Wednesday, July 30, 2008

Spain's Retail Sales Down 7.9% in June, Building Permits Plummet

Well, this is now becoming more and more of a nightmare by the day. According to the national statistics office this morning, Spain's inflation adjusted retail sales were down 9.8% year on year in June. In working day adjusted terms this represented a 7.9 percent fall, making it the largest drop on record in Spain, following seven consecutive months of decline.

And there is clearly worse to come, at least till we get nearer to October/November and the low base effect kicks in.

Building Permit Applications Plummet

We also learn today that permits issued for building new houses in Spain plummeted 57 percent over the first five months of the year when compared to the equivalent period in 2007, according to data from Spain's College of Architects. In what is only now one additional confirmation that Spain's decade-long construction boom is now well and truly over, the College said 143,918 permits were granted in the first five months of 2008, down from 336,263 in the same period of 2007.

Basically Spain's economy is like a car cruising down the motorway without any oil in the engine, and one of the pistons about to seize-up. And as of the time of writing no one - in either Brussles or Madrid - seems to have the presence of mind to try to alter the course of destiny.

Spanish Corporates Sell Whatever They Can In the Great Liquidity Race

The real point to get hold of at the present moment is that it is Spain's non-construction corporate sector which is really feeling the pain of the fact that the cash strapped banks can't help them with liquidity. Yesterday it was Iberia who had to look for a swift marriage, and today we learn that media entity Promotora de Informaciones SA (aka Grupo Prisa) - the publisher of newspaper El Pais - have just completed the sale of three buildings for 300 million euros ($467 million). The sale of the poperties to Longshore is expected to generate a capital gain of 227 million euros, the Madrid-based company said in a regulatory filing. Prisa said it will use the funds to reduce debt. Basically, in the present property market, if you are forced to sell to reduce debt, then you really are in trouble.

As can be seen from the chart below, the indebtedness of Spanish corporates is even more important than the indebtedness of Spanish households, and is way above the average for the other eurozone countries.

And today it was also the turn of Gas Natural and Fenosa to stop the trading in their shares, not because either of these utilities companies is in trouble, but because Actividades de Construccion & Servicios, Spain's biggest construction company has a 45 percent stake in Union Fenosa, and it badly needs to sell. ACS is scheduled to post earnings after the close of trading in Spain today, and obviously the outlook is not good, hence the rush to cut a deal before closing today.

Spain's Gas Natural have announced that their board will meet at 14:00 CET today to study a possible bid for ACS's stake in Spanish utility Union Fenosa. Spanish media had been suggesting that Gas Natural would make an offer today for the 45 percent stake at a price of up to 18 euros per share, which values the utility at around 16 billion euros ($25.17 billion). Under Spanish law, the stake buy must be followed by an obligatory full bid.

A widely quoted bank analyst bank has requested not to be named is sayinh: "An 18 euros offer would be 13 percent up on the 15-16 euros mooted up to now, but Gas Natural could stretch to that...But it would have to be a mix of 60 percent in cash and 40 percent via a capital hike...That would take the gearing of the new Gas Natural-Fenosa to about 56 percent, which would be just about at the permissible limit."

Electric Glyde In Blue?

Also today Spanish Industry Minister Miguel Sebastian has announced that the Spanish government aims to have 1 million electric cars on the roads by 2014 as part of a plan to cut energy consumption and dependence on expensive imports

"Electric vehicles are the future and the driver of the industrial revolution," Sebastian said in testimony to a congressional panel.

Now frankly I don't know whether this is sheer science fiction, or a realistic policy. Having a million electric cars on the road would be positive (depending on how you are going to generate the electricity, and how efficient they are), but first you need one million people willing to buy them, and Spain is likely to be in the midst of a deep slump, at least during the first half of this period. So is this real, or isn't it? At this point I don't have the technical expertise to decide.

Tuesday, July 29, 2008

Spanish Mortgage Lending Down Sharply In May, Bank Credit Ratings Increasingly Under Review

Spanish house sales dropped sharply again in May for the fourth month running, official figures showed on Monday, and talk of price declines is now becoming much more general. House sales fell by 34 percent year-on-year in May and mortgage borrowing was down by 40.4 percent from a year earlier, according to the latest data from Spain's National Statistics Institute. The result is rather a shocker since many had obviously been clutching at straws following April's better-than-expected year on year decline in new mortgages of only 7.8%. Reality is, unfortunately, now starting to sink in.

Sales of resale properties appear to be suffering the most, down 44% to 25,280, compared to the 21% fall (to 24,890) in the number of newly built properties sold by developers. This figure is misleading, however, as the INE’s figures are based on property transactions inscribed in Spain’s property register, not new sales achieved by developers, which are down by between 40% and 60%.

To add insult to injury Barcleona property consultant Aguirre Newman have said Spain's real estate market is depressed by anything up to 1.5 million unsold new homes (ie the estimate is now moving up from the earlier estimate of Spanish builder OHL who suggested there were between 500,000 to 1 million new homes in Spain sitting empty and waiting to be sold after overbuilding.). Aguirre Newman also report that the average time needed to sell a residential property in Barcelona has now gone up to 27 months (from 17 months one year ago).

Mortgage Security Credit Downgrades

Last week it was also announced that Moody's Investors Service has put about 16.9 billion euros of Spanish residential mortgage-backed securities under review for possible downgrades after adjusting for rising default rates and slowing house price growth. Moody's say they are in the process of reviewing 68 tranches of 13 deals after updating their model.This issue of downgrades is an important one, since if the securities are downgraded then, one way or another, they will become more difficult for the banks to finance and re-finance.

"Moody's believes that many Spanish mortgage borrowers have now debt-to-income ratios above the 40 percent benchmark observed in 2005,"

Deals singled out for review tend to have higher loan-to-value ratios and higher-risk products and have been performing below expectations, Moody's said. Riskier features are thought to include involving borrowers who are not Spanish residents (such clients account for as much as 10 percent of some deals), loans to multiple borrowers, loans as part of debt consolidation and interest-only loans.

Current ratings on the different tranches of the 13 deals from issuers including BBVA and Santander vary from triple-A to junk levels as low as Ca. The review over the next three to six months is likely to produce one-notch downgrades and some two-notch downgrades.

Standard and Poor's also said on July 10 that they were considering cutting the ratings on 298 million euros of bonds backed by subordinated debt issued by nine Spanish savings banks, including the top-ranking triple-A bonds.

Standard and Poor's said its decision to review its ratings on the bonds, a deal called AyT Deuda Subordinada I that was issued in November 2006, was due to a deterioration in the underlying debt. Both these actions constitute a further sign of the problems in the Spanish financial sector and illustrate very clearly how one problem can add to another in a cycle of progressively deteriorating headaches.

Standard also Poor's also downgraded two Spanish banks and changed the outlook on three others to negative, citing "the sharp deterioration in economic conditions and increasingly difficult operating environment in Spain." According to a pre-sale report they issued in 2006, the nine banks that issued the debt backing the deal are Caja de Ahorros y Monte de Piedad de Cordoba, Caja de Ahorro Provincial de Guadalajara, Caja Provincial de Ahorros de Jaen, Caja General de Ahorros de Granada, Caja de Ahorros y Monte de Piedad de las Baleares, Caixa d'Estalvis de Girona, Caja Insular de Ahorros de Canarias, Caixad'Estalvis Comarcal de Manlleu, and Caja de Ahorros y Monte de Piedad de Madrid. The agency only rates the last of these publicly, at AA- and it was the outlook on that rating which was modified to negative.

Of the nine banks, just four account for 78.9 percent of the debt which underlies the deal under review: Cordoba, Girona, Granada and Baleares, according to S&P.

Meanwhile Bloomberg this morning report that Banco Santander - Spain's biggest lender - have a group of bonds - which form part of an issue called Santander Hipotecario 4 - that are backed by mortgages that exceed property values by as much as 24 percent. Now Santander assert that they have not made any extensive use of the ECB liquidity facility involving collateral of mortgage backed securities, and there is no suggesting that Hipotecario 4 bonds - which presumeably still carry investment grade rating - have been used, but all of this does put the ECB in a very difficult position, since in principle (as with Italian government paper) they are willing to accept them. It is only the exercise of due discretion by Santander itself which means they are not already vaulted-up in Frankfurt.

Spanish lenders have, however, almost tripled borrowings from the ECB in the past year to 47 billion euros. Most ECB loans mature in one week or three months, but the bank have been providing some six month loans since the start of the credit crunch last August. Spanish banks increased their use of three- and six-month ECB loans to 27.5 billion euros as of June 30 - thus accountsing for for some 10 percent of the ECB's three- and six- month lending - up from from 2.4 billion euros a year earlier, according to Bank of Spain data. Of course the 10% level is completely in line with the level of Spain's participation in the eurosystem, so there is nothing necessarily preoccupying here, but the speed of the rise in borrowing is noteworthy.

Spanish loan defaults rose in May to 27.76 billion euros or 1.5 percent, from 12.05 billion euros or 0.77 percent a year earlier, according to the latest Bank of Spain data. Obviously the level of defaults varies from bank to bank. Banco Popular Espanol, Spain's third-biggest listed bank, scrapped its earnings forecast last week as bad loans more than tripled to 1.15 billion euros, or 1.89 percent of total debt.

Spanish AAA rated mortgage debt is now judged to be the riskiest on the continent, with investors demanding as much as 240 basis points above Euribor, up from 85 basis points at the end of 2007, according to Dresdner Kleinwort prices. That's more than twice the interest margin on equivalent securities in the Netherlands. Only bonds secured by home loans to U.K. borrowers with poor credit histories trade at higher spreads, according to Dresdner data.

Iberia To Join British Airways

And to cap a very busy day, British Airways and Spain's Iberia have announced they are in merger talks as airline industry participants seek to consolidate to compensate for rising oil costs that have been hitting both their top- and bottom-lines. As the level of economic activity has deteriorated in Spain and the UK, both airlines have struggled to keep their planes full. In the year to June, Iberia's passenger load factor, a measure of passengers to available seats, fell by 0.6 of a percentage point, to 79.6%. The same measure for British Airways dropped to 76.8% from April to June, down 3.4 percentage points.

And well-well-well, the main shareholder in Iberia is guess who, savings bank Caja Madrid, you know, the one who had an estimated one billion euro exposure to failed builder Martinsa-Fadesa, is very supportive of the Spanish airline's plan to merge with British Airways. "Caja Madrid is happy," according to reports. They would be, they have a 23 percent stake in Iberia, they had three Aaa rated bonds backed by mortgages placed on review for possible downgrade by Moody's only last week, and clearly they can't afford to have any more "lame duck bailouts" knocking around on their books at this point.

Monday, July 28, 2008

German Consumer Confidence Slides Raising Eurozone Recession Fears

German consumer confidence dropped to the lowest in more than five years entering August as the sharp rise in energy and food prices continued to weaken purchasing power and the economic outlook continued to deteriorate. The GfK forward looking consumer confidence index for August declined to 2.1, its lowest level since June 2003 (and down from a revised 3.6 in July).

The sub-index measuring income expectations decreased to minus 20 from minus 7.2, while the consumers' propensity to spend component fell to minus 26.2 from minus 23.7. Economic expectations dropped to minus 8 from 7.5.

Along with fears of high inflation, many Germans are concerned that there will be a more marked cooling of the economy than previously anticipated. News from the USA of the continuing gloom in the financial markets support these assumptions and not least, the continuing high value of the euro represents a hazard to exports.
GFK's August Report

This is only the latest in a series of readings from the German economy which indicate a sharp slowdown may well now be underway (I analysed in some detail the reasons why we might expect this in my recent What Is The Recession Risk For The German Economy? article on the Roubini European EconMonitor). In a sense, given the high level of export dependence, and the complete lack of buoyancy in domestic consumption, this is exactly what we should expect to see as key export markets slow. The German Finance Ministry have already warned of a significant contraction in German GDP in the second quarter, and the signs now seem to be growing that German GDP may also contract in Q3, in which case the German economy may already be in recession.

The Ifo institute's German business confidence index dropped 3.7 points in July (to 97.5) when compared with May. This is its lowest level in three years, and the biggest one month drop since the fall which followed the 11 September attacks. Meanwhile manufacturing and services across the euro area contracted for a second month in July according to the latest PMI flash estimate, with the reading sliding more sharply than expected in July to 47.8 points from 49.3. This was well below expectations which had been for a decline to 48.7, and it was in fact the lowest reading since November 2001.

German exports declined the most in almost four years in May, as a slowdown in some key eurozone economies (Spain, Italy) and a stronger euro curbed demand. Sales abroad, adjusted for working days and seasonal changes, decreased 3.2 percent from April. That's the biggest drop since June 2004.

German industrial production declined for a third consecutive month in May. Seasonal and inflation adjusted output was down 2.4 percent from April, when it fell 0.2 percent. That is the largest month on month fall since February 1999. Output was up 0.8 percenton May 2007, on a working day adjusted basis.

Record oil and food prices pushed inflation in Germany to 3.4 percent last month, squeezing disposable incomes just as the euro's gains and a slowing global economy coupled with problems in some key eurozone economies like Spain and Italy curbed the demand for exports.

It appears that the rate of inflation is initially stagnating around the three percent mark. This means that consumers are watching any pleasing increase in their purchasing power generated by the significant wage and salary increases in some industries being steadily demolished by inflation. Even the positive effects on income of a buoyant job market are negated by price increases and so relegated to the background for the moment.
GFK's August Report

In addition German producer prices rose at their fastest pace in 26 years in June, adding to pressure on the European Central Bank to keep interest rates high even as economic growth slows. Producer prices increased by 6.7 percent from a year earlier, the most since March 1982, after rising an annual 6 percent in May.

All of Europe's largest economies have been showing signs of slowing since the end of the first quarter. In Italy, business confidence slipped to its weakest since October 2001, according to the Isae Institute index. Spanish consumer confidence is at all time lows, while in France business confidence fell to the lowest in more than three years in July. The UK is now slowing very rapidly on the back of a credit crunch induced slowdown in the housing market.

The possibility that we may see a eurozone wide contraction in the second quarter is now a real one, and if Germany continues to contract in Q3 (as well as Spain and Italy: Spain is already in recession IMHO) then we may even see a whole zone contraction in the third quarter, giving the zone what will effectively be the first recession in its short history. Certainly the flash PMI reading for the whole eurozone manufacturing sector (which fell from 49.2 points in June to 47.5 in July) suggests that a Q3 contraction is now a real possibility. With both manufacturing and services indicators well below the 50-mark separating expansion from contraction this certainly constitutes an unequivocal recession warning. To be watched, and closely, in my considered opinion.

Thursday, July 24, 2008

The Eurozone - That Sinking Feeling?

By Claus Vistesen Copenhagen

One need not be well versed in the art of reading entrails or posses any other kind of unworldly powers to see that the Eurozone economy may be about to head off over the cliff. Now, just as the Q1 GDP figure was something of a technical glitch due to the forward pushing of investment which made Germany ride an impressive 1.5% reading q-o-q, so is the corresponding Q2 figure likely to be a similar (negative) glitch. The only important question is the extent of the slowdown since without that, we really cannot build any sound forecasts for an annual growth rate of the Eurozone, not to speak of Germany itself.

Yet, if we move beyond the immediate excitement of the upcoming GDP release and the extent to which it will have vultures gathering over an increasingly weak economy, the forward looking indicators also turned an abysmal showing. Consider then the following: In Italy, business confidence slumped to the lowest level in seven years; in France, it clocked in at the lowest since 2005 and in Germany the ever so important (for ECB policy that is) IFO survey declined to a three year low.

But the show does not, by any means of the phrase, stop here. Adding to the gloom we also got the PMI release showing its lowest reading since 2001.

Furthermore, in Spain where it isn't the proverbial Rome but moreso Madrid (or perhaps the Cedulas?) that are burning, an already groggy economy got some additional blows in the kidneys (see also below) as we learned how secondary inflation rose to an all time highs at one and the same time as the economy shed jobs in Q2 to move into double digit territory with respect to the unemployment rate. As for real economic data, consumer spending in France added a near final nail to the coffin by dropping 0.4%. Furthermore, data released on French builders also confirmed that slowdown as the index slid two points. Builders noted in particular how order books were judged to be less vibrant than normal as well as they see a slowdown in activity for the next three months.

There can be little doubt that the data releases above are suggestive of the fact that the Eurozone may well be heading for a full blown recession in Q2 and Q3. In that light, Trichet also moved in lately, and with good reason, to reassure us that while the next two quarters would see a "trough" in economic growth we would revert to normal services from Q4 and onwards.

Two important questions arise then.

First of all we have the obvious question of just how far the this slowdown will drag on and as a derivative what kind of trend will we revert to? As I have stated above it is really difficult to say anything remotely sane about GDP outlook until we get Q2 numbers (currently the Eurozone is standing at a 2.8% annualised q-o-q with Germany at 6% annualised q-o-q (!), and I am sure not even the greatest optimist would venture such a call). However, for me the question about the "trend" or "normal" pace of growth is much more interesting since my feeling is that the underlying momentum of a post recession Eurozone will surprise on the negative side. As such, it is not about the potential recession itself since these things come and go (although with a bit too high frequency in some countries it seems), but much more so it is a question about the Eurozone which emerges and what we can reasonably expect in terms of overall gusto.

A Step too Far?

Amidst all this doom and gloom and recession sabre rattling some would perhaps feel inclined to point out that the ECB seems to be getting just what it ordered with its recent 0.25% rate increase as oil prices have dropped smartly in the past weeks. I can see this point, if anyone should feel like making it, but I am also sure that we can all agree that oil prices these days are moved by more than the ECB. In fact, a raising ECB in so far as it would pummel the USD should not make oil go anywhere but up.

Meanwhile, the governing council at the ECB must obviously be watching the incoming barrage of poor data with more than a faint eye since it comes just weeks after rates were increased. Now, I should make it clear that this was the ECB's intention all along. Ever since the crisis began it was obvious for everybody that it would push the business cycle into reverse but the ECB always opted for inflation over growth; or at least it did not succumb to the temptation to lower rates. Now the butcher is coming to collect his bill and it could seem as if the ECB's credit card is in for a nasty overdraft. Actually, this may turn out to be a quite literal conceptualization if the Spanish mortgage market is about to turn into a pile of smoldering bricks.

To sum up, Q2 GDP will be interesting to watch since it will give us a sense of overall direction. Other than that I am watching Germany very closely and most specifically the export link with Eastern Europe. Basically, Germany have been living on exports not only to its main trading partners in the Eurozone (who are all now slowing considerabl) but also on the margin to the CEE economies. Especially this last link is about to break now and the repercussions will be swift and severe in terms of economic momentum lost. Finally, one cannot help but feel that Spain may be in for the worst of all (perhaps even worse than Italy). The link between builders and their banks seems a crucial issue to watch going forward.

Want More?

Below you will find a list of statistical reports used in this piece as well as other reports. This is for the analysts and investors who want the gory details.

France Business Survev (INSEE) - Enquête mensuelle de conjoncture dans l’industrie – Juillet 2008

France Business Survev (INSEE) - Enquête mensuelle de conjoncture dans le commerce de détail et le commerce
et la réparation automobile – Juillet 2008

France Consumer Spending (INSEE) - Dépenses de consommation des ménages en produits manufacturés - Juin 2008

France Building Activity Survey (INSEE) - Enquête mensuelle de conjoncture dans le bâtiment - Juillet 2008

Germany - IFO Survey, July 2008

Spain (INE) - Industry New Orders Received Indices and Industry Turnover Indices, May 2008

Spain (INE) - Industrial Price Indices, June 2008

Spain (INE) - Services Sector Activity Indicators, May 2008

Bank Defaults Up Sharply In Q2

Both Banco Popular Espanol and Banco Sabadell reported their second-quarter earnings today that, and both provided evidence of a rise in defaults as the economic collapse which is steadily working its way across Spain hits the ability of borrowers to repay loans.

Popular, Spain's third-biggest bank, said defaults as a percentage of total lending doubled to 1.4 percent from 0.72 percent a year ago as bad loans on the Madrid-based company's books jumped to 1.47 billion euros ($2.3 billion) from 686.3 million euros a year ago.

Sabadell, Spain's fourth-biggest bank, reported a default ratio of 0.85 percent compared with 0.39 percent a year ago as loans in default on its books surged to 662.8 million euros from 270.8 million euros a year ago. Newly defaulted loans climbed 208 percent to 457 million euros from 148.3 million euros a year ago.

Bankinter SA, Spain's fifth-largest bank, said its loan default ratio rose to 0.67 percent from 0.28 percent a year ago as loans in arrears more than doubled to 296.2 million euros from 113.8 million euros a year ago.

Perhaps the most important piece of information we have learnt today is that the ratio of provisions to defaults at Banco Popular has now plunged to 139 percent, down from 185 percent in March and 256 percent a year ago, as new defaults have only increased and increased, rising to 1.15 billion euros from 359.2 million euros a year ago.

Of course, this is only the start, but the rate of deterioration is significant I think.

Spanish Unemployment Rises Sharply Again The Second Quarter, Bank Lending Slows and Banco Popular Default Provisions Ratio Plummets

Unemployment in Spain, which was the source of half the eurozone's new jobs between 2001 and 2006, was up sharply in the second quarter as the credit crunch in the financial sector gradually extended its reach across the whole economy.

Spain's unemployment rate was up at 10.4 percent (from 9.6 percent in Q1) according to data from the National Statistics Office (INE) this morning. The number of people in employment increased 0.1 percent from the previous quarter and stood at 20.4 million, as compared with a 0.4 percent decline in the first quarter, but we need to consider seasonal factors here, since employment should normally be rising sharply in the second quarter.

The number of jobs in construction fell 4.5 percent to 2.55 million, while manufacturing jobs declined 2.1 percent and agricultural jobs were down 5 percent. Service jobs increased 1.9 percent to 13.81 million.

This data is compiled by the INE on a quarterly basis using a different methodology (survey based) than that used by INEM, which gives the monthly data. At this point it is hard to estimate the actual July increase which we should get to see next week, but it is likely to have been considerable. Meantime here is the last monthly chart based on the INEM data.

Bank Lending To Households and Corporates

Well, I am now going to present two of what I consider to be the most important charts for understanding the mechanics of the current Spanish crisis. The rate of growth in lending to households and the rate of growth in lending to corporates.

We now have the May 2008 data from the Bank of Spain, and as we will see, in each case they continue to slow. But first, why do I say "the most important charts". Well simply because they sum up the core of what the problem is in a very simply nutshell. The Spanish banks are struggling to find liquidity, and as a result they are unable to maintain the pace of lending expansion to individuals and to households that they previously could. This is what is provoking the severity of the problem, and in comparison with this everything else is a mere detail (although of course some of the details will soon be becoming big problems in and of themselves). Basically, as we know, more houses are still being built this year than ever. So construction at this point hasn't slowed that much. The thing is though the builders are accumulating unsold homes (which will soon be passed on to the banks as the builders go bust one by one), since individuals don't have acces to sufficient mortgage finance to buy them.

Thus the rate of new lending to households has been dropping steadily:

And then we see that corporate Spain is having the same problem, which is why so many people are busy out there trying to sell subsidiaries, and such like, since they are having problems borrowing sufficient money, and of course sales and profits are now steadily going down.

Now if we look at the next chart, you will see that Spanish companies and households are much more indebted than their average eurozone neighbours, and companies especially - at around 120% of GDP.

Now you might say, well isn't it a good thing that all this is slowing, since so much lending and debt was hardly healthy? And I would have to agree with you. But nothing is so simple, since after so many years of debt indulgence the economy is badly structurally distorted, and relative prices are way out of line with most competitors, so as domestic consumption drops exports can't take over and down the whole edifice comes.

Those of you who can speak Spanish can probably read Italian too, and I just found this comment from one of the readers of this blog on an Italian financial forum:

"L'euro ha ucciso (finanziariamente parlando) la Spagna: una moneta troppo forte, ed un tasso di interesse troppo basso, hanno distorto il mercato del credito, provocato una colossale bolla immobiliare, finanziata con capitali esteri che adesso non arrivano più o peggio stanno tornando da dove sono venuti. Inoltre, visto che la politica monetaria si fa decide a Francoforte, e non a Madrid, la BC spagnola è totalmente priva di mezzi macroeconomici per fronteggiare la crisi bancaria:"

I don't know about the idea of hiring people to give economics classes to Zapatero, but if they are looking for someone, this guy gives effectively a master class in one short paragraph. What he is really saying is that the absence of independent monetary policy meant you had no way to stop yourselves going up, you were simply shot out of the cannon, and now you have no way to stop yourselves coming down just as quickly as you went up. I remind everyone: interest rates at the ECB just went up, not down, and deflation - and possibly a very whopping dose - not inflation, is about to become Spain's problem.

Banco Popular Under The Microscope

Today Banco Popular is back in the news again. Banco Popular Espanol is Spain's third-biggest listed bank, and today they reported that second quarter profits rose less than analysts estimated as asset sales offset higher loan defaults. Perhaps the most important piece of information we have learnt today is that the ratio of provisions to defaults has now plunged to 139 percent, down from 185 percent in March and 256 percent a year ago as new defaults have only increased and increased 1.15 billion euros from 359.2 million euros a year ago.

Popular fell as much as 5.4 percent in Madrid trading after reporting net income increased 8.3 percent to 352.2 million euros ($552.5 million) from 325.3 million euros a year earlier. That missed five analysts' 392 million-euro median estimate. Popular may need to raise capital in the not too distant future should loan losses continue to mount. Popular fell 35 cents, or 4.4 percent, to 7.60 euros at 9:30 a.m. in Madrid, which was the most since July 15 and which puts this year's decline to 35 percent after the shares had recovered somewhat in recent days.

In May, the bank reported provisions of 39.3 million euros to cover loans to Inmobiliaria Colonial SA. On July 15, Popular said it set aside 100 million euros to cover loans to Martinsa-Fadesa SA, Spain's first traded developer to seek bankruptcy protection. Popular made 332 million euros in provisions in the quarter. It used gains of 200 million euros from the sale of real estate to cover part of the loan-loss provisions. Popular also booked 40 million euros in gains from the sale of its French banking unit.

Popular reported core capital, a measure of the underlying solvency backing its business, of 6.67 percent in June and said core capital could reach 7 percent by the end of 2008. The bank reported loan losses as a proportion of total loans of 1.42 percent, up from 0.98 percent in March and 0.72 percent a year ago.

Losses from impairment of assets climbed 325 percent to 343.6 million euros from 80.8 million euros a year ago. Lending growth slowed to 8.1 percent from 11.7 percent in March and 16.7 percent in the same period last year. Client funds Net interest income rose 8.8 percent to 630.97 million euros.

Tuesday, July 22, 2008

Italian Consumer Confidence Falls Again In July

Hi everyone. Well I am starting this post off in a rather unusual fashion. Since the main message in this post is rather pessimistic (consumer confidence just plummeted), I thought I would try and give things a slightly different slant, by offering my own personal dose of measured optimism. In the photo above you can see Nanni Morreti and Alessandro Gassman sitting on a park bench. The excuse for this engaging and seemingly everyday scene was the recent film by Antonello Grimaldi - Caos Calmo - which I went to see (and thoroughly enjoyed) last weekend.

Now Moretti is an individual with whom, on the surface, I would seem to have relatively little in common, since I am in no way sympathetic to his ideological stance. On the other hand, I do admire his enormous creativity, his willingness to take artistic risks, and his ability (as so well symbolised by his improvised "headquarters" in the park in Caos Calmo) to organise and mobilise the physical and intellectual space he has around him. He is, after all, an artist.

So in many ways what Moretti does in the Grimaldi film could be thought to represent a kind of metaphor for what Italy now so badly needs: a redefinition of its corporate values and a reorganisation of its institutional space. And with that little homily, now on to....

Italian consumer confidence in July slumped to the lowest since 1993, when the country was - we should note - in a recession. The Rome-based Isae Institute's index, calculated from a survey of 2,000 families, fell to 95.8 from a revised 99.9 last month. In November 1993, the 26-year-old index hit a record low of 95.4.

A sub-index measuring optimism about the broad economic situation dropped to a 14-year low of 72.2 from 81.6, Isae said today in its report. A gauge of households' perception about their short-term prospects decreased to 88.4 from 97.6.

Italian families are cutting back on spending, including putting off car purchases and eating out less, the institute said. And in June retail sales declined for the 16the consecutive month, the Bloomberg purchasing managers index showed on June 27.

Sales in what is still Europe's second-biggest car market fell 19.5 percent in June, a sixth straight monthly decline. Registrations at Fiat fell 16.5 percent in the month and the company has announced that it will temporarily shut four of its six Italian factories for three weeks between September and November because of weaker demand.

According to forecasts from both the Bank of Italy and ISAE the Italian economy will expand by only 0.4 percent this year, the slowest pace since 2003. And even this must now be subject to downside risk - ie we may even see an annual contraction, it all depends in my opinion on whether we see a rebound in Q4. Basically I will stick my neck out at this point and say that this latest consumer confidence index makes it quite probable that Italy is already in a technical recession (two consecutive quarters of negative growth). One of the charts which has impressed me most in recent days is this one prepared by PNB Paribas (in an analysis of the Spanish economy):

What we can see above is a comparison (for Spain, I simply haven't had the time to do one for Italy) of quarterly consumer confidence and private consumption with a one quarter lag (that is consumer confidence of the earlier quarter compared with actual spending in the subsequent one. As can be seen the fit is pretty close, which means that apart from the slight rebound in May we are now looking at a very dismal outlook for private spending from April through September, hence my feeling that we will see negative growth over these two quarters.

Monday, July 21, 2008

Wolfgang Munchau Proposes The EU Organise An IMF-type Rescue For Spain

Well some times I agree with Wolfgang Munchau, and sometimes I don't. This is one of the occasions when I do, especially the following passage which can be found in his Financial Times op-ed this morning:

"Some degree of competitive adjustment is probably needed but the huge scale of the shock that is unfolding in Spain will almost certainly require a macroeconomic response that Spain cannot deliver on its own..........So what actions would be needed? In the very short run, a transfer mechanism to provide help for countries in severe distress. Of course, any transfers would have to come with IMF-style conditions attached."

Basically this is broadly in line with what I was suggesting in my RGE Europe EconMonitor piece - What Is The Risk Of A Serious Melt-Down In The Spanish Economy? - last Friday. Essentially the ECB has now gone about as far as it can, and the EU Commission in some yet to be determined way needs to play the role of the US Treasury (we lack the appropriate architecture at this point, but still), and inject cash - rather a lot of it. This is an EU problem and not simply a Spanish one since the source of the bubble lies very clearly in earlier monetary policy over at the ECB (or in deficiencies in the way in which the "one size fits all policy has been administered, see in particular "How to prick local housing bubbles in a monetary union: regulation and countercyclical taxes" by Alan Ahearne , Juan Delgado and Jakob von Weizsäcker - also on RGE last Friday).

It appears the Spanish cabinet is now divided between one group - lead by Industry Minister Miguel Sebastian - who favours intervention to rescue ailing builders - and another - lead by Economy Minister Pedro Solbes - who do not favour intervention.

My view is that a substantial, but as of yet indeterminate quantity of money (possibly in the region of 300 - 500 billion euros) needs to be injected urgently into the Spanish banking system, either directly (by buying cedulas hipotecarias outright) or indirectly by buying up and closing down builders as part of a "restructuring programme", and this needs to be done by the EU equivalent of the US Treasury (whatever we decide that that actually is) and not by the ECB. Thus I am neither with Sebastian (who would, I suspect like to save the builders) or with Solbes. Of course, as Munchau indicates, any such intervention would need to come with all manner of conditions attached (a restructuring of the whole Spanish mortgage situation, to put the banks back on a sound footing, being just one of these), and this would mean that the Spanish government would to some considerable extent lose control of its own internal affairs. But this possibility was already implicit in the creation of the eurozone in the first place, so I suppose you could say that one day or another this situation had to arise. And now it has. So let's get on with things and take some decisions.

You can find the relevant part of Munchau's editorial below:

But what about intra-eurozone divergences? I was struck the other day by a statistic from the ECB that shows Spain losing competitiveness relative to Germany, even now. We knew this happened during the years of high economic growth in Spain and low growth in Germany. But the trend continued even when the relative positions of the two countries were reversing. One explanation is that Spanish wages are directly linked to inflation, while German real wages are still declining.

Worse, Spain’s slippage comes amid the prospect of a serious downturn in its economy. Last week’s collapse of Martinsa-Fadesa, a large property developer, has been a reminder, if any were needed, of the massive scale of the Spanish property crash. Serious financial and economic distress is almost inevitable. Do not be fooled by the fact that Spanish banks had virtually no exposure to US subprime mortgages. Being exposed to Spanish mortgages is probably worse.

Spain is in a more delicate position than the US or the UK because, as a member of a monetary union, the country has fewer macroeconomic adjustment tools at its disposal. The dollar and the pound have devalued in real effective terms, while Spain has one of the hardest currencies in the world. Spanish interest rates have gone up while US rates have gone down.

The good news is that Spain has some room for manoeuvre in fiscal policy, given its low debt-to-GDP ratio. But the whole structural and legal setup of the eurozone requires that, in any adjustment, most of the heavy lifting is done via the real economy. Spain is thus in danger of entering a decade of misery, with falling real wages.

The problem is that even if Spain were to try to pull itself up through competitive adjustment, it is not at all clear that this would work. I am not even sure whether it works all that well for Germany in the long run, but that is another story. Some degree of competitive adjustment is probably needed but the huge scale of the shock that is unfolding in Spain will almost certainly require a macroeconomic response that Spain cannot deliver on its own.

Yet the eurozone’s system of economic governance is not designed to produce this type of response. There are no cyclical transfer schemes, only structural funds. No common rules exist on bank bail-outs. Small-minded national banking regulators even refuse to countenance the very obvious necessity of a central banking regulator for cross-border banks. The eurozone does not even have single representation at the International Monetary Fund. The economic shocks to be experienced by Spain, and by Ireland, will seriously test the eurozone’s see-no-evil-hear-no-evil approach to economic governance.

I have long thought that the only way the current set-up will be changed is not through debate about future eventualities but as a result of being plunged into crisis. Eurozone finance ministers – the so-called eurogroup – are a complacent bunch. They never do anything until it is absolutely necessary. But they will act eventually. I am relatively optimistic that they will always be able to ward off the worst-case scenario, one that still excites some commentators: the threat of a eurozone break-up.

So what actions would be needed? In the very short run, a transfer mechanism to provide help for countries in severe distress. Of course, any transfers would have to come with IMF-style conditions attached. As a price for an increase in intra-eurozone solidarity, the other member states would almost certainly demand that the beneficiaries end the silly policies that got them into the mess in the first place. Spain, for example, should end the automatic link between inflation and wages. It should also end the monopoly of the one-month euro interbank offered rate mortgage, which has had a hugely pro-cyclical effect on mortgage lending and the housing market.

The one institution that cannot help Spain is the ECB. Its role is to run an optimal policy for the eurozone as a whole. Dealing with this hugely asymmetric shock is primarily a matter for politicians, not central bankers. Anybody who claims to be serious about economic policy co-ordination, such as President Nicolas Sarkozy of France or the European parliament’s economic and monetary affairs committee, should therefore stop bashing the ECB for a few months and focus attention on the storm that is building up on the eurozone’s western front.

Friday, July 18, 2008

What Is The Risk Of A Serious Melt-Down In The Spanish Economy?

Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past, the ocean is flat again
John Maynard Keynes

'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 this week to Spanish radio station Punto Radio

Jose Luis Borges tells a story about two rascally villains, eternal rivals, who - under sentence of death - are offered one last bet: rather than accepting a conventional execution they can agree to have their throats slit simultaneously, just to see who is a able to run the farthest. Immortality, rather than fame, in an instant. Now I mention this since tale I can readily anticipate the immediate feelings many will have on reading what follows (I am at the end of the day going to argue that it is necessary to inject money - and I do mean rather a lot of money - into a banking and construction system which many will want to argue is largely responsible for Spain's present distress, and indeed, that having made a good deal of money out of the operation, these are the very people who should now be forced to don that sackcloth and ashes costume which so behoves them (actually the way things stand they are much more likely to find themselves reduced to a sporting a loincloth, but still). I understand why many ordinary Spanish people may have such feeling, but I do think this is a time for cool heads, and that what is most needed here is an extreme dose of pragmatism coupled with a lot of emotional intelligence. There is no point in agreeing to have your own throat slit just to see people you don't like have their's slit first.

Martinsa Fadesa The First To Go

This week's filing by the Spanish property developer Martinsa-Fadesa for protection from its creditors has brought Spain's ongoing economic agony back to the headlines. The decision follows a request from Martinsa Fadesa last Friday to its creditor banks for a postponement of the deadline on their requirement that the company obtain a 150 million euro ($235.7 million) loan. The banks refused the request and the rest is now, as they say, history. The failure of Martinsa - Fadesa whose debts are in the region of 5 billion euros - is not only the largest corporate bankruptcy in Spanish history, it is also a reflection of the pain which must now be being felt in Spain's troubled banking and construction sectors, and a harbinger of what is, in all probability, going to be much worse to come.

Spain At Risk

So to come directly to the matter which has provided me with the header to this post, just what is the risk that the present recession in Spain is something a bit more than a mere recession? What is the risk of a real and serious economic melt down just across France's Southern border, a mere stone's throw away (by plane) from Brussels or Frankfurt, yet still on the other side of that intellectual and cultural divide which seems to be formed by that ever so picturesque natural barrier known as the Pyrennees? Well it is a non-negligable one, in my view. Let me explain a bit.

First, as background it would be worth reading my Artemio Cruz Syndrome post, since all the main macroeconomic arguments are presented there (and those who seriously want to know what is going on should definitely read the excellent "Spain:Bubble Bursting - We now expect a full-blown recession" desknote from PNB Paribas).

Secondly, we need a bit of vocabulary clarification, since the terminology being used has become somewhat confusing of late. We could reasonably break things down as follows I think:

i) Soft Landing
ii) Hard Landing
iii) Melt Down

Now, in terms of the available semantic space, why don't we allow that "soft landing" means a recession of the more or less garden variety (as Portugal or Italy have at this moment, or as say France may anticipate, or Denmark) and not consider this to mean avoiding recession completely, which is how some seem to have used the term in recent times (I think it is hard to imagine any EU 15 economy avoiding recession completely between now and Q2 2009). Possibly Hungary up to this point could also be said to have had a comparatively soft landing.

"Hard Landing", on the other hand would be what they are currently experiencing over in the Baltics, what they may well soon experience in Romania, Bulgaria, the UK, and Ireland, and what is now most certainly taking place in Spain. Thus by "hard landing" I mean a very sharp slowdown in growth, a medium sized contraction in consumption, financial distress and bankruptcy in some areas, and a recession which drags itself on for more than a mere two quarters (in and out of negative growth) and probably results in annualised negative growth for a period of at least 12 consecutive months. What happened in Turkey in 2000 was certainly a hard landing in this sense.

iii) "Melt Down", following such definitions, would then be a Hard Landing plus, a Hard Landing plus a shock (or in Hungary's case, where the shock would be a run on the forint, you could imagine what initially is only a Soft Landing being converted into a melt down, but arguably Hungary's case is very special given the very high level of exposure of household balance sheets to CHF denominated forex loans).

Such a shock could be a banking crisis, a run on the currency, a sovereign default (this is where Italy's series of perpetual soft landings could move decisively into meltdown mode one of these fine days if something isn't done to correct the low growth/high sovereign debt to GDP dynamic while there is still time).

Now in this sense, Spain's economy is at some significant level in danger of having a melt down - lets define this as more than two years of negative GDP growth with a magnitude of more than one percentage point, coupled with (in the case of countries which have their own currency) very sharp devaluations, and in the case of those that don't severe and extended price deflation (ie a mini version of what happened in the USA in 1930).

Now the recession in Spain is, I think, more or less most certainly already served. The Spanish press were talking earlier in the week about a quarter on quarter contraction of 0.3% in Q2, and it is hard to see any acceleration of the economy in Q3. Pedro Solbes, when questioned explicitly by Punto Radio on the possibility that whole year growth for 2008 could turn negative replied diplomatically "It's not my feeling at the moment", which means basically that it might well turn out to be the case.

If this expectation if fulfilled then Paribas may have to revise their latest forecast slightly (see above link) since - in what is really an excellent general analysis - they pencil-in the recession to start in Q3 2008 and then move on to anticipate a contraction in the Spanish economy of 0.75% in 2009 (although as they freely admit all the risks here are skewed to the downside). My own personal call at this point is that the recession may well have started in Q2 (we will soon know) and that the contraction in whole year 2009 will be over 1 percentage point. Further than that I am not willing to go at this stage, since it all depends, and in particular it depends on whether or not we get a nasty "event" or series of events which send the economy hurtling out of the "hard landing" bracket and into the "melt down" one. It is because I strongly believe we be should doing everything we possibly can to avoid that eventuality that (and not continue to languish under our blankets with a heavy dose of the Artemio Cruz syndrome) that I am writing this post now.

Before continuing, however, I should point out that even the Paribas idea of negative growth in 2009 is still very nonconsensual, despite the widespread pessimism which currently surrounds the Spanish economy. The consensus economic survey for June gives a median 2009 growth forecast of 1.5%. The lowest forecast in the survey is 0.4% but most are grouped in the range 1.0-1.8%. Maybe the consensus will catch up with the curve in due course.

Structural Unwind

So what would be my justification for making such an apparently gloomy forecast? Well as I argue in my Artemio Cruz piece, and as Paribas re-iterate in their study, this is no ordinary crisis. It is taking place against a background of a severe credit crunch which affects the entire financial sector, in a country with an enormous external deficit (CA deficit over 1o% of GDP and rising), which has a strong external energy dependence, and at a time when food and energy prices have been rising sharply. All of this is bound to exert a very strong downward pressure on internal consumer demand, and as a knock-on impact on investment spending. At the same time slowing growth globally, and in the EU and eurozone economies in particular, makes for a very difficult external environment where increasing exports (even assuming Spanish export prices were currently competitive, which they aren't) becomes difficult, if not well nigh impossible.

Serious Structural Distortions

So let's take a quick look at some of the underlying structural issues. In the first place both Spanish households and corporates are extremely highly leveraged at this point in terms of their outstanding debt obligations. The levels of debt to GDP are really extraordinarily high when compared with their eurozone peers.

So how did Spain get into this rather precarious situation? Well I don't think you need to look too far to discover the answer. As can be seen in the chart below, Spain effectively had negative interest rates throughout the entire period between the start of 2002 and the autumn of 2006. That this state of affairs was produced in the very earliest years of the history of the eurozone was indeed, in my opinion, truly unfortunate, since it meant that inflation expectations had not had time to be "steered down" by a central bank track record. Thus a very widespread reaction on the part of ordinary Spaniards to what were generally perceived to be derisory interest rates for savers was to withdraw money from longer term deposit accounts and to place it in what was considered to be the safest of safe inflation hedges: property. Thus began what may well turn out to have been one of the most serious property bubbles in recent history.

The situation was also doubly unfortunate, since the ECB along with other central banks had lowered interest rates in an attempt to support economic weakness produced by a drop in stock market values following the collapse of the internet boom. In Spain's case however, the excesses caused by the internet boom never really had the opportunity to unwind, since as one boom ended, another one simply got going in its place. This effect can be clearly seen in the chart for long term quarterly GDP growth produced below, where we can see that following the 1992/93 recession (and up to Q2 2008) Spain simply hasn't had one single quarter of negative growth - that is during 15 years. Hence the legend of the Spanish economic miracle was born. But as with all legends, we should also really be asking ourselves what the reality was which lay behind it, since as we can now see, the absence of recession - and in particular the absence of recession in 2002/03 - simply means that we now have a lot of extra "distortion" lying out there and waiting to be "corrected" (the waste-pipes were effectively never flushed, which is why we are now faced with such a peculiar smell emmanating from the sewage system). This would be the main reason why I would argue that what we cannot now expect is a relatively smooth "return to trend" in 12 to 18 months time, since Spain has effectively been "off trend" for some six or seven years now, and the magnitude of the excesses (10%+ CA deficit, 5 million immigrants in eight years, corporate indebtedness pushing the 120% of GDP mark etc etc) is prima facie evidence for this. So even in the best of cases we are almost certainly now facing a significant period of negative and then very low headline GDP growth. But we may not be lucky enough to get away from all this with a simple best case scenario.

The last piece of structural evidence I would offer in this post refers to the CA deficit situation. Since I deal with that reasonably exhaustively in the Artemio Cruz piece, I will only refer to one item here: the deteriorating balance on the income account.

Now this is important in my opinion. It is important since obviously any of the remedies to Spain's short term financing problems imply borrowing money (in some way, shape or form via the support which is offered by belonging to the eurosystem). Spain needs one of those proverbial "bailouts", even though since Spain does not have its own idependent currency this position is somewhat masked by the fact that everything is denominated in euros. But debts incur interest, and the more you borrow, the more you effectively have to pay, not only in capital, but also in interest. And if Spain country risk rises sharply in any way - as some analysts are suggesting it may have to - well then what is already a serious problem is only going to become a more serious one.

Land Prices

So where are the risks? Well I think it is no simple accident that Martinsa-Fadesa has been the first major developer to go, since a very large part of their portfolio is composed of land. According to press reports Martinsa Fadesa had land totalling 28.67 million square metres, 41 percent of which is outside Spain (and 50% of which is not "zoned", that is it is without the necessary premission to build). They also have a stock of more than 173,000 newly-built and unsold properties (again by no means all of these are in Spain). Now land is going to be a very important component in this whole "correction", since a lot of land (as we can see) has been accumulated with intent to build, and much of this land may now become virtually worthless. And land prices are already falling faster than house prices. Data from the Ministry of Housing shows that land for building fell to 251 Euros/m2 in March, a 7.7% drop when compared with March 2007. Land prices had fallen for 3 consecutive months by March with the average cost of land in Spain now being back somewhere around where it was at the end of 2004.

So I would say this is one of the first issues the Spanish government needs to tackle, and quite urgently. Frankly I can see little alternative to having the government intervene and take this land off the books of those who are holding it - not at market prices, they can handle some sort of "haircut" - but I don't think the government should be sitting idly back and watch one developer after another simply fold, since the end result of this is that the problem then moves over into an already overstretched banking sector.

Which brings me to my exhibit one: Japan land prices.

One of the key features in Japan's ongoing battle against deflation has been the way in which land prices were simply allowed to fall after the property bubble burst in 1991. The above chart shows the sharp rise in Japanese land prices from 1986 to 1990 - a period during which they more than doubled - and how they subsequently fell - albeit more gradually — by roughly two thirds from 1990-91 to 2005. Although urban land prices started to turn up slightly post 2006, land prices still continue to fall elsewhere, and of course we still haven't seen how the latest construction "bust" in Japan is going to leave things. Unsurprisingly, residential construction has remained virtually dormant in Japan over this entire deflationary period.So the question is, what is to stop this happening in Spain. I would be grateful to anyone who can present me with a reasoned argument as to why what happened in Japan won't happen here. Meanwhile the risk is evidently there.

The Builders In General

Obviously even if the most immediate and pressing problem in Spain is arising in the area of land prices, the rest of the housing related construction sector will not be far behind. This is a problem that is simply waiting to happen. According to the latest data from the Spanish housing ministry, average Spanish property prices fell by 0.3% in the 3 months to the end of June, but they were still 2% up on prices in Q2 2007, a factor which is leading many to question the reliability of the Spanish data (one more time Artemio Cruz strikes, since Spanish institutions are far from swift in responding to problems, and would seem to prefer denying that they exist). One explanation for the present situation may be that prices are being measured in terms of the initial asking price and not the final selling price. Whatever the explanation prices are certainly set to tumble, and even the the G-14 developers’ association, traditionally a staunch upholder of the immobility of property values, has had to admit that new-build prices have fallen by 15% in the last 6 months alone, while Cue Mariano Miguel, ex-president and present board member of the much troubled developer Colonial, is already predicting a fall in the region of 25% to 30% over the next two years. And new property in Barcelona (which is where I live) is now taking ten times longer to sell than it was only a year ago, according to real estate consultancy Aguirre Newman.

Meanwhile we learn from Jose Luis Malo de Molina, director general at the Bank of Spain (speaking at a recent conference in Valencia) that the number of new homes which will be completed in Spain in 2008 will beat all previous records (I said this was a system which was slow to react), simply piling one more house after another in order to add to that glut of newly completed homes that is already idly languishing and casting its long shadow over the Spanish property market. Muñoz's explanation for this phenomenon is simply that “the real estate sector can’t turn around quickly, it works in the medium and long term, so this year the properties started at the end of 2005 and beginning of 2006 will be completed, which means the number of new properties on the market will hit an all time high.” As I say, "just in time" may be an idea that has entered the heads of the more agile companies like the textile consortium Inditex, but most of Spain is a very, very long way from being able to offer an agile response. On the anecdotal front, a friend of mine recently went to visit family homes in the North West of Spain. In Vigo he spoke to the owner of a brick factory, and in Leon someone who had a quarry. In both cases production was continuing (there is simply no on/off switch here) but the inventory already had piled up to the extent of being now prepared to satisfy normal requirements for the whole of 2009 (in both cases), and of course, in 2009 requirements will not be normal, since housing starts in 2008 have collapsed to a forecast of below 200,000 (down from 600,000 plus in 2007).

At this point estimating the volume of unsold housing in Spain is really a question of "its anyone's guess" rather than a matter of scientific fact. The number 1 million is popular, but I suspect this is more a question of serving up an easily managed factoid than one of accurately measuring empty houses one by one. The same applies to the estimates for the size of the likely fall in property values. All we can safely say at this point, I think, is that the number in both cases is large.

The big question for our current concerns is who is exposed to the risk on all this, and the answer to that question is a lot simpler: Spain's already cash-strapped banking system.

One common estimate of the exposure of the banks to the builders would be somthing of the order of 300 billion euros - this is the opinion of Spanish analyst Inigo Vega at Iberian Securities (and it is one I more or less share). So we could say we have something in the region of 20% to 25% (or more) of Spanish annual GDP in play here.

Bank Exposure Through Mortgage Backed Securites

To this second order exposure of the banking system to the construction sector alone (and remember, through the negative impact of all this on the real economy, we should never lose sight of those non-construction corporates, you remember, the ones who had all that indebtedness we saw in the first chart) we need to add the exposure of the banks to the cedulas hipotecarias, which alone run to something in the 250 to 300 billion euro range (to which we need to add, of course, other classes of more conventional mortgage backed-securities ). If we add these two together - the builders and the cedulas - then we are obviously talking about a potential injection into something of over half of one years GDP in Spain.

According to Celine Choulet of PNB Paribas mortgage-backed securities in the broader sense of the term (ie including cedulas and MBS) now add up to around 37% of outstanding mortgage loans in Spain. She also estimates that asset backed securities held by non-residents may amount to as much as 81% of the total securities issued.

Outstanding home loans (for purchases and refis) represent a substantial percentage of the Spanish banking institutions’ balance sheets (21.5% of total assets and 35.6% of total loans to the non-financial private sector in the second quarter of 2007). In the second quarter of 2007, outstanding home loans amounted to 589 billion euros, 56.4% of which were distributed by cajas (29.8% of their assets), 37.2% by commercial banks (15.4%) and 6.4% by mutual institutions (30.9%).

If we add together home loans and the financing of real estate sector (construction and property services), the overall exposure of Spanish credit institutions has increased significantly over the last decade (37% of assets in the second quarter of 2007, 61.5% of total loans to the non-financial private sector). Exposure of Spanish banks to the real estate sector has exceeded, both in level and in growth rate, that of US, Japanese and British banks. In total, in the second quarter of 2007, cajas (49.7% of assets, 70.5% of loans) and mutual institutions (46% and 56.3% respectively) were almost twice as exposed as commercial banks (28% and 55.2% respectively).

According to Choulet - and just to take one example - in 2006 total new funding to the Spanish mortgage market reached 201.3 billion euros, of which 88.3 billion took the form of covered bonds (representing 43.9% of the total of mortgage securities market) and 113 billion was in mortgage-backed securities (56.1%).

And remember the cedulas all need to be "rolled over" in the next few years (with a big chunk coming up between now and 2012). And the problem starts this autumn. According to an article in the Spanish daily El Pais at the end of June the Spanish banking sector needs to raise 62 billion Euros before the end of this year just to rollover what they have coming up on the immediate horizon.

So what does all this add up to? Well, to do some simple rule of thumb arithmetic, just to soak up the builders debts and handle the cedulas mess, we are talking of quantities in the region of 500 to 600 billion euros, or more than half of one years Spanish GDP. Of course, not every builder is going to go bust, and not every cedula cannot be refinanced, but the weight of all this on the Spanish banking system is going to be enormous. Banco Popular is the most visible sign of the pressure, and their shares have already dropped by 44% this year, and by 7.9% on Tuesday alone (they were the listed bank which was most exposed to Mrtinsa Fadesa).

So it is either inject a lot of money now - more than Spain itslelf can afford alone - or have several percentage points of GDP contraction over several years and very large price deflation - ie a rather big slump - in my very humble opinion. And it is just at this point that we hit a major structural, and hitherto I think, unforeseen problem in the eurosystem (although Marty Feldstein was scratching around in the right area from the start). The question really we need an answer to is this one: if there is to be a massive cash injection into Spain's economy, who is going to do the injecting? Spain alone will surely simply crumble under the weight, and it is evident that the problem has arisen not as the result of bad decisions on the part of the Spanish government, but as a result of institutional policies administered in Brussels and monetary policy formulated over at the ECB. And yet, the Commission and the ECB are not the United States Treasury and the Federal Reserve, no amount of talk about European countries being similar to Florida and Nebraska is going to get us out of this one: and it is going to be step up to the plate and put your money where your mouth is time soon enough. Yet, cor blimey, we are still busying ourselves arguing about the small print on the Lisbon Treaty.

Demographics and Construction

The third major area of risk I would like to highlight today relates to the problem of demographics and their impact on the construction outlook. PNB Paribas (see initial link) see demography as one of the principal downside risks to their forecast. They put it like this:

"With United Nations population projections pointing to growth of only 300k per year on a ‘high-population’ variant for 2010-15, housing starts could fall considerably further. Hence the risks to our central forecast of 30% off housing investment by end-2009 are to the downside. The correction could be more rapid than expected. If not, it is likely to persist into 2010. ...........Our forecast has housing investment converging to levels consistent with relatively strong population growth. A weaker population assumption or some undershoot of the ‘equilibrium’ level would lead to a worse outcome."

Basically, I think the big topic in this context is the coming rate of new household formation. And here it is worth remembering that while the countries most affected by the property-driven credit crunch in the EU would appear to be Spain, Ireland and the UK, the UK is rather different from the other two, since while housebuilding grew by 187% in Spain between 1996 and 2006 (and by 177% in Ireland), the equivalent increase in the UK was just 12%. Planning restrictions in Britain meant fewer homes were built and the resulting relative scarcity may provide one part of the explanation for why house prices have almost doubled, in real terms, in the UK since 1999 despite the comparatively low percentage of new builds (this would bring us back to the huge zoned and un-zoned lang overhang in Spain, and what the dynamics are that produced it). That is, while the UK can to some extent offset the impact of the crisis in the longer term by increasing homebuilding (to house, for example, all those extra people from Poland and other parts of Eastern Europe), in Spain and Ireland the problem is going to be very different, since they both have to sharply reduce housebuilding capacity.

So what are the main sources of new household formation in Spain? Well basically they are threefold: natural population development, migration, and second homeowners from the north of Europe. Now if we start with the question of natural population evolution in Spain, ex-migration the Spanish population is virtually stationary at this point - with an average annual increase of a mere 30,000. But what matters in housing terms is not so much the size of the population as its age structure, and here we don't need to go to the level of refinement involved in looking at longer term UN population projections (high, median or otherwise) because in terms of Spanish property from now to 2020 (at least in terms of natural population drift) the deal is now done (or rather the goose is now cooked), and a quick glance at the US Census Bureau IDB population pyramid for 2000 should make this abundantly clear (see below).

What we can effectively see is that in 2000 (and please click on the image if you want a better look) Spain's three historically largest 5 year cohorts constituted the 25 to 40 age group. But if we mentally fast forward as far as 2015 we will see that the aggregate size of the cohorts in this age range is very significantly smaller, and if we fast forward again to 2020, we will see that what we have are the three smallest cohorts in the last forty years. And from here on in we only go down and down - talk about absence of sustainability!

So we are left with North Europeans is search of second homes and migrants to offer some support to Spain's rapidly crumbling housing sector in the coming years. Well on the North Europeans front the picture doesn't look exactly promising either, since the bulk of the buyers in recent years have been British (Britons own an estimated 500,000 to 700,000 properties in Spain), and they are already having their own problems, plus the fact that changes in the value of the GBP and interest rates mean that affordability is becoming an issue, an issue to which you have to add the drop in attraction of properties whose prices may now be set to seriously deflate, and over a significant number of years.

Indeed, according to Manuel Gandarias, president of the ‘Live in Spain’ holiday-home developers’ association, sales of holiday homes in Spain are now down by 50% from the peak “In recent years between 120,000 and 125,000 holiday homes were sold each year, this year it will be half that,” he is quoted as saying. And of course it isn't only the cost of buying the home that has been going up, it is also the cost of servicing the debt that buying the home brings with it. Josep Suárez, director at Solbank in London estimates that the combined impact of rising Euribor rates and the appreciation of the Euro against the pound (15% in the last 9 months) means that mortgage payments for Britons with mortgages in Spain are now 25% higher than they were a year ago.

So the outlook on the North European second home market doesn't exactly look bright either, which leaves us with the migrants. As is now generally well known, Spain's population has increased dramatically in recent years - from around 40 million in 2000 to around 45 million in 2008 - and this increase has been almost exclusively (natural increase is no more than a quarter of a million) the result of huge inward migration.

Basically the future of all these migrants is now deeply uncertain. I would even say that losing the migrants constitutes the most important of all the downside risks to the Spanish economic crisis for the impact it will have on urban rents and mortgage delinquency in the short term (since many of the migrants have bought flats), and for the consequences for Spain's housing market and pensions system in the mid term. Evidently, since most of the migrants are economic migrants the inward flow must surely be about to dry up (since there are few if any jobs for them) and thus our attention should be focused on the need to hold onto those we already have.

Is There A Rescue Plan Available?

Basically, and on the basis of all the above, I would like to now put forward a five point "rescue" plan for the Spanish economy. It would look something like this:

1/ Set up a national land agency, to buy up land and to irrevocably convert it to other uses (agriculture wouldn't be a bad bet where possible given present food prices). This to include the proviso that such land could never again be zoned.
2/ Buy out and close down the bankrupt builders as part of a general restructuring programme such as the one which was developed for the shipyards and the mines.
3/ Buy up and burn immediately ALL outstanding cedulas hipotecarias. Well, I'm exaggerating here, but something very decisive needs to be done to take these things out of circulation in the longer term, or we will never ease Spain out from under this.
4/ Establish a programme to help immigrants in difficult circumstances, and offer training etc to prepare for the future. Abasic focus of policy needs to be on trying to persuade migrants to stay.
5/ Restructure all existing mortgage contracts - which will involve every one paying more - in order to put mortgage financing in Spain back on a sound footing. This will obviously require legislative intervention, and will equally obviously involve breaking the direct tie with one year euribor. It has been following euribor up and down which has gotten the Spanish mortgage market into this mess in the first place.

OK, I warned you. I said none of this was going to be popular. And none of these propsals should be consider as carved in stone. Better ones could well, I am sure, be put forward, but in the absence of anything credible in the way of alternatives I am putting them forward now. As I said at the start, there is no point in agreeing to have your own throat slit just to see people you don't like have their's slit first.

It is very, very important that some form of "corta fuegos" (fire break) is put in place, and put in place now, otherwise the whole of Spain could very easily burn down in just the same way the Liceu opera house did here in Barcelona, simply because some chump decided to do on-stage soldering repairs with the safety curtain up! Risk sir, there's no risk here. It's all as safe as houses.

Tuesday, July 15, 2008

German Investor Confidence Drops To 16 Year Low In July

German investor confidence fell to a record low in July as surging inflation and slowing export growth started to cloud the outlook for growth in Europe's largest economy. The ZEW Center for European Economic Research in Mannheim said its index of investor and analyst expectations dropped to minus 63.9, the lowest since the index was first compiled in December 1991, down from minus 52.4 in June.

As a stronger euro weighs on exports and the U.S. housing slump damps confidence worldwide, Germany's benchmark DAX share index has dropped 7 percent in the past month and 23 percent this year. The dollar fell to a record low against the euro again this morning, hitting $1.6038 at one point. The dollar thus extended this year's 10 percent slide following concern that confidence in the debt of Fannie Mae and Freddie Mac will deteriorate even after the U.S. government pledged support for the buyers of home loans. The stronger euro is putting pressure on German exporters already coping with a slowing global economy. The currency has gained 15 percent against the dollar over the past year, while the crisis in U.S. subprime mortgages has been sending shock waves through financial markets and reducing the outlook for global growth.

German exports declined the most in almost four years in May, as a slowdown in some key eurozone economies (Spain, Italy) and a stronger euro curbed demand. Sales abroad, adjusted for working days and seasonal changes, decreased 3.2 percent from April, the Federal Statistics Office said this morning. That was the biggest drop since June 2004.


There seems to be a general consenus at the present time that the German economy is slowing. Where there is no real consensus is over the rate at which it is slowing and where and when the slowdown will settle. It is already clear, however, that GDP growth in 2008 will be below the heady 2.9% annual rate achieved in 2006, or the 2.5% clocked up in 2007.

The median of five forecasts published in June by the major German economic institutes sees growth in the German economy this year of 2.2%. This really now seems a highly optimistic number, especially bearing in mind the economy may in fact have shrunk in the second quarter after expanding 1.5 percent in the first three months, according to the recent statement of Deputy Economy Minister Walther Otremba.

I personally will be very surprised if we see growth at or near the 2.2% the institutes are forecasting (and much less the 2.5% put forward in the now somewhat dated EU commission April forecast, although Eurostat now have a 1.8% forecast pencilled into their database). I even consider the 1.7% from the OECD and 1.9% from Morgan Stanley to be still on the high side given the extent of downside risk and the sort of real economy data we are now seeing.

At the start of the year the German government was reckoning on a growth rate of 1.7 per cent, while Peer Steinbrück is basing himself on 1.2% for the draft budget.

“Now the president of the Bundesbank told the cabinet it might be 2 per cent, to my surprise,” Peer Steinbrück informed the Financial Times recently. “For my 2009 budget, I estimated growth at around 1.2 per cent, which accounts for all the downside risk ... Some people say it might be 1.4 or 1.5.”

Obviously I am one of the people in question, since I would go much nearer to the 1.4% rate forecast by the IMF in its April World Economic Outlook forecast, and my reasoning would be as follows. We have already had 1.5% growth in the first quarter, but we may have a negative number to put next to it in Q2. Lets make a guess: -0.2%. That brings us back to around 1.3% (its not as simple as this in practice, but bear with me for a second). So then, what if we get, say, a reasonably positive Q3: 0.4% expansion, say. But what then if we get a contraction in Q4? Then everything would depend on the rate of contraction.

Well, there's a lot of guessing going on here, and we will be a little clearer when we get the Q2 number, but the basic structure of the situation is, I think, the one I am suggesting here. Very weak (and possibly negative) growth in Q2 followed by a "bounce back" in Q3, and then a second negative quarter in Q4, a quarter which could well by that point be the first of two consecutive quarters of negative growth, that is the first part of a recession.

In addition all the indications suggest that German consumption will continue to be weak throughout 2008. So if consumer consumption is at best flat, government consumption equally so, and investment and construction weakening, we are simply lefy with export growth, and here the outlook is definitely more negative in 2008 than it was in 2007. So I would say that, based on current data, 1.4% growth in Germany in 2008 looks to be a reasonable estimate at this point, and if there is risk to this call, then I would say that it was mainly downside.