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Tuesday, August 31, 2010

Spain's Unemployment Continues To Rise

Spain's EU harmonised seasonally-adjusted unemployment rate (which is the interesting number) rose again in July, according to the latest data from Eurostat. It rose to 20.3% from 20.2% in June.




So despite a double digit fiscal deficit, Spain has not yet succeeded in putting a brake on the upward drift in the headline unemployment number.

And the number of those officially working continues to decline, according to the data on those paying insurance contributions from the Social Security Ministry.



Clearly having broken the 20% barrier the number looks like heading up even further in the second half of the year, although quite how far up is hard to say, since my feeling is that some of the increase in unemployment is now being offset by the silent march of feet, heading for the door, and looking for employment abroad.

On The Shoulders Of Giants - How Spain Is Destined To Follow In Germany's Footsteps

The current generation of policymakers seem to be like Captains of large ocean liners, out there on the high seas, bereft of either compass or adequate charts, trying hard to calm there worried passengers by telling them nothing is amiss. But the charts are there, if only they would look at them, and in the present Spanish case, unlike the old refrain, the future is ours to see, and it has a name: Germany.

For those willing and able to examine our present situation with a reasonably open mind, a comparison of the recent history of the Spanish and German economies can prove illuminating, especially since, as I will argue below, there are strong structural homologues to be observed in the evolution of the two.

This post will contain comparatively few words (what a blessing!) since I will try and let the charts themselves tell their own story, in the hope that concepts which seem to be difficult to convey verbally, may be easier to grasp visually.

Consumer Boom

The first myth I would like to debunk is that it simply is not true that the Germans are a group of "non consumers", and inveterate savers. Back in the 1990s German private consumption enjoyed a huge boom, a boom which ground itself to a halt around the year 2000. It is only since 2000 that German private consumption growth has been lacklustre, and incapable of driving the economy. (I am using a Bloomberg chart here, since I don't have a long enough time series to hand to make my own version).



Now if we look at the same chart for Spain, we can see that private consumption growth enjoyed the same kind of "blossoming" that German consumption did between roughly 1999 and 2007.


Driven By Borrowing

But more than the phenomenon of the consumption boom in and of itself, what is interesting is what was driving it. Unsurprisingly we find the "usual suspect" - rapid increases in credit. Again, the following charts belie the idea that Germans have always been a nation of meticulous savers.





And again, the Spanish charts for mortgage increases tell a very similar (if even more exaggerated) story.





And it wasn't only households, corporates were busy at it too. Interestingly, corporate borrowing seems to have had a brief renaissance in Germany on the back of the current crisis.






Yet again, the only area in which Spain distinguishes itself is in the magnitude of the phenomenon. Spanish corporate indebtedness is a much, much more serious problem than German corporate indebtedness ever was.






When we come to look at the last set of loan charts, I would point of two features. In the first place, total private sector debt is not that different between the two countries, despite the fact that German GDP is around twice as large as Spanish GDP.





And in the second place, look at the long tail on German year-on-year borrowing, this is the point where those with eyes to see should be able to discern something of the future which awaits Spain. Interannual lending in Spain isn't going to climb back up again, and we should expect it to trawl around the zero percent level for many years to come, as Spain's private sector deleverages itself.





From Current Account Deficits To Current Account Surpluses

Which brings us to the next point, the association between lending booms and current account surpluses. As we can see in the chart below, Germany was no exception to the rule here, and all through the duration of the consumption boom the country ran small current account deficits. Deficits which then became surpluses after the huge structural adjustment the country went through in the transition from being a consumer driven to being an export driven economy.




And this is the path that Spain will now surely have to follow, but just note the massive difference in scale between the two. Spain's adjustment will need to be enormous. And how could this have happened we might like to ask ourselves? Were all the relevant drivers fast asleep, lurched over their wheels? How come no one "saw this coming"?



Given the magnitude of the correction, it is not really surprising that the IMF seem to want to hope against hope that it really won't be necessary. As the chart below illustrates, they seem to be hoping markets will sustain the current account deficits all the way through till 2015. As can be seen, Spain is the worst case offender, and the country where the structural transformation will need to be largest. So why do the IMF continue to believe in something which is scarcely credible? It could be that they simply accept the Spanish government's own optimistic idea that private consumption will come back to the 2% growth level again, kick started by a surge in borrowing. But a study of what happened in Germany makes that highly unlikely. Spain's banks are having trouble enough financing themselves as things stand, are people seriously suggesting the markets will now fund another bout of additional leveraging?



And if the private sector isn't going to do the borrowing, then who is? Since simple book-keeping tells us that having a CA deficit on the one hand implies capital flows on the other to fund it. The only conclusion I can come to - and this is what I argue in this post - is that we are assuming the government is going to continue to run a sizeable deficit, or that there will be straight fiscal transfers from other parts of the Euro Area to Spain. Otherwise the numbers simply don't add up.

Worm Into Butterfly?

What I have been arguing so far should be relatively uncontroversial for anyone with a sound grasp of applied macro. What comes next is more of a hypothesis. As we have seen, economies seem to transit from being consumption driven to export driven, so we might like to ask ourselves, is the process merely random, or are their underlying structural dynamics at work. As I am trying to argue in the German case, the shift doesn't seem to be a cultural one, and if Spain follows Germany down the same road then we will certainly know it isn't.

So what could be driving all this. Well, as Claus Vistesen and I have speculated, ageing populations and the demographic transition may well have something to tell us here. Using Modigliani's life cycle saving and borrowing idea, and the Swedish demographer Bo Malmberg's idea of population "ages" (child, young adult, middle aged and elderly), Claus has prepared the following chart in an attempt to illustrate the process.



Of course, all of this at the moment remains at the levl of hypothesis. I tend to use median population ages as a rough and ready measure of ageing, and (even though I wouldn't want to claim any precision here) it is interesting to note that both Germany and Spain have started to transit off towards export dependence at around the 40 median age point.






Still, this is early days yet, and we will know a lot more in this regard when we see how the different countries all along Europe's periphery perfom in the years to come. Will they, as the IMF and the EU Commission seem to assume, go back to being consumption driven, or will they be condemned to follow the German path? Certainly Hungary, to take just one example, seems to look more and more as if its economy which desparately trying - but so far unable - to transform itself into yet another Germany.

Real Devaluation

The worrying thing looking at the above inter-country comparison is how much larger Spain's correction is going to need to be than Germany's was. As Wolfgang Munchau pointed out in the FT yesterday, Germany entered the eurozone at an uncompetitive exchange rate and embarked on a long period of (quite painful) wage moderation and deep structural reform. In fact, Germany entered the Euro with an excahnge rate which was too high, give the new role exports were going to play in economic growth. The German adjustment can be clearly seen in the REER chart below, as can the very large adjustment that Spain will have to make in comparison with the German one.



When macro economists say this will be "painful" they don't do so to be sadists, they say this since they know this is going to be hard, very hard. And doubly so when almost all those responsible for taking policy decisions at all the respective levels seem to deny that it is going to be necessary. I have advanced two suggestings (a systematic reduction of 20% in wages and prices in Spain, or a temporary exit of Germany from the Euro Zone). Since neither of these have gained any traction at all, it is reasonale to assume they are now not going to happen (at least in any orderly way). But the car is still heading full speed towards that brick wall. When it finally does crash, will the Queen of England once more say to Luis Garicano, "but tell me Luis, just why was it no one saw this coming?".

Thursday, August 26, 2010

Chart Of The Day: How Spain's Stimulus Money Helps Germany Achieve Record Growth

Well, here's a nice way of putting things. Spain did less badly than expected in Q2 2010 as compared with a year ago, since in Q2 2009 it actually did worse than it initially appeard (following a downward revision in the data). Well, that's one way to improve, push the past backwards.

On a more serious note, the detailed data on the second quarter are now available for Spain, and interesting reading they make. Basically, what little improvement Spain did manage to achieve (0.2 q-o-q, -0.1% y-o-y) came from domestic demand and not exports, while the external trade balance deteriorated. Exactly the opposite to what you want to happen.



As the statistics office (INE) say: "On analysing the two large components of Spanish GDP from the perspective of expenditure, a similar pattern of performance could be observed as in the previous quarter. Thus, on the one hand, the negative contribution of domestic demand to GDP decreased two points and three tenths in this quarter, from –2.8 to –0.5 points. Whereas, in contrast, foreign demand decreased its positive contribution to the aggregate growth one point and one tenth, from 1.5 to 0.4 points".

In other words, all that deficit spending money is simply getting wasted, and there is no competitiveness correction taking place. In the midst of a huge potential export boom, Spain's economy is growing thanks to domestic demand, as the trade deficit deteriorates.



So one very simple way of putting this, so everyone can understand, is that the Spanish government is running a double digit deficit, and one part of the money spent is going straight out in additional imports which (among other places) come from Germany. That is, Spain is getting itself even more into debt to lend a kindly helping hand to the German economy. In theory, the exact opposite was to happen, and the German expansion was supposed to help Spain's net exports. But Spanish industry isn't, well you know..

And just to remind us, here are the respective industrial output charts I published in this post.





So when are people at the EU Commission and the IMF going to finally wake up to reality? This isn't going to work like this, and Spain needs to adopt concrete measures to restore competitiveness, and not find ever more ingenious ways to kick the can even further down the road. Either that, or we will all live to regret our own inaction one of these fine days.

New Series Of Spain Podcasts


Here's a sort of summary from Matthew of what goes on.

The short version: market reaction so far this year has, as always, been irrational, underlying indicators are not in a good place and Spain has no plan to replace the construction industry as the engine of its economic recovery.

* Spain, Greece and the EU bailout package;
* The madness of the markets and rational analysis of underlying factors;
* Is there any basis for the current apparent economic and financial calm?
* Important changes in the role of the ECB and its relationship with sovereign states;
* The impact of cuts announced by Zapatero in June;
* Spanish banks reliance on ECB funding and moral hazard;
* The civil service wage cut announced in June is not really a wage cut;
* Car sales in July were down 30% on June, after the Spanish version of cash-for-clunkers was withdrawn and VAT rose 2%. Is that indicative of what the rest of the economy might look like if we took away government stimulus?
* The effect of the VAT rise on consumer behaviour and the real-estate market;
* Inflation, deflation or stagflation?
* There’s no plan to replace the weight of the construction industry in the make-up of Spanish GDP. Could tourism replace the construction industry in Spain’s GDP?
* Europe and the IMF are not being harsh enough on Spain;
* The Spanish government’s hope of reaching 2.7% GDP growth and 3% deficit targets by 2013 is totally unrealistic;
* The north-south economic divide in the eurozone;
* What happens to Spain when the ECB starts raising interest rates and monthly mortgage payments start rising again?

Sunday, August 22, 2010

How Many Times Can One Driver Fall Asleep At The Same Wheel (And Live)?



“Break the thermometer, then you won’t have a fever.” - Former Polish President Lech Walesa

Watching the TV news here is Spain at the moment is often a rather discomforting and sad affair. The normal menu seems to consist of a constant stream of ministers who have to appear before the cameras and the public to explain something that they, in all fairness, don't really understand themselves. And so it was on Saturday, as I tucked into my early morning breakast of sausage and beans (Catalan style) in the village near my mountain retreat, there in the background I could see the face of Spain's Labour Minister Celestino Corbacho (photo above), giving details to the assembled press corps of the latest government decision to make another six month extension for the 426 euro monthly "exceptional" payment for those whose unemployment benefits have run out. Why there are so many unemployed in Spain, and why renewing this subsidy is now an almost permanent necessity (this is now the third time that this "temporary" means of support has been extended), or what the real prospects of creating enough jobs to start reducing the unemployment mountain any time in the foreseeable future, was not explained. Well, the future is not ours to see, so "que sera, sera".



Of course, the decision to extend the payment is to be welcomed not rebuked, but it is the set of circumstances which makes the measure necessary which is so worrysome, and the feeling that the country whose economy these ministers are responsible for managing is now more akin to a ship in mid Ocean, where the steering tackle is jammed and the captain has neither the faintest idea in which direction land is to be sought, nor knowledge of the appropriate wavelength across which to send out a Mayday rescue call.

Truth be told, the same could be said about the Spanish government decision - announced last Wednesday - to restore some €500m cut from the state infrastructure investment budget for next year as part of a slight "easing" of its austerity plans. An easing which Minster Salgado was only too quick to inform us would not change the governments "complete and unwavering" commitment ti fulfil its promises by reducing the annual budget deficit in line with agreed targets.

Of course, this increase could easily be justified as a measure to take some of those unfortunate people who find themselves stuck on the unemployment register out of the never-ending dole queues, but still the doubts remain. Herman Van Rompuy admitted earlier this year that the Euro Area administrators had "fallen asleep at the wheel" over the last decade in allowing the severe competitiveness problems many economies now face to come into existence in the first place. But, following the calming of the markets in May with the ECBs decisions to maintain emergency liquidity provision and intervene in the secondary bond market, together with the creation of the European Stability Fund, could it not be that the drivers are not one more time lurching soporifically over those very same steering wheels?

Certainly there is a real nonchalance at the moment about budgets which are based on hopelessly unrealistic government growth forecasts, but then again, as Mr Zapatero well knows, any oversights can well be contained by balooning just a tad more Spain's rising mountain of off balance sheet debt (see my extensive post on this last week). Or then again, as PSOE Municipal spokesman Antonio Hernando explained to the press agency EFE in an interview today, the government is planning to make credit lines available for Spain's hard pressed local authorities to pay off some of their short term arrears via an institution known as the Instituto de Crédito Oficial (ICO), so effectively debt will be melted down in one place, only to be accumulated in another.

Of course, as Economy Minister Elena Salgado stressed when announcing the extra package (which for its magnitude is, of course, sheer tokenism) the additional €500m in spending – which represents only about 0.05 per cent of the country’s gross domestic product – has been made possible due to the falling cost of servicing Spain's debt as interest rate spreads drop back from their May highs. But isn't this, surely, short-termism and short-sightedness at its very, very worst.

And especially if you look at how the spreads are being reduced. In the first place Spain's banks have been massively increasing their borrowing over at the ECB.



And in the second place, as explained in this article here, the government has been increasingly resorting to the social security reserve fund to buy its bonds.

In fact, the argument about Spanish bank borrowing over at the ECB provides us with one good illustration of the quaint Spanish custom of permanently moving the goalposts in argument when the going gets tough. Back in June 2008 MAFO (Bank of Spain Governor Miguel Angel Fernandez Ordoñez) was arguing that Spain's Central Bank was meticulously targeting around the 8.3% of total borrowing level which constituted the % participation of the BdE in the ECB capitalisation. He did so when speaking before the Economy and Taxation Commission of the Spanish Congress (June 24 2008 - see this file page 9) and he stated explicitly that Spanish banks had increased their participation in eurosystem fundings, "without going far beyond the equivalent participation in the key of the Bank of Spain in ECB capital". As he says in Spanish "elevando su recurso al Eurosistema...sin alejarse de la participación equivalente a la “clave” del Banco de España en el capital del BCE".

Well when this target didn't hold, we moved on, and by March 2010 José Viñals (the Bank of Spain's "man" over at the IMF) was arguing that such ECB dependence on the part of Spain's banks was not really troubling, since it was, after all, only proportional to the share of Spanish GDP (13.5%) in total Euro Area GDP. Fair enough, you might think, but then in June this year the proportion shot up to 24%, and then in July to 30% (no wonder interest spreads have been coming down), but all, I am sure is "normal" and explicable, if only you are constantly willing to move the goalposts far enough.

But just to show us that not everyone is currently falling asleep at the wheel, the Euro did hit a five week low of 1.2673 to the USD on Friday, after European Central Bank council member Axel Weber said the ECB should help banks through their inevitable end-of-year liquidity tensions before determining in the first quarter of 2011 when to withdraw emergency lending measures. “Most of these discussions about the continuation of the exit I think will be focused on the first quarter,” he said in an interview with Bloomberg Television in Frankfurt. “It’s clear that we need to re-embark on a normalization procedure.” Re-embark would be the keyword here, since it implies that at the current point we aren't on one, nor is it envisaged we will return to one anytime this year.

Indeed Weber added that it would be “wise” to keep full allotment in weekly, monthly and three-month refinancing operations until after the end of the year, while six-month loans should be allowed to expire. Monsieur Trichet and his governing council have guaranteed unlimited seven-day loans, the main plank of ECB’s emergency policy, until October 12 and unlimited three-month loans until the end of September. Additional details on the bank’s timetable after that will await, in his preferred expression, "rendez-vous" in September.

Going back for a moment to the Spanish administration's tendency to move the goalposts, we have also seen a permanent chorus of complaints from them that using Reel Effective Exchange Rate data to assess competitiveness is not valid or relevant in the Spanish case (those on whom this data fall negatively rarely are prepared to accept it has any), since Spain's export sector has been well able to retain its share in global exports despite the distrortions produced by the property boom. Fine! Perfect! But then how the hell do you explain the difference between these two charts?





The difference is evident, even to the least well-trained eye. Spain and Germany face the same external demand conditions, so why is German industry reacting like a rocket launching itself off a ramp, and Spanish industry responding like a limp dinghus in receipt of only the mildest of mild stimulation? Come off it, Spain's industry has a long (or as Jimmy Cliff would have it "hard") road to travel before it can step into the ring with its German counterpart. All that the arguments we have been hearing so much of recently actually do is encourage complacency (you know zzzz at the wheel), while what Spain needs is a call to action.

But going back to the pension system, the reserve fund this year has something like 64 billion euros at its disposal. In 2007, the share of the total which was invested in Spanish bonds was somewhere under 50%. At the present time this proportion has shot up to nearly 90%.
At the end of 2009 (when the fund held 58 billion euros on behalf of Spain's pension contributors) some 44.53 billion (or 76.27%) were in Spanish bonds. This left 13.486 billion euros which was distributed between Dutch (39.56% of foreign holdings), French (30.49%) and German (29.95%) bonds.

So the proportion of domestic bondholdings has been creeping up during the crisis, and his year, the Comité de Gestión del Fondo de Reserva has, in its wisdom, decided to go even further, and invest another 5.191 billion euros in bonds. At the same time some 3.256 billion euros currently invested in foreign bonds will mature. According to official sources, cited by the Spanish publication Cinco Dias, the combined total will be invested in Spanish government debt, and as a result, according to estimates from the Secretary of State for Social Security, Octavio Granado, nine out of every ten euros of Spanish pension savings will be invested in domestic government debt. Whether Spain's future pensioners have their savings adequately hedged at this point, I will leave you to judge. The key point to grasp, is that these 58 billion euros or so (nearly 6% of Spain's GDP) do not count towards the Maastricht debt (EDP criteria), simply because they are help by another government agency.

So, let's be very clear what is going on here, as we now enter the fourth year of the crisis in Spain (with no end in sight), Spain's banks (aided and abetted by their representative at the IMF, José Viñals - see the Global Financial Stability Report he editied, with the Appendix on Spains banks prepared under his auspices last April,) are taking a huge gamble on behalf of the 46.9 million Spanish residents (and the rest of the citizens in the Euro Area when you come to think about it). Viñals in the GFSR seems to pretty much buy the line that banks are good managers of real estate and that prices will eventually go up again. As the report says: "Over the last two years, given the ailing state of the real estate and the construction sectors, Spanish banks have increased the use of debt-for-property swaps to manage their credit portfolios efficiently, trying to maximize asset value recovery. This practice helps banks in managing of their credit risk portfolios and minimizes losses, provided that property prices stabilize in the medium term and banks can sell those assets at their book value."

So what the spokespeople for the Spanish banking system imagine is that what we have in front of us is a repetition of the crisis which hit Spanish property (after the end of the Olympics boom) between 1992 and 1995, and it is this feeling of "self certainty" which encourages them to continue adding to their property holdings almost indefinitely (since after 1996 they were even able to sell the property accumulated at a profit). They refuse to accept that this time it IS different, they cite the presence of a global crisis almost as an excuse, refuse to see that this makes it far more difficult for Spain's economy to recover, refuse to accept that Spain's industrial infrastructure has become badly distorted in a way which will require years to put right (given the limitations of the Eurosystem), and feel cushioned by the large reserves the built up under the dynamic provisioning system they instituted following their earlier experience, and, most importantly of all, they want to hear nothing of any possible 20% reduction in prices and wages (internal devaluation), which would, of course, lead to a huge impairment in their mortgage book.

Naturally, what is going to happen if we reach 2015, there is still no sustained return to growth, unemployment remains near today's very high level of 20%, and house prices keep falling (and incidentally, not all offialdom buys their "this time it's the same argument - here's a link to a recent working paper from the Bank for International Settlements which predicts a fall in Spanish property prices of some 75% between now and 2050, simply for demographic reasons) they don't seem to ask themselves. Or maybe they do. Maybe at that point they will simply come out and say, sorry we made a miscalculation, can we have a bailout please (knowing that Spain is, effectively, "too big to fail"). So they are effectively playing Monte Carlo rules, with all the risk being assumed elsewhere (including, as I say, by those who week-in week-out are contributing to the pension system).

So the interests of Spain's bankers (and the government which seems to be bending to their will) and those of the Spanish population at large (which are for a rapid return to economic growth, and job creation) couldn't be more diametrically opposed at this point.

Coming back now to the delicate issue of pensions, it is interesting to note that only last week a group of EU member states in central and eastern Europe, plus Sweden, made a direct appeal to Europe's leaders to take into account the cost of pension system reform when assessing debt levels.

Basically the issue concerns those countries who have, in recent years) introduced funded pension schemes (or second pillars) that invest and generate money to future pensioners using the funds saved by contributors over the course of their professional careers. This is a major departure from the so-called pay-as-you-go schemes, where the money contributed by employees is immediately distributed to pensioners as payments.

Now, as all parties recognise, the phasing-out of the pay-as-you-go system will take decades. Once it’s over, governments should be able to play a much smaller role in making sure there’s enough money to pay pensions. In the meantime, the state has to subsidize the old scheme that’s left without much of the current revenue from people in the productive age. In most cases, governments issue more debt to keep monthly payments going to current pensioners.

The problem is that during the transition period a double burden falls on the pension system, since contributions are diverted (or at least partially) to fund future liabilities, while current liabilities still have to be met. Simply passing all this over to taxation is not desireable, since after years of ultra low fertility many EU countries now have very "thin" younger generations, and the burden falling on their shoulders may either make job creation very difficult (due to the prohibitive costs) or lead many younger people to emigrate to "younger" countries where the burden is lower, producing negative feedback effects, which ultimately may make default inevitable.

So Lithuania, Latvia, Bulgaria, Sweden, Slovakia, Hungary, Poland, Romania and the Czech Republic have made their appeal, as the WSJ blog report on the topic says, they are effectively asking for the accruing debt to be swept under the carpet (just like so much of the other debt we are looking at), but as the countries concerned stress, they are effectively being penalised by the Eurostat criteria for carrying out reform.

This means those who have not reformed have little short term incentive to do so. Which brings us back to Spain, and its much vaunted pension reform. Spain's system is effectively a hybrid one (in the sense that there is a small reserve fund), but given the massive ageing which is about to take place in Spain, on the existing parameters the fund won't need that long to start going into negative numbers (there is quite a lot of dispute about exactly how long - obviously this depends on the level of economic growth and the number of contributors).

So the plan is to increase the working life for each contributor (retiremnet age rises from 65 to 67), and reduce the level of pension (in relation to lifelong income), by changing the credit criteria. Well, all this is fine, but what Spain really needs is a full second pillar (along the lines say, of the Dutch or Norwegian ones), with an independently administered fund (ie one which doesn't invest all the savings held on behalf of Spain's citizens in Spanish government bonds). But as the Eastern countries suggest, the short term costs of the transition rise as the population ages, so countries (like Spain, unfortunately) get locked-in to the current, ultimately unsustainable system. Even though life expectancy rises, potential active working life does not seem to lengthen to the same extent, so there are limits to how high you can keep pushing the limit.

As a piece of short term expediency, Spanish policymakers effectively turned a blind eye to the massive irregular inward migration which occured during the early years of this century (and there were ultimately two "amnesties" to resolve the problems which were building up).



This worked for as long as it did, but now the migrant flows are begining to reverse direction, as able bodied migrants head elsewhere looking for work, while dependent relatives arrive as part of the process of family regroupment.



My point here is not an anti-immigrant one - having an inflow of migrants can help sustain the elderly dependency ratio while the pension transition takes place (if it takes place) - but if you have an unsustainable economic model, and then you enter denial when it becomes clear that this model is unsustainable, then obviously simply encouraging inward migration does not solve your problems. Especially if the job market collapses, as it has done. As we can see in the chart below, the number of contributors to the Spanish Social Security System has been falling continuously since th start of the crisis, and there is no sign of this trend turning the corner.



So to come back to the original issue, Spain's debt to GDP is obviously, in reality, rather higher than is being admitted publicly (or measured by Eurostat).

A request for clarification from the Bank of Spain as to the methodology involved in the Financial Accounts they published, both clarified and didn't clarify the key topics. The Bank say that there is no available document which briefly explains the differences between the concept of debt according to the Excess Deficit Procedure (EDP) and total liabilities shown in the financial accounts. However,they do say the major differences are due to fact the EDP debt that does not include accounts payable, that liabilities are deducted for debt movements between public authorities (the social security fund issue)and liabilities are valued using their nominal values rather than their market values.

On the other hand, they make plain that the debt of public corporations is not included in the EDP calculations (nor it seems in the Financial Accounts). So there is something like 50 billion euros in debt (or 5% of Spanish GDP) lingering around on the public corporation balance sheets.



The Bank of Spain also state they do not keep any data on PPPs. At the present time I am trying to identify who exactly does in the Spanish case.The issue of PPPs is a complicated one (I have a post on the whole topic here). Basically PPPs often work on the basis of accounts receivable (see this wikipedia entry for a description of what is involved, and this supplement on "factoring" since PPPs in many cases with public authorities are a form of factoring). Basically, PPPs work like this. You want to build a new motorway, or a hospital, or a "city of justice" (the Barcelona case), and you either don't want to, or can't, accululate more debt. So you seek private finance (Berlusconi's bridge to Sicily probably incorporates some element of this) and agree to pay for the use of the facility (per user), with the unusual detail that, as opposed to the typical "toll" system, where there is a stream of income from the users, the public agency meets the obligations out of current income. This system (in the toll road case) is known as "peaje en la sombra" (or shadow toll) in Spain.

Of course, although no debt is formally incurred, the "virtual" debt still has to be serviced, which means there is a constant drain on revenue, and since the securitisation normally implies some sort of "super senior" status for loan, then what happens is that paying these become a priority, while obligations to real current suppliers, where there is no such securitisation, go to the back of the queue, with the obvious consequence that arrears in the normal accounts payable simply pile up.According to Spain's Financial Accounts, there were some 73 billion euros (7% of GDP) of these in the entire government system at the end of Q1.



For those who are still not clear what this is about, here's a chart I found from a road show promoting the PPP model, which shows a list of advantages and possible applications. And among the advantages of the system is, of course, that it largely falls outside the current Eurostat EDP accounting system.



And here is a photo of Spain's Public Works Minister José Blanco (and friends) beaming away at the camera over at the offices of the Instituto de Credito Oficial (ICO) after signing a PPP type deal with banks and builders to reinstitute 17 billion euros in cuts from his department via another route. The agreement was signed in April (see Spanish press release here, strangely there was no version of this on the English language website), and although the plan seems to have been temporarily shelved at the moment, it wouldn't be surprising to find - during the renewed bout of "sleeping sickness" from which our institutions all seem to be suffering - the plan were being suddenly reactivated again.



So, as I ask at the start of this post, just how many time can one driver fall asleep at the wheel and live? Well, looking at Mr Zapatero and his administration the answer obviously is, many. They seems to have more lives than the proverbial cat. And when we come to those inspectors at Eurostat, and the new debt vigilantes at the EU Commission, the answer would also seem to be, quite a few, since the loopholes described here are obvious, and must be known to all, and yet nothing (so far) seems to be being done.

Spain's debt for 2010 according to the EDP is expected to reach around 77% of GDP (EU Commission spring forecast), and while we feel it is still possible to agree with the IMF when they say that that "Spain’s (public) debt ratio is low compared with many other countries in Europe", it is only possible to do so if we do not forget that if we add in the 6% that is held by the Social Security Fund, the 7% that has built up in Accounts Payable and the 5% owed by Spains Public Corporations, we end up with a total of something like 95% debt to GDP, which is, of course, above the average. And this is not to even begin to count all those impending pension liabilities.

But getting through to the bottom line now, my big beef in all of this is not that the Spanish government has been spending so much money to address the current crisis, it is that it has spent so much money, and NOT EVEN BEGUN to address the roots of the crisis. That is the ultimate condemnation of what has been going on in Spain, and is the question which generations of Spaniards to come will be wanting to put to their predecessors.

Wednesday, August 18, 2010

Controlling The Uncontrollable: Spain's National Addiction To The Use Of "Dinero B"

Well, before we go any further, I would like to make clear that what I am going to talk about in this post is not anything illegal, or even irregular (things like this must be going on in almost all Euro Area countries even as I write). Bending of the rules? Perhaps. Taking them to their limit? Certainly.

What Spain's central, local and regional government does is take advantage of loopholes in Eurostat accounting regulations to generate debt that really is debt, but is not classified as such according to the Eurostat excess deficit criteria. Key areas involved are debts on the balance sheets of state (or regionally, or locally) owned companies, overdue payments for receivables (very common practice in Spain), and public-private-partnership-type leaseback-arrangements. None of these are (typically) classified as debt, though they do all have to be paid at some point, which means there is a stream of revenue (flow) impact rather than a debt (stock) one (unless and until Eurostat changes the rules). Which means that while they do not impact that critical debt to GDP number, servicing these liabilities does exaccerbate the annual fiscal deficit one. Which is why ultimately bringing Spain's fiscal deficit under control will almost certainly prove to be much harder work than it seems.

We are able to make this comparison since the Bank of Spain effectively maintains a double entry book keeping system, whereby it keeps one record under the National Financial Accounts of the total debt , while at the same time keeping a separate record of debt as classified for the EU Excess Deficit Procedure.

As we can see in the chart below, total gross government debt in Spain as classified in the Financial Accounts was some 751 billion euros (or around 75% of GDP), as compared with the 585 billion (or around 58% of GDP) in gross debt recognised under the EU excess deficit procedure classification.

Now if we look at the chart below, we will see that the proportion of Spanish national debt which remains outside the Eurostat classification system has risen since the introduction of the euro - from 14 to around 23 per cent - but most of the increase actually took place in the run up to the crisis. So as Spains funding problem has deteriorated, there does not seem to be any direct evidence that this has impacted the level of "non-accounted" debt, it has simply remained the same (in % terms). Of course, as the debt itself has balooned, so too has the "dinero B" part.


In the case of the regions (Spain's Autonomous Communities) the position is not that different - the % has increased from 12% in 2000 to around 25% at the present time - even if there is rather more evidence of "stress" on their finances after the start of 2008 (see chart).



The position of Spain's local authorities is also similar - with the proportion of "non-accounted" debt rising from 14 to about 23% - although again, there is even more evidence of post-crisis financial stress if we look at the gap between the two lines, and how it widens, which is none too surprising when you consider that it was the local authorities who lost the biggest chunk of their financing with the collapse of the construction boom. Indeed, it is my impression that in this case the gap only hasn't widened further due to the fact that very few people are now willing to give any sort of credit to Spain's local authorities.



As I indicate, one of the easiest ways of "kicking the can down the road" in terms of public finances, is to delay payment on receiveables (if you are not sure what receivables are, check this wikipedia entry), and the following charts show the relentless use of this procedure in Spain, despite the promise of Spain's government to bring short term credit under control by 2013, there is no sign of this happening to date.



The other big area of "non-accounted" debt, is that accumulated by governmentally owned or "satellite" companies (who may for example run public transport, or outsourced cleaning services for local authorities). As can be seen from the charts below, this debt has increased massively since the crisis started.






As I say at the start of this post, none of this debt is hidden, nor is it illegal under Eurostat regulations, so there is nothing (in principle) out-of-order here. This fact doesn't make the situation any less preoccupying, since one way or another all this debt will have to be paid. What its continuing presence does, I think, indicate, is the existence of some degree of "laissez faire" attitude towards fiscal targets on the part of the EU Commission and indeed the IMF (as I argue in this post, it is hard to understand the IMFs own Spain growth forecasts and CA deficit levels if they are not assuming a rather higher level of indebtedness into the future than anyone is prepared to admit right now) . The May measures are deemed to have worked. Europe's Soveregin Debt Crisis is, if not over, at least in abeyance.

Symptomatic of the current "relaxed" state of things is the fact that only last week José Luis Rodríguez Zapatero, the Spanish prime minister, even started to air the possibility of reversing some of the spending cuts his government announced in May. In a cautious statement, which the FTs Victor Mallet reports was apparently aimed at testing the mood of financial markets, Mr Zapatero said the government expected to restore some suspended infrastructure investments if – as the government anticipated – renewed financial stability left room for manoeuvre in the 2011 budget. There is nothing here about growth, please note.

“In 10 to 15 days we will be able to give some positive news in relation to restoring investment activity in infrastructure, which will affect most regions and would provide relief, an important boost, to construction companies,” he told a news conference in Mallorca after meeting King Juan Carlos at the monarch’s summer residence.


A €6bn cut in public sector investment was among the biggest austerity measures announced by Mr Zapatero in May to coincide with the EU and IMF announcement of a €750bn financing facility for the eurozone.

Despite the fact that among the evident losers in what was effectively a "U turn" at the ECB in May were the monetary hard-liners like Jürgen Stark and Axel Weber, you obviosuly can't keep a good man down, and European Central Bank Executive Board member Stark was out again on Monday, warning in the columns of the Financial Times that the European Union is all set to ramp up economic surveillance to prevent a repeat of the region's recent debt crisis. "A new framework for macroeconomic surveillance will monitor whether national trends are compatible with those that are appropriate for the Union as a whole", he said. "This framework will allow both targeted peer pressure and differentiated and more binding recommendations on follow-up action at the national level."

All I can say looking at the above numbers is, there isn't much sign of any of this being operational yet, but then, as I say, the Jürgen Starks of this world have rather had their noses pushed out of joint in recent weeks.

Saturday, August 07, 2010

One Chart To Rule Them All, One Chart To Find Them (Out)

Look, if there is one simple chart which sums up everything that is wrong with current thinking at the International Monetary Fund, then it is this one.



Basically, I spent much of the day yesterday scratching my head, trying to work out how the hell the IMF could be forecasting Spanish GDP growth of 1.7% in 2012, of 1.9% in both 2013 and 2014 and 1.8% in 2015. And now it has dawned on me how and why they can. Quite simply they are forecasting current account deficits for Spain of 5.3% of GDP in 2010, 5.1% in 2011, 5.0% in 2012, 5.0 in 2013, 5.0% in 2014%, and 5.0% again in 2015. In other words, the assumption is that nothing fundamental is going to change in the post 2008 world, when compared with the years that preceded it. And this is clear when you come to look at the whole structure of current account balances revealed in the chart above, which are based on the IMF forcasts through 2015 as set out in the April 2010 World Economic Outlook. It is a case of plus ça change.

And all this becomes even clearer when we see that it isn't only Spain where the current account deficits are going to persist, since they are also expected to continue in the US, and the UK. The structural surplus countries China, Japan and Germany - will also continue on their path, as if nothing important had happened. Which means the global imbalances will remain just the way they were, untouched and unmolested by the crisis - OK, some of Spain's most severe "excesses" will be gone, since the deficit will fall from 10% to "only" 5% - and I can't help asking myself, wasn't that how we got here in the first place?

The thing about these CA deficit assumptions is that they effectively make the argument a circular one. You don't start with the real growth potential of the Spanish economy (that was what had me scratching my head yesterday about the degree to which the export sector could rise to meet the challenge). Now I realise I was wasting my time. The export sector isn't going to have to grow, since Spain is going to continue to run a trade deficit, out into the future and as far as the eye can see, it seems.

But the interesting question to ask is what exactly the current account deficit is going to be for. I mean, who exactly is going to be doing the borrowing that it will be funding? What has happened in Spain has been the result of what some have termed a "causal reversal", since in the current case it is the capital inflows (borrowing, made possible by structural surpluses elsewhere in the Euro Area which lead to comparatively cheap interest rates) which produce the current account deficits, rather than the the normal balance of payments problem where growing deficits lead to the need to borrow. And it isn't hard to see evidence for this kind causal reversal in the Spanish case. Under normal circumstances when a growing current account deficit produces the need for external borrowing, the exchange rate tends to fall, and the interest rate charged rises. In causally reversed situations, the currency tends to rise, and the central bank holds rates down to try and discourage the arrival of evn more liquidity.

In Spain, there is no exchange rate to fall, and interest rates are set elsewhere - over at the ECB, and in the Euro Area interbank market - but still the funds arrived (via the interbank market) to meet the mortgage needs of a Spanish citizenry who were rather light on savings. Spain is, in fact, relatively insulated from current account pressures on both the above fronts, or at least it was. Then, of course, what was called the "European Sovereign Debt" crisis set in, and the interbank market seized up (effectively closing its doors to Spanish banks) while spreads on government bonds started to rise. In the Spanish case the term "Sovereign Debt" crisis is a complete misnomer, since as many commentators tirelessly point out, Spanish sovereign debt (at this point) is comparatively low by European standards, and what Spain is suffering from is a "Private Sector Indebtedness" crisis. Which is what makes the assumption of ongoing current account deficits look rather odd, because it leads me to ask: who exactly is going to be doing the borrowing that will produce the current account deficit, the private or the public sector?

If it is to be the latter - and I can't avoid the conclusion that it is going to have to be - then it suggests to me that the IMF are already assuming that Spain's fiscal deficit is going to be above the 3% level for considerably longer than up to 2013. Let's have a look and see.

Private Sector Debt

Spain has accumulated a very high level of net external debt. It currently hovers somewhere around 90% of GDP (see chart below), and continues to rise (naturally, that current account deficit), even as GDP hardly moves.



Private debt (both corporate and household) is large, and shows no signs of reducing significantly. Corporate debt currently stands at around 125% of GDP, and while it is down slightly (2.1% in June) on an annual basis, it has remained pretty stable during 2009 and 2010. With Spanish company indebtedness well over the European average, and the economy at best lithargic, their accumulating more debt at this point seems very unlikely.



Household debt stands at around 85% of GDP, and while it has been more or less stationary since mid 2008, even this has started to rise again even if ever so slightly (it was up an annual 1% in June). Some see this as a sign that credit is moving again, and thus a positive feature, but if Spain got into the mess it is in becuase its households became overindebted, accumulating yet more debt seems an unlikely solution.



The Dependence On External Credit Grows, Rather Than Reducing Over The Forecast Horizon


As I explained in this post, the slight GDP growth which was obtained in the first quarter of 2010 was primarily as a result of improved internal demand, and the net trade impact was negative (see chart below).

And this is hardly surprising given that the trade deficit has deteriorated.



And it would not be surprising to see the same pattern (of slight growth, largely supported by internal demand) being repeated in the second quarter, given that the trade deficit seems to have deteriorated further. And of course, the improvement in the current account position that was so evident in the middle of 2009 has now come to an end - but then the IMF seem (at this point at least) to be more or less resigned to this situation (although I can't for the life of me understand why they are).



Basically, the only serious reading which can be given to the IMF current account deficit forecast is that someone - the ECB or that new European Financial Stability Facility which conveniently came into official existence on Friday - will be intervening in the markets to provide the liquidity to make it possible to fund the deficits, although again, and for the life of me, I can't understand why they should want to do so.

And as I suggest above the only sense I can make out of those 5% annual current account deficits is that the government will be doing the borrowing to make them possible (via larger fiscal deficits than are currently formally anticipated) since I can't realistically see the private sector being willing and able to assume the debt that will be required - and especially if they start to raise interest rates at the ECB. Really I am not sure what is going on here, since I'm sure I can't be the only person around who is capable of making these (fairly reasonable) deductions. So if it is the investing community you want to convince, rather than the general public with nice headlines, something a bit more rigorous is really required.

But then, at the end of the day, the forecasting process probably got itself stuck, between the need to show reasonable growth rates, and avoid consumer price index readings that smell of deflation - so they end up projecting inflation of a little over 1% a year between 2011 and 2015 - and of course, if you do that, there is no way you are going to get a goods trade or current account surplus, since the misalingment in Spanish prices is just to great. So here we are. My feeling is that all this will only go on for as long as it does, and one of these days the Spanish government, the IMF and the EU Commission will find themselves trapped between an angry group of those so-called "bond vigilantes", and an even angrier group of Spanish voters, who will be demanding "Hungarian style" just why so many years of crisis and austerity have only served to get them even deeper into debt. At that point I don't think I especially want to hang around to see what gets to happen next.

Postscript

Of course, another way to get demand side growth is to get job creation, but this is a chicken and egg argument, since you are not going to get job creation without an increase in final demand to encourage employers to take on the extra labour (with or without the tepid labour market reform which will only influence flows and not stocks). This is the error that many micro-economists who only focus on supply side issues fall into - they forget the key role played by aggregate demand.

The latest news on this front is that affiliates to the social security system continue to fall (on a seasonally adjusted basis), and hit 17.6 million in July - down by just under 10% from the 19.4 million peak in January 2008.



Evidently, failure to reverse this trend has implications for the social security system as well as for growth, which brings us to another curious detail about the IMF forecast, they make no projections for employment or unemployment post 2011, which makes you wonder where exactly the growth forecasts come from, since if you don't assume job creation, and I think they are right not so to do, then the relatively strong GDP growth projections stand out even more strongly.