loans for the banks.

Faced with this, and crazy as it seems, there is a certain logic in continuing to fund zombie builders to build houses that evidently no one needs, since money is cheap from the ECB, and this way the bad-loan book looks, well if not good, at least not so bad. And who knows - so the thinking goes - maybe one day we will find a use for all these houses. And this is where the pre-funding issue comes in, since the builders have had to demonstrate in order to get the permission that they have the financial resources to see the projects through, and the banks accordingly have had to set aside the 50 billion euros or so in anticipation of this, which is why, as Madrid University Professor Daniel Villaba pointed out earlier in the year, keeping funding the zombie builders means effectively starving Spain's Pymes (or small businesses) of much needed working capital. But the banks can't simply tell the builders to go to hell, and not to build, since if they do the builders will declare themselves insolvent, with the evident consequences that that much cultivated non-Performing Loans rate would suddenly shoot up.

So adding everything up, we find that between them Spanish estate agents, banks, savings banks and private investors are now either owning or holding the tab on a grand total of something like 3.1 million properties, all of them looking for, or about to be looking for, that ever so elusive thing in Spain, the potential homebuyer.

Another interesting conclusion is that 75% of existing builders will simply go out of business in the next five years - since which everway you look at it, building now or building later - Spain's construction sector is hopelessly overpopulated.

Fortunately Mark Stucklin has - on his Spanish property buff blog - given us what he calls a a "bulleted summary" of the main points in the report, and these I reproduce below. To his summary I would only add two further points of my own.

Firstly the estimate of 25% unemployment by the end of next year contained in the report may well be on the low side, especially if the Spanish government is running out of funding for the stimulus programmes. Spanish INEM employment department officials have already leaked estimates that if the Plan E type projects are not renewed, then we could see something like 700,000 additional unemployed in October and November of this year alone. If these warnings turn out to be realistic then my feeling is that we will hit 25% unemployment around Easter, and then start heading up towards 30%. We should break through the 30% level around the turn of 2010/11 or by the spring of 2011, depending on a lot of factors which are still hard to see at this point. And where will we stop? No idea at all, since this simply depends on when the Spanish citizenry decide they have had enough and a package of emergency measures are put in place. It is hard, given the way the eurosystem works, to see how a "short sharp shock" may be administered, but something of the kind will be needed, or the patient will simply arrive moribund on the operating table.

My second observation is merely anecdotal, but the Acuña & Asociados report places a lot of emphasis on the coastal situation, which has, to some extent, already been "factored in" by most participants, however quite by chance I have talked with a number of people in recent days who have stressed with me just how serious the situation is in the satellite towns around Madrid, built as they have been for Ecuadorians who never arrived, or Romanians who have already left. I think this element is yet awaiting a proper accounting, and the cost is unlikely to be small.

Summary by Mark Stucklin of R. R. de Acuña & Asociados 2009 Annual Report On The Spanish Property Market

- “There are no green shoots around here,” said Fernando Rodríguez y Rodríguez de Acuña, president of the company, describing the state of the Spanish property market during a press conference introducing the report.

- At end of 2008 the supply of property for sale or under construction was 1,623,042, of which roughly 580,000 were resales, 500,000 newly built but unsold, and 470,000 under construction and nearing completion.

- Annual demand estimated as follows: 233,000 in 2008, and 218,000 in 2009.

- That means there are some 1,6 million homes on the market, whilst demand in the next few years is expected to run at around 220,000 homes. At current levels of demand it will take 6 to 7 years for the real estate sector to recover. So it could take until 2016 for the market to digest the current property glut.

- Looking at the market for holiday homes on the coast, local demand was estimated at 42,000 in 2008, expected to fall to 40,000 in 2009, whilst foreign demand for holiday homes on the coast was 21,000 in 2008, falling to 20,000 in 2009.

- The report singles out the coast as one of the areas with the biggest glut of property, and therefore the biggest problem that will take the longest to resolve.

- Higher priced market segments are also a problem; more expensive market segments are expected to take more than 6 years to clear, compared to 3 years or less at the cheaper end.

- The only way developers and banks will get rid of the glut of property in the medium term is selling at a loss.

- After falling 1.83% in 2008, overall prices will fall 9.55% in 2009, 9.32% in 2010, and 4.81% in 2011, a cumulative fall of just under 25.5% in nominal terms.

- After falling 3.32% in 2008, coastal prices will fall 11.28% in 2009, 7.98% in 2010, and 4.31% in 2011, a cumulative fall of 27% in nominal terms.

- Housing starts will fall to between 50,000 and 75,000 a year in the next few years, down from more than 700,000 in 2005. “The market situation doesn’t justify more building, and anyway the banks won’t lend money to build something that won’t sell,” said Fernando Rodríguez y Rodríguez de Acuña.

- Thanks to long lead times in the construction business, the full economic impact of the collapse in residential construction is yet to be felt. The darkest hour for the Spanish economy will come in the second half of 2010, when unemployment could reach 25%.

- Developers will go out of business in greatest numbers during 2010 and 2011. “It gets increasingly harder for developers to refinance with assets they either can’t sell or which are already mortgaged, and are increasingly devalued,” said Fernando Rodríguez y Rodríguez de Acuña, who predicts that 75% of developers will be wiped out in the next 5 years by a combination of too much debt, the market slump, and “bad management”.

- Recovery won’t come until 2013, by which time the sector will be just half the size it used to be, if that.

Will Zapatero Be Out By Xmas?

Vengence, they say in Spain, is a dish which is best served cold. Looking at the pace with which things are now moving here, maybe the waiters are getting themselves ready.

According to Bloomberg the Spanish Dept Agency now has a new head - Gonzalo Garcia - who previously lead the Spanish Treasury’s financial analysis department. Garcia is 35 years old, and already has ten years experience working for the Spanish Treasury in the head that is sitting on those ever so young shoulders, while the person he will replace - Enrique Ezquerra - himself only 37, now becomes economic adviser with Spain’s Permanent Representation to the European Union based in Brussels. Something, it seems to me, is afoot, and it isn't that hard to work out what. With Spain's banks having something like 75 billion euros in short term loans which need to be renewed with the ECB in Frankfurt next June (see this post for a full explanation of the background to all this), and the Spanish government having a similar (or before we get to the end of the year possibly somewhat greater) quantity of debt outsanding in one year bonds which will need to be renewed next year along with all the extra debt they will also need to finance next year, and with a domestic banking system which is already struggling to refinance existing household and domestic loans, it isn't hard to see that the position of Head of the Spanish Debt Department and direct coordination with Brussels are two of the key items on next years Spanish government agenda.

And the only issue left in my mind is whether the head which will need to be served up on the proverbial plate as the ritual offering to ensure the free flow of communication (and money) will not be none other than that of the existing President of the Spanish government, José Luis Rodriguez Zapatero.

Certainly all the early warning signs are there, and no one can watch Spanish television news, or listen to the radio here without becoming immediately aware that something has now changed, and that he who was once all powerful is now, himself, in his turn steadily being subjected to that big squeeze of which he was, in an earlier epoch, such an admirable exponent himself. Basically I have no doubt that, whether the coup de grace comes later or sooner, Zapatero is now on his way out, and the only real outstanding question I have is whether he will in the end go before xmas (the start of Spain's EU Presidency) or after June (when it finishes). The decision is I suppose in the hands of the Spanish people, and it is just a question of how much more unemployment they are willing to stomach before those inevitable "casserolades" start to break out.

Interestingly, for those us who follow this kind of thing, one of the obvious candidates, if not to replace him, then at least to take a key role in the new government of economic technocrats which is undoubtedly being prepared even as I write - ex Public Administration Minister Jordi Sevilla - recently left his seat in the Spanish Parliament - in an ominous and deeply significant leaving of the sinking ship with two other ex-ministers Pedro Solbes and ex-Defence Minister José Bono - to go and work for Price Waterhouse Coopers. And irony of all ironies, he had earlier been replaced in the Public Administration Ministry by the unfortunate Elena Salgado, who may well be about to see her short term in the Economics Ministry abruptly brought to an end. But Sevilla's latest move becomes even more charged with symbolic significance when you consider that the role model for what may now be about to befall Zapatero, Ferenc Gyurcsany, was replaced by the current Hungarian Prime Minister Gordon Bajnai, who immediately called the now Finance Minister Péter Oszkó away from his labours at Deloitte. And Gyurcsany in what could be an early anticipation of what Zapatero may now need to do, resigned while muttering "I am leaving as I am being told I am the biggest obstacle to the structural economic reforms my country is said to so badly need". Who exactly it was that was telling him this it may be judicious not to ask, but one thing is obvious, you can't have people always coming from the same consultancy group, now can you? It just wouldn't look right.

Wednesday, September 16, 2009

How Will The ECB Ever Manage To Stop Funding Spanish Government Debt?

The looming problem of what will happen as and when some of the other Eurozone economies eventually start to recover while the Spanish one languishes in decline is finally starting to make the columns of the global financial press. Yesterday Thomas Catan had an article in the Wall Street Journal entitled Spain's Struggles Illustrate Pitfalls of Europe's Common Currency while Emma Ross-Thomas and Gabi Thesing also had a similar sort of piece in Bloomberg, under the heading Europe’s Two-Speed Economy Complicates ECB Rate Plans.

So the difficulty Spain could represent for the rest of the Eurozone is now it seems becoming the "Topic du Jour".

As Thomas Catan says:

Even as France and Germany begin to show signs of economic recovery, weaker members of the European common-currency union remain mired in recession. Without painful overhauls, euro-zone countries such as Spain, Italy, Greece and Portugal seem set for years of meager growth, making their debts harder to pay. That raises the question: Could the divergent economic fortunes of euro-zone countries pose a problem for the currency union itself?
Or, as the Bloomberg columnists say:



Europe’s economies are rebounding at different speeds, complicating the European Central Bank’s efforts to put the region back on a more stable footing.

Even as the global economy recovers and Germany and France return to growth, the European Commission yesterday cut its forecasts for Spain and Italy. Deutsche Bank AG says some of the economies that were once motors of growth and job creation across the 16-nation bloc may stay mired in recession next year.
So what is the background here? Let's look at what has happened in Spain. The Spanish property bubble started to slowly puncture throughout 2006 (well before the outbreak of the Sub Prime crisis) as the ECB steadily started to tight monetary policy and raised interest rates - the biggest weakness, and greatest vulnerability in the Spanish domestic economy is the way Spanish mortgages are overwhelmingly (85% plus) of the variable interest rate variety. That makes Spanish consumption exceptionally dependent on ECB interest rates. Thus, when these are lowered, as has happened over the last nine months, the relief is virtually instantaneous (as can be seen in the recent surge in the consumer confidence index) but when they are raised the squeeze on spending power is acute.

Spain's construction industry was the first to notice the change, and activity slowed as the prospect of higher interest rates loomed. In fact by the time we reached last July the construction industry had already been contracting for three years, and from the July 2006 peak activity was down by 30.5% - that is it is the industry had shrunk to 70% of what it used to be.




The decline in construction was followed by a decline in industrial output and job creation, which both peaked in June/July 2007 - with production having fallen by 33.45% from the peak by last July. That is industrial output has now been falling for over two years. Then, as the economy slowed domestic demand started to fall, and retail sales are now down a little over 10% from their November 2007 peak. So, as we can see, the whole economy is steadily sliding down, as first the builders, then households, and then finally companies steadily reduce their spending, and the drift is relentless.



And so things continue, and we hit the next stage, and in comes the government to support the economy, which is now extraordinarily indebted and at the same time extremely demand deficient. It is demand deficient because all the main groups of domestic economic agents are steadily trying to cut back on spending and debt, and the export oriented sector, after years of neglect and internal price inflation is now just not competitive enough to make up for the gap. So there is simply a huge sucking sound and the economy folds in on itself, and it is just this implosion force that the rise in government activity attempts to cushion.


So far, so good. This is the stuff burt bubbles are made of. But this respite offered by the rise in government indebtedness is only viable and worthwhile (after all, you are only creating even more debt, which at some point needs to be paid) if it serves to facilitate the kind of economic correction Spain most urgently needs, which involves inevitably and inexorably transforming itself into an export driven economy. But what happens as the government starts to take on all the debt, well, as we saw last year, the interest differential, or "spread", that the Spanish government has to pay on its debt suddenly starts to surge, as investors begin to worry about the sustainability of all the new debt.



So what happens next? Well, as Claus Vistesen points out in his recent analysis, the ECB needs to step in with a massive one year liquidity injection, and this effectively enables the Spanish banks to borrow the money they need to buy the bonds directly from the government, and then deposit the bonds purchased over at the ECB (with a haircut - or discount) to serve as collateral for their borrowing, earning on the way a minimal interest differential, or "carry" for their labours. Thus the ECB does indeed indirectly slightly improve the liquidity position of Spain's banks, even if the big news here is really that the ECB is - wittingly or unwittingly - indirectly funding Spain's fiscal deficit. Let's take a look at the spreads for a moment. The first chart shows a comparison of the "usual suspects" club - Spain, Ireland, Greece, Italy, Portugal and Austria. As can be seen, these spreads widened notably last winter, on the back of the Lehman collapse inspired financial crisis. They have subsequently narrowed again although notably we are still not were we were before conditions deteriorated, and especially the Greek and Irish spreads remain worryingly high.



Of course, part of the explanation for the improvement is the return of risk appetite, but there is also another factor, an institutional one, which I hope in the course of the coming paragraphs I will be able to demonstrate, since it is my contention that, in at least the Spanish case, the tightening of the spreads has been (an intended or unintended) direct consequence of ECB liquidity provision. And if the spread has only come down (see the chart below for the Spanish case on its own), then the reasonable question to start thinking about is what might happen to the spread once this support is withdrawn.



As we can see in the accompanying chart below, the issuance of short term debt (the maroon line, the one which spikes dramatically) has grown at very high year on year rates this year, yet despite all the talk of governments ahving difficulty placing debt, the spread on Spanish debt has softened. Now why might that be?



The ECB Furnishes The Proof

Well, quite conveniently for our present needs, the ECB, in its June Monthly Bulletin, supplied some useful details about the level of government debt purchases made by the various financial institutions. Basically what can be seen from the data is the way in which Monetary and Financial Institutions (MFIs) have been steadily moving away from riskier assets into the relatively safer area of government debt as the force of the financial crisis blast hit them head on.

The ECB estimates that the Eurozone banks really started seriously acquiring government debt in the first quarter of 2008, building up their stocks at an average rate of about €30bn a quarter. But then, in the first quarter of 2009, there was a sudden surge to a rate of around €90b.

During the last part of 2008 and early 2009 many of these purchases were in fact made by what are called money market funds which, as Barclays Capital analyst Laurent Fransolet points out in a June research note (to which I am indebted for this part of my analysis), is not entirely surprising since at the end of last year a lot of the buying originated from French, Luxembourg and Irish MFIs, the three countries which are host to biggest slice of the money market fund industry in Europe. Since the beginning of 2009, however, things have changed, and it is clear that the banks have actually been responsible for most of the buying. Based on the ECB estimates, it seems that something like 75% of the Q1 buying was conducted by banks. The ECB explanation is that a lot of this buying is more or less normal at this stage in the credit and business cycle, when risk sentiment is low. In fact Fransolet points out, and illustrates with a chart (below), how historically there has been a reasonably good relationship between the steepness of the yield curve and the buying of government debt by banks (and indeed MFIs in general).



Basically all of this is a reflection of the sort of "carry" positions banks find it convenient to take on board when yield curves are steep, since they can normally fund themselves at a pretty low rate, it is then quite interesting for them to buy near 0% risk-weighted assets that are yielding a few percentages points over their funding costs, and in this way they both make money and rebuild their capital base and de-risk their balance sheets at one and the same time.

As Fransolet notes the ECB does not offer a direct breakdown of such purchases by country. However the ECB database does contain a breakdown by country at the MFI level. What we find here is that the purchasing of government debts by MFIs has been far from uniform across countries. In fact the largest purchaser has been, guess who, the Spanish financial system who have bought about €9bn a month over the past six months - strange how that number just nicely covers what is needed for the current account deficit, isn't it .

Relative to the other countries and the size of the Spanish banking sector, this is, as Fransolet states, pretty big beer indeed. Buying of government securities was also brisk in several of the other usual suspects - Italy, Greece and Ireland (+€22bn, €13bn and €1 bn over the six months to April). Hence, we find, surprise surprise, that banks in countries that have experienced large rises in government debt issuance (and which previously had wide spreads versus Germany) have been quite active in supporting their own domestic debt markets this year. Not a smoking gun, but........



As Fransolet concludes: "Obviously, this bank buying is not the only reason why cross-market spreads have retightened recently, but it has definitely been a big factor."

To this I would add another piece of circumstantial evidence, one that hasn't been widely reported in the press, and that is that Spain's share of the 442 billion euro June 24 one year tender represented something over 15% of the total, when the share of the Bank of Spain in the Eurosystem is just over 8%. Not only that, as can be seen in the chart below, the level funding injection into the Spanish banking system (net of Spanish bank reserve deposits with the ECB) has continued to shoot up all year.



So let's retrace our steps now and ask ourselves the same question the other way round; just where is all this money going? Well if we go back to some charts I posted yesterday, the answer isn't hard to see. Lending to households has been flat:



and lending to corporates ditto:



while lending to government has, of course, and as we have been noting, been shooting up.



So while it is surely true that we can't say simply say outright and categorically that the ECB is carrying out indirect intentional debt monetisation and thus engaging in Quantitative Easing stricto sensu, we can say, and without a shadow of a doubt, the ECB one year liquidity injection has, in the Spanish case, largely served to help monetise Spanish government debt. And this is where the problems and all the exit related issues start.

As Claus Vistesen puts it in his excellent summary of the current battery of ECB measures:

"The ECB is not actively pursuing a policy of funding the growing pile of government debt in Austria, Ireland and Southern Europe, but it is in fact doing so as an indirect consequence of its actions. Thus, given that I think we can all assume that any eventual recovery will be uneven, unwinding liquidity provision in the aforementioned countries is going to involve very special problems, since evidently, if these governments seek to substitute free market funding for the current institutional one the spreads will evidently balloon again. And here is the dilemma, for those who can recover will, while the rest may be simply sent straight to hell."

Basically the current ECB approach raises the following issues and problems:

i) it is a quite common and normal process for central banks to facilitate the monetization of government debt, allowing the high street banks to earn some liquidity from "carry" in the process";
ii) this process can later lead to difficulties in the banking sector if there are differing maturities on the debt in question, that is, if the banks borrow short to lend to governments who needs are over the much longer term, this leads to a problem when the central bank withdraws funding if ready support is not available for the government debt in the private market. This would be the position in Spain if the ECB go for exit in July, and the Spanish government needs to rollover its 2009 debt at the same time as funding its 2010 deficit.
iii) the central bank also runs the risk of financing excessive deficits, if it has no political control over the actions of the government in question (which in the ECB case it manifestly doesn't) then funding supplied for one purpose can easily be used for another, and this is exactly what is happening now in Spain, as funding made available to ease Spain through a much needed correction is quite simply being wasted. This situation can create "grave dilemmas" for the central bank. This is where the ECB is at now with Spain.
iv) all of this is one of the reasons why the Maastricht Treaty tried to tie the ECB's hands quite strongly, but well....
v) and the worst of all this is that not having carried out the correction, the most serious problems will face Spain should the rest of Europe begin to recover before Spain does.

And this takes this whole post back to just where it started. The reason for (v) should be obvious, since if we think about the fact that most Spanish mortages are variable, then the ECB will not only be withdrawing the credit enhancement liquidity support from the banks, it will also be raising rates, indirectly tightening the noose even more strongly around the neck of the unfortunate Spanish, most of whom actually have no idea at all of what is to come next.

So in closing I will go back to Thomas Catan in the Wall Street Journal. As he sees it, when faced with a debt crisis the ECB and the EU Commission have essentially three ways out, and it is now up to history (and hopefully a few strokes of good fortune) to decide which of the alternatives he outlines will actually carry the day.

In the case of a debt crisis, there would be three main ways out -- all of them painful. Faced with a debt crisis in weaker members, the euro zone could eliminate the problem by moving to full political union. Government bonds would be issued centrally, with the funds doled out to member nations. But that seems like an awfully hard sell at a time when there is scant enthusiasm for further integration in many European countries.

The second is the so-called nuclear option. Tired of paltry growth and spiraling debts, a country such as Spain or Italy could decide to scrap the euro. That would almost certainly mean defaulting on its national debt, which is denominated in euros. Investors would pile pressure on the next weak link, possibly leading to a chain reaction and a collapse of the currency.

Given how damaging the nuclear option would be to everyone involved, one has to imagine that Europe would opt for the third option -- bailout -- no matter how unpalatable.

Such a bailout would be hugely controversial. Germany and France would find it hard to justify it to their own taxpayers. And they would most likely have to impose unpopular, International Monetary Fund-style austerity plans on the other countries, stoking tensions within the EU.

The euro zone still has time to kick-start growth by taking concerted action. Unfortunately, it may need the threat of a debt crisis to begin doing so.

Tuesday, September 15, 2009

House Sales Stabilise, While Prices Fall, And The EU Forecast The Country Has A Long Hard Road Ahead

Spanish house sales were down an annual 20.3% in July, with a total of 37,039 homes changing hands. 50.5% of these were new according to data released today from the National Statistics Institute (INE). The interannual rate was thus down over June, when it stood at 25.5%. In fact, month on month sales were up 4.7%, although over the first seven months of the year as a whole there was an inter-annual drop of 33.1%.



However, while it is clear that sales have been improving now since April, which was definitely the worst month to date, with monthly sales down 65.1% over the January 2007 peak, the recovery rate is very timid, and if we take into account that there must be more well over 1 million empty, unsold new houses all over Spain, and in July there was only a net difference of 18704 homes (50.5%) or about 1.9% of the total, then across Spain as a country about 374 houses per Spanish province were sold. At the current rate, it would take 1,000,000 / (18704 x 12) ≈5 years just to get back to the starting block, and this with no new homebuilding at all between now and 2015. And if we were start to think about migrants who change country, young educated Spanish people who emigrate in search of work, and residential tourists who simply give the keys back and go, then as long as there are more than 374 immigrants/residential tourists leaving each province each month, the Spanish housing market will simply be treading water. This is the very high cost which could be attached to having that "L" shaped non recovery which the irresponsible government "non policies" risk inflicting on the Spanish people.



And even after all this is said, in July monthly sales were still down 55.75% from their peak. The improvement evidently reflects growing pressure on people to sell, at prices which are still dropping by the month, and where the total quantity of funding available for mortgages remains more or less stationary. That is to say it would be rather foolish to expect any real rebound in total value realised at this point - quite the contrary.





As I say, prices are still falling, and in this context you need to bear in mind the phenomenon of lies, damn lies, and then there are press releases, since according to the latest one of these from Spanish valuers TINSA - "The general IMIE (Spanish Real Estate Market Index) continued to soften its year-on-year fall in August, recording 8.9% compared to 9.2% the previous month."

Well, this IS interesting isn't it. It appears that things are getting better - and indeed that is the conclusion most popular press journalists seem to have drawn. Well no, actually, they aren't. This data point is a complete statistical anomoly, based on the fact that prices have now been falling for more than 12 consecutive months, in such cases year on year data becomes virtually meaningless.



Indeed the most valid measure now is the P2P one I have introduced (peak to present) since using this we can see how far the indicator moves around. See next chart. In absolute terms, the index continued to fall from the figure recorded in July 1983 to that of August 1964. In terms of accumulated rates, the general index dropped 14% from the maximum recorded in December 2007.



In fairness TINSA also point out that - in absolute terms - the index continued to fall in August from the figure recorded in July.

Tinsa also do report that the cumulative decine is now down 14% from the December 2007 peak. So proces are falling, and there is no real sign of easing, and indeed the only real issue is how far they will fall. My guess is 40% minimum, but others are invited to make their own attempt - as in a lottery - and we will see at the end of the day who the winning ticket belongs to. The other issue will be, once the fall stops, how long it will be before they return to only 30% below the December 2007 peak. My guess is five years after they bottom, but as I say this is pure guesswork, and is about as useful at this point as the year on year piece of data TINSA kindly provided us with.



Bank Lending Near Stationary Point


Bank lending to households has been effectively stationary for some months now:



While year on year lending to households dropped to just an increase of 0.4% in July.



Corporate borrowing was also more or less stationary on the month in July, at around 130.9 billion euros it was up just 0.3 biliion euros on June.




And the interannual rate of increase in corporate borrowing has also been falling steadily, and is now down to 2.4%.



As Households And Companies Deleverage Furiously, The Government Tries to Fill The Gap


As can be seen in the chart below - prepared by PNB Paribas Chief European Economist Dominic Bryant - under the pressures of growing unenomployment and falling domestic demand both Spanish households and companies are furiously trying to put their balance sheets in order by saving and starting to pay off their their debts. Given the unsustainably high pre-crisis levels of indebtedness there is basically no alternative to this process, and this is precisely why the only way for Spain to return to growth is by increasing exports and running a trade surplus. During this process of transformation in the Spanish economy (known among economists colloquially as a correction) there is no real alternative to the government stepping in, and stepping up spending to soften the blow, and this is what we can note in the chart.


Thus the Spanish government is, like other European governments, running a large stimulus programme. The problem is, however, this money is not being spent on supporting what would otherwise be a very painful structural correction. Rather it is being essentially wasted by trying to drive straight on ahead in the hope that no such correction will be needed. This is setting off alarm signals everywhere, and is what forms the background to the pressure on the Spanish government to begin to put in place plans to structurally reduce the deficit.

The urgency of the restructuring of the governments funding programme was brought into harsh relief at the start of the month when it was announced that the gap between government income and spending have shot up by 500% over the last 12 months. In July alone the gap grew by 28.7% over June, and stood at around 50 billion euros, or around 4.7% of the estimated GDP for this year.




Government spending in the first seven months rose to 108 billion euros, while income only came to 58 billion. Income was thus down 16.9% on 2008. Direct taxes were down 14%, while indirect taxes (including IVA) were down 27.5%. Income tax receipts were down 12.9%, with IVA alone down a horrifying 36%




As a result of this lamentable situation Spain will now need to significantly reduce its anti-crisis fiscal spending - both between now and the end of the year and again in 2010 - if it seriously intends to bring its fiscal deficit back towards E.U. limits by 2012. Indeed Treasury Secretary Carlos Ocana openly accepted this in his statements last Friday. The Spanish government is likely to go for some variant of reduced spending combined with increased tax increases.


And the pressure isn't only coming from Brussels and Frankfurt, Bank of Spain Governor Miguel Angel Fernandez Ordonez is also treading on Zapatero's coattails, arguing that Spain's government must be prepared to adopt all measures necessary to bring down the ballooning public deficit to address soaring unemployment. The problem is, by this point in the game this will not be as easy a task as it was earlier, since Spain is now becoming trapped in the kind of spiral we have already seen operating in the East of Europe whereby cuts in spending only produce more unemployment, while tax increases weakend consumption further, accelerating the economic contraction, and again sending up unemployment. Spain is now in a lose-lose dilemma, with no easy short term options and some inevitably hard and difficult years now lying ahead.

No Early Recovery In Spain


Indeed only yesterday the recent pie-in-the-sky claims by Spanish Prime Minister José Lluis Rodriguez Zapatero, and Economy Minister Elena Salgado that they could see signs the Spanish economy was about to recover had yet another bucket of cold water poured over them, and this time from an unexpected source - European Commissioner for Economic and Monetary Affairs, and PSOE member, Joaquin Almunia - who predicted Spain would continue to remain in recession until the end of 2009. Almunia forecast the Spanish economy would shrink by 3.7 percent this year, a reduction of about half a percentage point on previous expectations, and would remain in recession into next year. My own feeling is that even this outlook could prove over-optimistic given that my current calculations best effort indicate a contraction of this year of around 5%, and even this has downside risk if the goverment are forced to cut back strongly on spending programmes.

"The recession is less deep than the European average, but it is going to last longer. The reason for that is the adjustment from the disequilibriums which have accumulated over the last 10 years," Almunia said, referring to the construction boom, external deficit and continuing reliance on ECB funding in the absence of external investors willing to offer finance to the banking system at affordable rates.

Almunia's warning has also been echoed this week by analysts at Deutsche Bank, who say in their latest report that some of the European economies who were once motors of growth and job creation for the 16-nation bloc may stay mired in recession next year. The risk - according to the analysts - is that a recovery in the largest euro nations will prompt the ECB to tighten policy before smaller countries like Spain or Ireland have reached the end of their correction, making matters far worse for economies that are still struggling with slumping house prices and surging unemployment. Any increase in interest rates will make it harder for governments and consumers to pay interest on their mounting debt, potentially pushing their borrowing costs higher.

“The ECB will have to normalize rates from next year and it will hurt countries like Spain and Ireland which will still be in recession and burdened by piles of debt,” said Gilles Moec, an economist at Deutsche Bank in London. He forecasts the ECB will double its benchmark interest rate, currently at a record low of 1 percent, by the end of 2010.
The OECD has also warned that Spain and Ireland, where households are already among the most indebted in the euro region, will contract 0.9 percent and 1.5 percent in 2010 and will also post the euro area's largest budget deficits. In contrast, says the OECD Germany and France will both expand by 0.2 percent.

Basically the issue of exit strategy for the ECB is a separate topic, and I will leave this for a subsequent post, but those of you who are in a hurry for the news could well download and read Claus Vistesen's latest extensive offering - The ECB's Balance Sheet at a Glance - carfeful this is a PDF file, and heavy duty stuff it is inevery sense.

Monday, September 07, 2009

There Is Another Shoe To Drop In The Global Economic and Financial Crisis - And The Focus Will Be On Europe's Perifery

'As far as I am concerned, this is ... the most complex crisis we've ever seen due to the number of factors in play'
Spanish Economy Minister Pedro Solbes speaking to the Spanish radio station Punto Radio September 2008

“‘The global imbalances have to add up to zero and so, if the US is going to be less the consumer importer of last resort, then other countries are going to need to be in different positions as well."
Director of the US president’s National Economic Council Larry Summers, speaking over lunch with the FT’s Chrystia Freeland.


Basically what we now have before us - as Pedro Solbes pointed out before being uncerimoniously defenestrated from the inner circle of the Spanish government - is an extremely complex situation and problem set. The background has evidentally been an unprecedented global financial and economic crisis, but this crisis has affected countries unequally, and it is noteworthy just how many people in what could be called the "weaker" countries have often sought refuge in the global nature of the crisis, rather than asking themselves just what it is exactly about their own particular economy that makes them "weaker", and more vulnerable, and why the crisis has struck more severely "here" rather than "there". Thus there is a great danger that people take refuge in the fact that the crisis is global in order to avoid thinking about the actual reality that faces them. This danger becomes even more of an issue as some countries begin timidly to return to growth, leaving others stuck in the mire - and possibly in danger of bringing the whole pack of cards tumbling down on top of them again. One such danger is evident in China (for which see the numerous warnings from Andy Xie) but others are for me somewhat nearer home, on Europe's periphery. A number of countries in Eastern Europe immediately come to mind - not only the Baltics, but also Russia, Ukraine, Bulgaria, Romania, Hungary, Serbia and Croatia. And in Southern Europe Spain and Greece stand out as in particular need of what Jean Claude Trichet would undoubtedly call "extreme vigilance".

If we leave out Russia (which is arguably a rather special case due to its dependence on energy revenue), then the simple fact of the matter is that what all of these countries had in common during the bubble years was that they were all running large (unrealistically large) current account deficits, which were produced to fuel strong credit driven housing and consumption booms. The crisis has struck all these countries like a shot of lightening for the simple reason that under present conditions such current account deficits are now no longer sustainable.


Now, the only way forward for such countries, as Paul Krugman points out (citing Reinhardt and Rogoff) is to export their way back to growth, and to demonstrate how this might work Krugman produced a simple chart in his Lionel Robbins lectures, which although rather rough and ready does serve the purpose adequately well.





So the central point I wish to make is that all these countries now need to run current account and trade surpluses to generate headline economic growth and to start paying down the external debt they accumulated during the heady years of the boom. Countries are no different to households in this sense. And the wider the current account deficit at the height of the boom, the bigger the correction needed. Without the much needed correction these countries simply will not recover, and we will see the famous "L" shaped recovery. If people think otherwise they are simply deluding themselves.

The situation in the US and the UK is, of course, not that different structurally from that which is to be found in some parts of Eastern and Southern Europe, but it is less extreme, in that the Current Account deficit peaked at between 5% & 6% of GDP. This is still large, and correcting it is going to be one of the very good reasons that the global economiy ISN'T going to return to any kind of strong growth anytime soon, given the strategic importance of the economies concerned.

The UK and the US do, however, have one large and significant advantage over the worst affected countries in South and East of Europe, and this lies in the fact they can issue debt in their own currency, and they can allow that currency to devalue, and that in fact is the road that both these countries are now going down. But remember, the result of this is that US and UK consumers will now play little part in facilitating headline growth in the global economy, since they themselves will now be net savers. But most of the worst affected East European economies are either locked-into currency pegs with the euro (the Baltics and Bulgaria), or cannot devalue very far due to the strong dependence on forex loans (Romania and Hungary) or both. Nor can these countries realistically expect to issue debt in their own currencies. So they are in effect in a very parlous situation, on financial life support from the EU and the IMF, while unable to make sufficient adjustments sufficiently quickly to stop unemployment rising out of hand, and non performing loans piling up in the banking sector.

Which brings us to Southern Europe. Italy is a case apart - since it is "simply" suffering from a kind of ageing-related terminal slow death "Venice style", and thus has a different problem set - in particular, while the Italian government is heavily in debt, Italian households are strong net savers, and thus any eventual default would be largely a "home team" issue. Portugal, Greece and Spain, on the other hand, were all running large CA deficits between 2000 and 2008, and these are deficits are now being forceably closed. But of course, and here comes the rub, these countries don't have their own currency - they have to issue debt in euros, and they can't simply fuel inflation (like they did in the past) since they can't print money, only the ECB can do that, and the ECB is a multi-national not a national institution.

Now people over at the ECB are well aware of this problem, and the bank is facilitating all the liquidity these countries need in the short term, but it is so very important important to understand this only aids liquidity, it does not resolve the solvency-related issues (which the individulal countries have to sort out for themselves) and in fact the short term palliative only adds to long term accumulated debt problem if the breathing space offered is not taken advantage of. And, here comes the problem, since all the available evidence suggests that the correction the ECB would like to be funding is either not taking place, or is taking place too slowly to be of much use. That is, the ECB has the funding capacity, but it does not have the necessary political clout.

Take Spain for example - Spain's external debt is continuing to rising even as I write, while at the same time GDP is falling, and will continue to fall untill we get back to export competitiveness. Worse, nominal GDP (that is current price GDP) is now falling faster than real (inflation-adjusted) GDP, so the value of the debt remains - in money terms - where it is, while GDP shrinks in relation to this absolute reference point - both in real terms, and even more so in nominal terms. I have been following this problem in Japan for the best part of a decade now, and the solution is evidently not an easy one, since - if you take the core core price index - Japan never really came out of deflation after 1998, and land prices are now back at the levels of somewhere in the early 1980s. Needless to say, if this repeats itself in Spain, the mess will not be a pretty one, and the problem for the ENTIRE global financial system will be substantial, due to the counterparty risk element.

So we are really caught on the horns of a dilema here, Spain and other EU periphery countries have to deflate (willingly or unwillingly, they need to carry out what has now come to be known as "internal devaluation") but so long as they fail to do this and to attract sufficient investment for new export industries to turn the economic dynamic around AND as long the rest of the global economy doesn't recover strongly enough with some countries starting to shoulder significant deficits again, then we are all only going to plumb the bottom. Worse, unemployment will continue to mount, and bad debts pressurise the banking system, which is where the next shoe might then not only drop, but be forced right off the foot first.

The only way in which it would be possible for these countries to attract the necessary investment to be able to start to create employment employment again would be to restore competitiveness, and over the time horizon we should be thinking about this is impossible for them to do via productivity improvements alone: hence the pressing urgency for the "internal devaluation" solution.

And let's not be fooling ourselves here - the main reason those famous government bond "spreads" have all tightened so impressively recently has been the willingness of the ECB to discount the national government bonds which are first purchased by local financial entities and then passed on for discounting at the ECB - a practice one of my Spanish friends calls the "truco del almendruco" (that is, you sell the 10,000 euro new car for 9,995 euros thus changing the key headline digit, giving everyone the impression there has been a large and significant discount, and, oh yes, first of all you need to dump a wheelbarrow load of cash on the banks - in this case on a one year financing basis).

"Between October 2008 and April 2009 MFIs’ net purchases of debt securities issued by the euro area general government sector totalled €217 billion in the context of rapidly declining short-term interest rates. This entirely reversed the net sales of €191 billion observed between December 2005 and September 2008 in the context of rising short-term interest rates."
ECB Monthly Bulletin, June 2009

So what I am saying is that the ECB is effectively conducting expansionary fiscal policy in the Eurozone countries - by buying a large part of the new government debt, a state of affairs which is in fact equivalent to conducting Quantitative Easing via the back door, while the EU/IMF tandem is offering similar support to the key countries in the East. Anatole Kaletsky made a similar point in the Times back in June, when the ECB announced its €442 billion of new cash into the euro money markets in what was the biggest long-term lending operation in the history of central banking and roughly equivalent to half the Fed’s entire monetary expansion in the past 18 months.

The Fed has “monetised” roughly $1 trillion of US Government debt since 2007, if we combine its Treasury and agency bond buying. Meanwhile, the ECB has lent $1.5 trillion to the euro-area banks. But what have the euroland banks done with this new money? They have lent most of it straight to their governments. Indeed, the governments in Ireland, Greece, Portugal, Spain and Austria would long-since have gone bust had it not been for the willingness of the commercial banks in these struggling economies to buy unlimited quantities of government bonds with money borrowed from the ECB. And these bond purchases have, in turn, been used as collateral for more ECB borrowings, which could be used to buy more government bonds.

In effect, therefore, the ECB has been lending money by the shed-load to governments, with commercial banks acting merely as a fig leaf for what would otherwise be seen as a blatant monetisation of the most insolvent European countries’ public debt.


Now Anatole only has it half right here, the objective is not to finance dubious government debt in semi-bankrupt countries (Italy, for example), but to enbale those countries who had been running extraordinarily large current account deficits (Spain, Greece and Portugal) to close the deficits gradually (ie without precipitating a dramatic implosion in the economies) by facilitating government borrowing to fill the gap left by domestic and corporate deleveraging. The situation I am trying to describe is perhaps best illustrated by the following chart on Financial Balances prepared by PNB Paribas Chief European Economist Dominic Bryant for a recent research report on Spain.



As households and companies desperately try to save, to put some sort of order back into their balance sheets, government steps in (Krugman's push button "G") to help ease the transition. Such a policy is, of course, all well and good and totally justified (since there is effectively no alternative), so long as the structural transition which such support is meant to facilitate is actually carried through. And this is a big if, especially since most of the evidence we have seen to date suggests it isn't.

And in my humble opinion the ECB will only be willing and able to do this for a limited period of time, since they will not be in a position to keep accumulating Irish, Austrian and Southern European bonds ad infinitum, and the sovereign governments won't be able to keep increasing their debt load for ever. Just look, for example at the kind of dynamic Spanish public finances have entered in 2009 (see chart below).



We also need to think about the risk the ECB is running of accumulating substantial capital losses if there is a sovereign debt problem (which there most likely will be at some point if the correction is not carried out) in one of the member states as the size of the ECB position simply grows by the day, and ultimately the German and French taxpayers will have to pay the losses being steadily accumulated, something I feel they will be very reluctant if those in the worst case scenario countries continue to harp on about a global economic and financial crisis whilst effectively doing nothing to put their own house in order.

So, coming back to where we started, growth in Germany and France. Such growth is unlikely to be anything like as strong as most commentators and analysts seem to be expecting. France will most likely do rather better than Germany, given that the German economy can't really move forward till other key economies move, due to export dependence. The German economy may well even ultimately contract over 2009 as a whole by more than the Spanish economy, and I expect Germany's problems (like Japan's) to continue well into 2010, simply because both these countries are now very high median age societies which are completely dependent on exports to grow - which means that now that the UK, US, Eastern and Southern Europe are no longer running current account deficits, Germany and Japan are very hard pressed to get the level of trade surplus they so badly need for achieving sustainable headling GDP growth, which brings us back to Krugman's joke about which planet is going to do the importing?

Structurally the previous drivers of growth will now fail to work, since as Krugman suggests, all the former CA deficit countries now need to export and run trade surpluses to grow and straighten out their financial imbalances , and it is not clear which countries can buy all the added output, especially when countries in general are still reducing imports, and certainly not about to open up deficits which would soak up all those new surpluses.

Essentially, I would close by emphasising that I am not a complete catastrophist, since I think there is a mid term solution out there - and that the answer lies in steadily unwinding the global demographic and wealth imbalances, through the economic development of a number of key emerging economies - in a way which would perhaps be similar to the implementation of the Marshall Plan which is what really brought the first great global depression to an end.

The problem is that I think we are still some years away from being able to get any sort of agreement on such a programme - as everyone will have noted the G20 isn't really talking about this yet, although I think they eventually will. In the meantime we all have to stagger forward. And it is the risk of further "events" occuring in countries like Latvia and Spain that make all this staggering onwards and downwards ever so dangerous. In all the key countries involved - the Baltics, Bulgaria, Romania and Hungary in the East, and Portugal, Greece and Spain in the South - government support is simply not sufficient to arrest the contraction in Krugman terminology simply hitting the "G" button will not work, and these economies are steadily "imploding" in on themselves, with the result, as I keep stressing, that unemployment inexorably rises, and bad debts simply mount up in the banking system, and if nothing is done to change course the outcome is surely a foregone conclusion.

The principal difference between the East and the South is that in the East governments no longer have the capacity to continue to sustain large deficits, while in the South they continue to be able to do so, though even here they cannot hold out indefinitely. Sometime in late 2010 or early 2011 all of this will, with a horrid and almost deterministic inevitability, all come to a head.

And this is why, I personally take the view that the global financial and economic crisis is far from over. There is another stage yet to come, and the focus of the problem will be Southern and Eastern Europe.

Thursday, September 03, 2009

P2P In The Spanish Economy

Well, we are getting a lot of waffle out there (noise), and talk about greens shoots and muted recovery, but all too often what is lacking is anything very substantial in the way of hard data to back up the various arguments. In poarticular, when it comes to Spain I would like to know where people are finding the justification for all the optimism, since as we will see below, there is little in the way of hard data to suggest anything other than continuing deterioration. In this post we will look at the most recent data for three key indicators - construction, industry and retail sales, as well as the most recent services and manufacturing Purchasing Managers Indexes (August).

As you will see, I have also introduced a new measure - P2P - which stands here for "Peak to Present", since after 12 months of decline the year on year measure is no longer interesting, and more than often misleading.

Here then are a series of P2P charts - showing the percentage drop from peak to present, which will enable us to follow the evolution of the crisis on a monthly basis.

You will also find with them the relevant index charts, and these also give a feeling for the extent of the drop.

Retail Sales

The latest retail sales figures (July) continue to confirm the same picture. According to Eurostat data, retail sales were down 1.2% month on month over June, and down 6.47% over July 2008. Sales are now down 10.11% over their November 2007 peak. So as we can see, sales are steadily sliding down, and the drift is relentless.






Construction

Latest data show that Spanish construction fell again between May and June, despite plan E, it was down 0.2%. Year on year figures are meaningless for an industry which will have been contracting for three years in July, but from the peak (July 2006) activity is now down by 30.5% - that is it is the industry has now shrunk to 70% of what it used to be.





Industrial Output

Industrial output continued to fall in June, and was down 16.2% year on year, which means it has now fallen 33.45% from the June 2007 peak. That is output has now been falling for over two years, and the decline seems to have continued in August (see manufacturing PMI report sumarised below)





August Purchasing Manager Surveys

And I have added the two Purchasing Managers Index charts - for services and manufacturing - for July, which is the first month of the third quarter, and so give us some idea of where we are going next. As can be seen, the contraction continues, more moderately, but it continues.

The Market Purchasing Managers' Index on Tuesday nudged lower to 47.2 from 47.3 in July, while manufacturing output again declined below the 50 mark -- the dividing line between expansion and contraction -- after peeking above that level last month for the first time since January, 2008. "The Spanish manufacturing sector appears to be stagnating, rather than entering full recovery mode during the third quarter," economist at Markit, Andrew Harker said of the survey.


Employment continued to decline, although at a slower pace for the second month running. The employment index has showed job cuts every month for the past two years.

Services PMI

Spanish service sector business conditions continued to deteriorate in August, but data pointed to a much slower drop in activity than in July. Input prices rose for the first time since December 2008, while optimism strengthened. The headline seasonally adjusted Business Activity Index – which is based on a single question asking respondents to report on the actual change in business activity at their companies compared to one month ago – rose to 45.3 in August, from 40.8 in July. Although the data indicated a marked contraction in business activity, it was the slowest since February 2008. Activity has now decreased in each of the past twenty months.



Yet Consumer Confidence Continues To Rise And Rise

And then, the strangest thing of all, consumer confidence goes on rising, month after month. Confidence in the current economic climate rose 3.9 points in July, continuing a six-month trend of increased optimism. The survey also indicated Spanish consumers have higher hopes than ever for the future of the economy, and the indicator for future economic expectations now stands at 106.7, up from a low of 59.8 in July 2008, partly according to the ICO (who organise the survey) due to an expectation that the job market is going to improve before the end of 2009. My guess is that a combination of falling prices and interest rates coupled with some salary increases for those on long term contracts has a lot to do with this bout of exhuberant optimism. As the job market continues to deteriorate in the autumn I predict we will start to see a reversal in the trend.

And Variant Perception Respond to Iberian Equities

Well, Jonathan Tepper has now written a reply to Iñigo Vega, of Iberian Equities, Izabella Kaminska covers the reply here, on FT Alphaville, and Claus Vistesen has a summary of the whole affair here, on his Alpha Sources blog.

And may I remind everyone of a recent quote from the Economist:


The new accounting guidelines will help Spanish lenders smooth out the effects of the property bust over time. But the risk is that the problems are merely postponed. The ratio of bad loans to the total, property included, has tripled to 4.6% over the past 12 months as unemployment appears to head inexorably towards 20%.

The true picture is worse still. Commercial banks have bought about €10 billion in debt-for-property swaps, according to UBS. Spain’s savings banks do not disclose the figure. Assume it is similar to their commercial peers and reclassify all these property purchases as bad loans, and then the non-performing loan ratio would be 5.7% (before any further adjustments for loan restructuring). Deferring losses to mañana doesn't change the extent of the difficulties facing Spain’s financial system.
The sad fact of the matter is, as the Economist says, that we really don't know what the real level of Non-performing Loans in the Spanish banking system is at this point, mainly because the system itself is not providing enough high-quality, detailed, credible information for us to make the necessary judgement.

That is partly why Jonathan Tepper is, I imagine, reduced to popular press articles and testimonials from insiders. And one last question, after reading Iñagi and Jonathan's latest exchange, is there really anyone still left out there who continues to believe that the ratio of bad loans actually fell to 4.6 percent in June from 4.66 percent in May? Whatever you make of the crossing the "t"s and dotting the "i"s part of the argument (or even if most of it is quite simply "beyond your ken"), all that is necessary for Jonathan's point - that Spain's banks are going to some considerable effort to cover up the extent of their growing bad loan problem - to be valid is that the former claim is untrue. This part I think is now clear enough. So c'mon gentlemen, try offering some credible numbers and then people may start to believe you. Have you never heard of getting the bad news all out in order to be able to get on with the job? But isn't this just Spain's problem at the moment, people are going to any length not to get on with that badly needed economic correction.

Variant Perception's Reply To Iberian Equities
by Jonathan Tepper

Variant Perception is very reluctant to get into public argument with someone we don’t know, but the issues facing Spain are large and serious.

We find it amusing that Iñigo Vega and Iberian Securities felt the need to issue a counter to our report. Variant Perception has written repeatedly about Spain for the last year and a half. Its conclusions have been far more accurate than those of Spanish analysts. We are an independent research house and express our views as we see things. What is interesting is that since the report came out, Spanish bank managers, surveyors, and developers have sent emails and come out of the woodwork to agree with us.

The report has struck a chord with readers because they know the emperor has no clothes. It seems only Spanish banking analysts are still blind. Interestingly, Iñigo Vega and Iberian Securities make few macroeconomic observations. We would be curious to know if Iñigo really thinks his loan loss assumptions make sense. Does he think this downturn is a normal downturn and does he feel he really has a grasp of the problems? How does he think the more than one million empty homes will be sold in a slow and orderly basis over the next few years? Who will buy them when affordability in Spain is so terrible and unemployment is above 20%?

Tellingly, he doesn’t even comment on the macro questions facing Spain. Sell side analysts engage in steady state thinking, but the world doesn’t stay the same. US housing analysts had very little macro understanding. They didn’t realize that house prices can go down, and they can go down a lot. In the case of Spain, he doesn’t once mention deflation, unemployment or why Spain will not suffer horrendous pains as it can’t simply devalue the peseta to get out of this crisis. That is why equity analysts have been so useless for the last two and a half years.

Spanish banks are sitting pretty, with high interest margins. Analysts must ask themselves how much of this is due to the fact that many commercial and residential loans were tied to Euribor with 12 month resets. Borrowers have been paying in at 2008 rates with high Euribor, while banks have been able to fund themselves for next to nothing. What will happen now that borrowers will get lower rates with a lag, and if the global green shoots rebound happens, Spanish banks might have to fund themselves at higher rates. The mind boggles.

This will be the last response, as Iñigo Vega and Iberian Securities aer not Paul Krugman and we are not Niall Ferguson.

And on a point by point basis:

Spain is Japan 2.0 - Not a bad start

We’re not sure what his point is here. He says that comparing Spain to Japan is “not a bad start,” but then goes on to make the very brave and foolish statement that Spanish banks have higher cumulative new NPLs than other developed markets. True, but beside the point. The question isn’t whether Spanish NPLs are high relative to other developed countries, but whether Spanish banks are indeed recognizing losses relative to what losses really are in Spain.

Loan loss ratios are being under-declared.

ADICAE, the Spanish banking consumer watchdog, agrees with me and explains how they do it. They are highly credible, independent and respected in Spain. They’ve done a far better job on tracking down ponzi schemes, abuses in the banking sector than the Bank of Spain or the CNMV have done. ADICAE highlights a variety of practices, not least the debt-equity swap. If he cares to read the article and speak to them, he might find it illuminating.

The president of the Association of Users of Banks, Cajas and Insures (ADICAE), Manuel Pardos, affirmed today that the data offered by the Bank of Spain on delinquencies of the Spanish credit institutions “are very distant” from reality, since banks are resorting to all sorts of “tricks and cons” to “put makeup” on thier accounts and reduce their non performing loans.

Source: Adicae duda de la fiabilidad de los datos de mora del Banco de España ante las "artimañas" de bancos y cajas

The argument that Spanish banks are like Japan is not only that Spanish banks are not recognizing all their losses. It is also that by providing capital to the weak, Spanish banks are not providing capital to other companies that desperately need it. That is how businesses are choked by lack of liquidity and financing. Also, by owning large amounts of property, which is by its very nature illiquid, Spanish banks are constraining their balance sheets. If he wants to understand the loss of liquidity caused by lending to zombie companies and keeping illiquid securities on a bank's balance sheet, he can read the following editorial in Spanish by Daniel Villalba, an economics professor in Madrid at the Universidad Autónoma.

¿Dónde está el crédito que "no aparece"?

470 billion euros in loans could go bad

We take his point on infrastructure spending. However, he states, “The report forgets to mention- however- that a chunk of the €323bn in outstanding loans to developers does not necessarily involve residential lending but commercial lending(which is relatively safe in Spain , in our view).” Really? How does he know? How does he think deflation, unemployment will not affect commercial lending?


His loan loss assumptions for residential mortgages are not dire enough. According to Expansion and the Bank of Apin 1 in 5 mortgages is at danger of becoming delinquent. We are curious: would he agree with that?

Source: Una de cada cinco hipotecas tiene alto riesgo de morosidad


Iñigo states in the introduction to the piece that residential real estate prices can go down 40%, but he thinks 50-60% Loan to Value (LTV ratios) are good. Does he not think banks may be forced to dispose of residential real estate at levels belowtheir fair value in order to move inventory?

Iñigo states that LTV ratios are fine for builders at 50-65%. That would be news to many smaller builders with political connections in the regional cajas. Even public builders had higher ratios than that. Colonial’s were closer to 75% before it went bust. Taking comfort in 50% LTV ratios is ridiculous. Martinsa Fadesa was 50% when it went bust. Its books had many irregularities, so its values were bogus. As values go down, LTVs deteriorate very quickly. Metrovacesa is a classic case in point after banks took it over, LTVs suddenly shot up. Loans are known and fixed; values are a moving target. Welcome to deflation.

Getting a boost from accounting provisions

n his piece, he writes, "Yes, the Bank of Spain changed last July the interpretation of the provisioning rule on some mortgage loans. Now the rule is more in line with the rules applied by most European/US banks (where provisions tend to match the expected loss as opposed to the frequency of losses). However, the measure has had zero impact on the system’s P&L hitherto."

He is also on the record in The Economist:

Iñigo Vega, an analyst at Iberian Equities, estimates that the new rules would relieve banks of the need to make provisions of about €22 billion ($31 billion) in coming months (assuming non-performing loans reach 8% by the end of 2010). To put that into context, Spain’s savings banks, which are heavily exposed to developers, are expected to make profits of only €16 billion before provisions this year.

Anyone who is slightly critical could be pardoned for asking: why would the Bank of Spain bother, if there is no P&L impact? Perhaps Iñigo would care to clarify his own statements and why the Bank of Spain would do something like that at this juncture.

Dynamic Provisioning

Iñigo makes a point that dynamic provisioning didn't start in 2000 and states this our summary is inaccurate. It is true that since time immemorial banks have set aside losses, and they did before 2000. However, central bankers all agree that Spanish Dynamic Provisioning started in 2000.

Perhaps he wants to disagree with the Bank of Spain:



The Bank of Spain is empowered to issue accounting ordinances to banks under its supervision. In this condition it regulates the solvency provisions that cover credit risk. Up to 1999, the main solvency provisions affect impaired assets. There is also a general flat 1% provision on non-impaired assets (0,5% on some mortgage guaranteed loans). In June 2000 the Banco de España introduced a new statistical (or dynamic) provision for Spanish credit institutions.

and the World Bank:

Banco de España, Spain’s central bank and its banking supervisor, put dynamic—or statistical— provisions into place in July 2000, to cope with a sharp increase in credit risk on Spanish banks’ balance sheets following a period of significant credit growth.

and the Bank of England:

The favourable economic environment in Spain over recent years has led to an improvement in banks’ asset quality and, in most cases, this has resulted in a reduction in loan loss provisions. The Bank of Spain was concerned that as banks’ loan portfolios continued to expand, partly because of a low interest rate environment, loan loss provisions were not keeping pace with potential credit losses latent in new lending. Consequently, the Bank of Spain introduced a new ‘statistical’ provisioning method which came into effect in July 20001.
We could go on, but it would bore the reader senseless.

Perhaps we're talking semantics when we refer to what "Dynamic Provisioning" is, but if so, we have no idea what his point is. In fact, we are not not sure he knows what his point is.

He states that the US would be better if it adopted dynamic provisioning. Greenland would be warmer if it were closer to the equator. That is a rather obvious, non controversial point. The question is: are Spanish reserves enough to absorb losses. Much like the US, loan losses in Spain have been much higher than has been anticipated. Does he really think that the provisions of Spanish banks are enough?

Iñigo Vega states, "In fact, Spanish Banks added €12.3bn in excess provisions over the last five years (end ’03-end’08) or 12% of its reported pre-tax profits (0.7% of loans)." Bravo! CCM, the only bank taken over so far by the government, was estimated to need almost 2.7 billion euros to be recapitalized. It has since reported over one billion in losses. Mr Vega is a brave analyst if he thinks that there aren't others out there that will have similar requirements. If provisioning is adequate, then perhaps he should let the government know. The government is setting up a fund with 9 billion euros and will have the capacity to raise an additional 90 billion euros in debt. Obviously the government thinks dymanic provisioning isn't enough.

Source: Spain Says Bank Aid Fund May Reach 99 Billion Euros

A simple back of the envelope calculation shows that provisionings aren't high enough. If there are 1,000,000 unsold homes, and the average mortgage on a home is 120,000 euros, if you assume a 30% loss on that (we think it will be higher), that is 36 billion euros. That is three times as much as the excess provisions. Many of the loans are developer loans and not mortgages, but run a similar back of the envelope calculation gets you to the same place.


Not marking loans to market

He should see my point above from ADICAE about banks not marking their loans to market. If a loan is non-performing, it should be marked as such.

Source: Adicae duda de la fiabilidad de los datos de mora del Banco de España ante las "artimañas" de bancos y cajas

He should also speak to bank managers. Non-performing loans are being passed off as current, vacuumed up and rolled ito cedulas to deposit at the ECB's repo window. (Incidentally, that is the only way many Spanish banks are finding any semblance of liquidity right now. Without the ECB, some Spanish banks would have the same liquidity problems that subprime mortgage originators had. The ECB is a mega warehouse, effectively, for the Spanish banking system. This is intimately tied in to the question of funding excess consumption in Spain, which we discussed.)


Not marking assets swaps to market given conflict of interest- Additional comments are required

He agrees that there is a problem with appraisals. We're glad. Appraisers, too, think there is a problem. He states, "Yes we agree that there could be some downside in some properties given the poor environment but the difference should not be huge from current levels." Variant Perception could not disagree more. The anecdotal evidence that property prices are far below appraised values is overwhelming. He should get out and meet people and see what things are like in neighborhoods around Madrid and on the coast of Spain. There is a vast gap between official statistics and what prices properties are transacting at.

Source: On 'Foreclosure Road' in Spain, Bargains Abound

Spanish property statistics are notoriously bad at capturing what is actually happening in the markets. Spanish homes are often bought with laundered money or non-declared money. This leads to massive distortions of data series. He can read more here:

Source: Beware Property Statistics - is the market worse than it appears?

As one surveyor put it to me, Spanish homebuyers under-report purchase prices, typically by around 30%. However, over the last three or four years under declaration has been brought into the money-laundering field and as a result is much less prevalent. The result of this in a level market would be the Registries showing higher prices being paid for properties, which were in fact only being sold at the same total price. However, prices dropped substantially, in many cases by more than 30%. So the net effect would be that prices haven't changed. Anecdotal evidence shows that many properties have declined by 50% in value or more. In some places,homes aren't trading at any price, given total lack of liquidity.


Offering 100% 40 years LTV loans.

Banks aren't offering 40 year mortgages willy nilly. They're offering them to clients who would otherwise be foreclosed, i.e. zombie customers, or to customers who might buy houses sitting on banks' balance sheets. If he doubts the number and prevalance of 40 year mortgages, he should ask around. He can also check here and count the number of 40 year mortgages still on offer.

Why are 40 year mortgages being offered? The math is fairly simple. Homes are too expensive for the average Spaniard to afford, and it is much, much cheaper to rent than to buy. According to the financial news portal Facilisimo.com the average citizen would have to dedicate 61 years to pay off a mortgage of a 70 square meter house if he does not go above 30% of his salary. For couples it goes down to 19 years, but that assumes they earn far above the national average. Rental yields are very low in Spain and far below the average mortgage payment. Renting in Spain right now means saving around 37.5% relative to buying. That is why no one is going to buy any homes at current prices.

Source: Un ciudadano medio en España tarda 61 años en pagar su hipoteca

We wish Iñigo all the best and hope he's renting and hasn't bought.