Thursday, December 11, 2008

So Just When Does Spain's Twin Deficit Problem Become Unsustainable?

This, it seems, is the question of the day. According to the IMF Spain’s economy faces a contraction of at least one percent next year. And the IMF stress that the risks to this forecast “remain on the downside” since the country’s real-estate market is “in full correction,”. Also, horror of horrors (and we will return to this). The government’s budget deficit will exceed five percent of gross domestic product next year, the Fund forecast.

While the IMF seem to be more aware of the scale of the problem than the Spanish government currently are, they do seem to be putting all of the emphasis for recovery on some much needed labour market reforms, but personally I don't think even these are playing in the right ball park, we need a big picture "breakout" escape plan, to cut loose from the pincers of cash drought, corporate bankruptcy, construction dependency, large scale contraction and price deflation. It's a big mess, and will need an equally bold and ambitious plan to get to grips with it.

One point which is obvious at this stage is that Spanish government forecasting - which has currently built a 1% expansion into the 2009 budget - is getting ever more out of line with the economic dynamic. Really this is the first thing which has to change. Spain urgently needs someone leading the country who is able to turn the page, put some realistic numbers on the table, and try to work to meet objectives, instead of simply failing to achieve them time after time. What do I mean by this, well, if you seriously think that the contraction next year will be of 2% of GDP then it is better to say 3%, and beat your target, than say its going to be 1% growth and come in with a 2% contraction. Not only will your citizens be getting more and more fed up with all of this (and the impact on morale should not be treated lightly) but much more to the point, since Spain is heavily dependent on foreign finance to buy the debt that the government is going to need to issue (see more below) to finance the fiscal deficit, then each and every failure to achieve target is likely to be punished with a higher cost of financing debt (as the yield spread on the risk rises). So as well as the credibility cost, this kind of playing fast and loose with the forecast is now likely to carry a real financial cost.

Of course, in true wooden-bureaucrat style (where are we here, back in the old USSR?) a spokeswoman who declined to be named in line with ministry policy informed Bloomberg that while the Finance Ministry shares the IMF’s analysis of the economic situation, it doesn’t back the specific IMF forecasts on growth and the budget deficit. Obviously the spokeswoman not only decline to be named, she also declined to enter the Byzantine discussion of how it is possible to share the analysis without sharing the conclusions. On the other hand the man who is hotly rumoured to be pencilled in as Pedro Solbes successor in the next facelift - Economy Secretary David Vegara - was rather more elegant when questioned about the estimate by reporters "To me it's reasonable, I always think the IMF and OECD do their work with first class technical groups,". Exactly, although of course, in the forecasting game even the best of technical teams can get it wrong, which is what the IMF allow for when they talk about "downside risk".

Vergara was also of interest yesterday insofar as he specifically denied that Spain faced a deflation problem, although he did admit that inflation was likely to reach a very low level. I think, yet one more time, this is "ostrichism" (avestruzeria), since the drop in prices is now so evident, and the contraction in Spain is going to be so sharp, that Spain has to be the one developed economy where price deflation is now a near certainty, and you can quote me on that. As I go to my local bar for the morning coffee, I always take a look to see whether the 1.15 euros they currently charge for a cafe con leche has been brought down to 1.10 euros. Not yet of course, but when will that happen? In March? In June? I bet it happens before August next year (and I will report). And when it goes down to 1.10 euros, the next move will be 1.05 euros, and so on..... depending on just how long the deflation continues.

So Just How Much Will The Spanish Economy Contract In 2009?

Well, I think this is a very hard question to answer. I think a 1% contraction is a done deal, and my own previous best guess was in the 3% to 5% contraction range, which is, of course, very strong indeed. And there I was happy to leave it, until that is Deutsche Bank came out with their latest 2009 forecast for the German economy, where chief economist Norbert Walter has said that Germany's gross domestic product could contract by as much as 4 percent next year. This has to be "bottom of the range" estimate, but then, it might happen, I mean these are not just numbers spun out of thin air, they are backed by analysis, German manufacturing is contracting very rapidly at the moment (but not as rapidly as Spanish manufacturing). The German government itself is forecasting a 1% contraction, and the IFO institute came out today with 2% contraction for 2009 estimate (the median forecast?). At this point I won't go so far as to modify my original forecast for Spain, but what I will say is that if German GDP contracts by 4% in 2009, then Spain's will contract in the 5% to 7% range, since on every important reading Spain is contracting more rapidly than Germany at this point, and there really is no bottom in sight, just what appears to be a "black hole", sucking us down.

But what About The Sovereign Debt? What Is Going On With All That Government Spending?

This I think is the big point.

At the risk of boring to tears all my regular readers I would first like to stress that what we have in Spain is not a simple garden-variety housing correction. Spain is a country which was allowed across the 2000-2007 period to develop massive macroeconomic imbalances, which to some extent were reflected in a huge housing boom. But the imbalances (current account deficit of 10% of GDP, massive migrant flows - 5 million people in 8 years, rapidly rising household and corporate debt - rising at 20% pa, and reaching around 90% and 120% of GDP in 2008 respectively) and not the housing are the key to the problem. Thus Spain's economy is not reeling under the weight of the unwinding of the property boom, but rather Spain's property boom is reeling under the impact of the unwinding of the macro imbalances, and this unwinding became more or less inevitable once the US sub prime crisis broke out in August 2007. I think it is no accident that the two countries who noticed most the shell shock from the sub prime turmoil were Spain and Kazakhstan, since these two countries were the most dependent on selling some type of paper or other in the wholsale money markets to finance their imbalances, and the doors to these markets effectively closed in September 2007.

So what we need to think about is the impact Spain's financial system problem is having (due to difficulties in financing the current account deficit) on the housing bubble and the construction industry, since this I think is the way the causal arrow works in this case, and not the other way round. And it has been the failure to appreciate this causal chain, in my opinion, that has lead so many people to have had so much difficulty understanding the extent of the problem we have here in Spain.

Basically the housing boom had masked the enormous problem Spain had acculumlated in terms of its current account deficit, for the simple reason the funds which were happily flowing in to fuel the boom meant the books balanced easily enough each and every month. But once people became just a little bit nervous about what was happening to that boom, and how sustainable it was, the flow of funds suddenly dried up, just like that, in September 2007, and the size of the hole in the flagship side suddenly became apparent. Since that time the bilge pumps have been busily trying to drain all the water which has been flowing in, but alas without notable success.

When I say the bilge pumps have been working, I am talking about attempts by the ECB and others to provide liquidity to the Spanish banking system, but if we look at what has been happening to lending in Spain in recent months, we will see that this particular cocktail still isn't managing to reach the parts "the other beers cannot reach". Below we have a chart (based on Bank of Spain data) which shows net additional lending to households on a monthly basis.

What is clear from a quick glance is that lending since June has been virtually stationary, which means basically new funding is being provided for mortgages only at the same rate as old ones are paid up. This effectively means that if something can't be paid for in cash or with a credit card, then it really isn't being sold, and every time less so. To get things in perspective, new lending to households was running at the rate of about 10 billion euros a month up to the summer of 2007. It also means that a business sector which had become accustomed to having new business at the rate of 10 billion euros a month has no found itself with virtually nothing (as I say, simply the business you can do on the basis of recycling the old credits which are being paid off).

But there is new money every month, the CA deficit (which is reducing) is being squared, so where is the new money going. Well that's easy isn't it, it's going to the government to finance the growing deficit, and to Spain's corporates, who need to keep refinancing all that debt, debt which is only mounting, of course, because no one has money to buy the products they want to buy... and why, you may ask, don't they have money? Because the money needs to go to keep the companies afloat, or to fund government rescue plans, to help the firms (possibly via the banks) who can't sell becuse the customers don't have money to buy. Oh, I see.

Of course the solution to this macarbre vicious circle is not to lend the money to the customers who are in any event far to deep in debt, but to reduce the current account deficit which lies at the heart of the problem, possibly by encouraging some people abroad to borrow a bit more money, and then selling them something they need, at a price they may be interested in. It's called "export".

In fact Spanish corporates received a net 19 billion in additional lending over the three month July-September (while households received a net 800 million) but as we can see, all this extra debt isn't moving us forwards very fast, and indeed we are actually going backwards.

As I say, Spain's big problem is the current account deficit, which reached 10% of GDP last year (see chart above). At the present time this deficit is dropping slightly as imports collapse, but it is not falling as fast as it should be, and meantime, as I am saying, the Spanish government is raising its borrowing needs. Spain has movied in 2008 from having a 2% of GDP surplus in January to a 3% deficit in December (ie a shift of 5% of GDP), in 2009 we will move up to at least 5% (as the IMF suggest, and we could even move higher depending on what happens to GDP).

The fiscal response has been swift and large. The government has taken 4 percent of GDP in structural measures for 2008-09 to assist the economy-bigger than many EU partners and ahead in timing. Together with automatic stabilizers, this results in deficits of 3 percent of GDP in 2008 and over 5 percent in 2009-a swing of more than 7 percent of GDP in the headline balance (compared with an end-November 2008 estimate of 1¾ percent for the euro area as a whole). While the mission notes the focus in the 2009 package on spending for labor-intensive local public works, the authorities need to ensure that this is channeled to its most productive use. The mission sees this fiscal effort (with built-in unwinding as the exit strategy) as temporarily boosting demand.
IMF Article IV Consultation: December 2008

So in 2010 we could find ourselves with a CA deficit of around 8% of GDP and a government fiscal deficit rising up into the 5% to 7% region. If this does prove to be the case, then I think the financial markets are absolutely going to see red (there are already problems with the eurozone sovereign 10 year bond spreads, see the charts below - click on the image to see it better) and Spain could find itself just where Hungary was in 2006.

As ECB Council Member Jürgen Stark said in an article in yesterday's Wall Street Journal, the environment for conducting economic policies, and in particular monetary and fiscal policies, has now become extremely "challenging". One part of this challenge is going to be the funding of all the extra borrowing that euro-area governments will need to do to make good on all their promised support for the banking system, most notably the funds for recapitalization and guarantees for interbank loans. Stark estimate that to date, the envelope of funds for possible recapitalizations and guarantees amounts to some €2 trillion, or roughly 20% of euro-area GDP. This is a very large number.

As Stark also notes many euro-area governments failed to use the past boom times to consolidate their public finances (although this was not especially the Spanish case). As a consequence, many euro zone governments are now entering the current downturn with high deficit and debt ratios. Given the weak growth ahead and the costs of the bank bailouts, these ratios are inevitably set to rise. Stark estimates that in a year's time the deficits in many euro-area countries will be between 5% and 7%, up from around 3% now, while public debt may rise by 10 to 20 percentage points. Again these numbers are very large, and financing them is going to be, as Stark would say "challenging".

As can be seen from the chart above, interest-rate spreads for government bonds are already high (and rising) in a number euro-area countries, and I would draw special attention here to the cases of Greece and Italy, since they have been constantly warned about the danger of this kind of development. And governments are having growing difficulty selling paper, as both the Netherlands and Austria found out this week. The Dutch government failed to raise as much as it had targeted for three bonds - maturing over five, six and seven years, respectively - while the Austrian government saw one of the weakest auctions in years for 12-year paper. These difficulties highlight the potential problems that may be faced with the vast pipeline of government and government-backed debt following the announcements of big fiscal packages to stimulate economies and bail out banks.

And analysts are warning that while the problem isn't a big one right now, these early signs of stress, following so closely on the back of the announcement of big fiscal stimulus programmes, are a clear warning of potential problems next year when record volumes of debt are due to be issued. More than $1,000bn of government debt is expected to be raised in Europe in 2009, while close to $2,000bn is forecast in the US.

The Austrian government found itself forced to pay 13 basis points more than comparable 12-year bonds for its €1.1bn issue, while the Dutch government only managed to raise a total of €2.46bn for the three bonds being sold after indicating that it wanted between €2.5bn and €3.5bn. Since the Netherlands is normally considered one of the strongest and safest of credits,then frankly this does not augur well.

The thing is, Spain's downturn is now pushing the country's former fiscal rectitude into the distant past of historical memory. Worse, the debt is being levered up, not to buy a piece of the future for a country in the process of a thoroughgoing renewal, but rather to keep one group of already moribund and walking dead corporates alive, just as long as it remains possible to keep selling Spanish Sovereign debt at prices which don't swallow up most government revenue simply paying off the debt. But as those spreads move skywards that point will be reached, most probably in 2011. By which time Spain will be perfectly poised for one of those classic twin deficit national-bankruptcy scenarious financial crisis theorists like to write so much about.

Short-run fiscal policies need to be embedded in a long-run context to explain how the debt can be lowered once the economy stabilizes. Public debt, while still manageable, is poised to jump. To boost confidence in light of high aging costs, the authorities should present a plan how to lower the debt again once activity stabilizes, including with pension reform. The mission encourages the authorities to develop an intertemporal public sector balance sheet for publication in the annual budget. It would show the debt already incurred, and also the present value of the projected stream of future deficits (a forward-looking debt) under unchanged policies. This provides perspective on long-run fiscal sustainability.
IMF Article IV Consultation: December 2008

Keynes once recommended paying people to dig holes in the ground and fill them in again rather than leaving them languishing on the dole. The Spanish government seem to have gone one stage further, they are only paying us to dig the hole, there is no plan to fill it in again, unless that is they have a prepaid contract with Komatsu or Caterpillar to come over (in the eventuality this is needed, which it will be) with some earth moving equipment, and shove the soil back in to bury the lot of us.

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