Monday, December 28, 2009

Quantifying Eurozone Imbalances and the Internal Devaluation of Greece and Spain

By Claus Vistesen: Copenhagen

Now this is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning.

Churchill 1942


  • The extent, so far, of the internal devaluation process depends on the time period used for analysis. Using Q3-2007 as the beginning of the economic crisis suggest that Greece and Spain have not corrected relative to Germany as a benchmark. However, if we look entirely at the world in a post-Lehmann context the picture is different with Greece and Spain having observed excess deflation relative to Germany to the tune of -1.7% and -4.5% respectively for unit labour costs and -5.4% and -1.7% respectively for the PPI.
  • The correction observed in the context of unit labour costs appears technical as German unit labour costs have increased sharply since Q4-2008 due to a large reduction in working hours and an increase in short time work. In comparison, the relative correction in the PPI looks more solid.
  • The internal devaluation has not yet trickled down into the overall price level represented by the CPI. Both using the period Q3-07 to Q3-09 and Q4-08 to Q3-09 as the relevant time horizon reveals that there has been no meaningful internal devaluation in Greece and Spain measured on the CPI.
  • While the analysis presented here may go some way to quantify the intra-Eurozone imbalances and the course of the internal devaluation so far it is impossible to say precisely how far (and for how long) Greece and Spain (and indeed Latvia, Hungary etc) have to go here. More importantly, it is impossible to say exactly which measures that must be taken albeit that they have to be severe in the context of reigning in public spending and, ultimately, the public debt and ongoing deficit. Likewise, it is difficult to quantity just how high unemployment should drift and for how long it should stay there in order to grind down past excess.

As 2009 is fast approaching an end it is worth asking whether this also means an end to the financial and economic crisis. Even if 2009 will be a year thoroughly marked by a global recession it could still seem as if the worst is behind us. Most of the advanced world swung into positive growth rates in H02 2009, risky assets have rallied, volatility has declined to pre-crisis levels, and interest rates and fiscal stimulus have been adeptly deployed to avert catastrophe. However and precisely because the last part has been a crucial prerequisite for the first three and as policy makers are now adamant that emergency measures must be scaled back or abandoned either because of necessity or a balanced assessment, it appears as if Churchill's well known paraphrase is an adequate portrait of the situation at hand. In this way, what is really left in the way of global growth once we subtract the boost from fiscal and monetary stimuli and what is the underlying trend growth absent the crutches of extraordinary policy measures?

This question is likely to be a key theme for 2010.

Nowhere is this more relevant than in Greece and Spain who, together with Eastern Europe, have slowly but decisively taken center stage as focal points of the economic crisis. With this change of focus a whole new set of issues have emerged in the context of just how efficiently (or not) the institutional setup of the Eurozone and EU will transmit and indeed endure the crisis.

I won't go into detail on this here mainly because I would simply be playing second fiddle to what Edward has already said again (and again) in the context of his ongoing analysis of the Spanish and Greek economy to which I can subscribe without reservations. It will consequently suffice to reiterate two overall points in the context of Spain and Greece.

Firstly, the main source of these economies' difficulties, while certainly very much present in the here and now, essentially has its roots in population ageing and a period, too long, of below replacement fertility that has now put their respective economic models to the wall. It is interesting here to note that while it is intuitively easy to explain why economic growth and dynamism should decline as economies experience ongoing population ageing, it is through the interaction with public spending and debt that the issue becomes a real problem for the modern market economy. Contributions are plentiful here but Deckle (2002) on Japan and Börsh-Supan and Wilke (2004) on Germany are good examples of how simple forward extrapolation of public debt in light of unchanged social and institutional structures clearly indicate how something, at some point, has to give. Whether Spain and Greece have indeed reached an inflection point is difficult to say for certain. However, as Edward rightfully has pointed out, this situation is first and foremost about a broken economic model than merely a question of staging a correction on the back of a crisis.

Secondly and although it could seem as stating the obvious, Greece and Spain are members of the Eurozone and while this has certainly engendered positive economic (side)effects, it has also allowed them to build up massive external imbalances without no clear mechanism of correction. Thus, as the demographic situation has simply continued to deteriorate so have these two economies reached the end of the road. In this way, being a member of the EU and the Eurozone clearly means that you may expect to enjoy protection if faced with difficulty, but it also means that the measures needed to regain lost competitiveness and economic dynamism can be very tough. Specially and while no-one with but the faintest of economic intuition would disagree that the growth path taken by Greece and Spain during the past decade should have led to intense pressure on their domestic currencies, it is exactly this which the institutional setup of the Eurozone has prevented. I have long been critical of this exact mismatch between the potential to build internal imbalances and the inability to correct them, but we are beyond this discussion I think. Especially, we can safely assume that the economists roaming the corridors in Frankfurt and Brussels are not stupid and that they have known full well what kind of path Greece and Spain (and Italy) invariably were moving towards.

Essentially, what Greece and Spain now face (alongside Ireland, Hungary, Latvia etc) is an internal devaluation which has to serve as the only means of adjustment since, as is evidently clearly, the nominal exchange rate is bound by the gravitional laws of the Eurozone. Now, I am not making an argument about the virtues of devaluation versus a domestic structural correction since it will often be a combination of the two (i.e. as in Hungary). What I am trying to emphasize is simply two things; firstly, the danger of imposing internal devaluations in economies whose demographic structure resemble that of Greece and Spain and secondly, whether it can actually be done within the confines of the current political and economic setup in the Eurozone.

On the last question I personally adamant that it has to since failure would mean the end of the Eurozone as we know it but this is also why I am quite worried, and intrigued as an economist, on the first question. Specifically and as Edward and myself have been at pains to point out (and to test and verify) this medicine while certainly viable in theory has three principal problems. Firstly, it takes time and may thus amount to too little too late in the face of an immediate threat of economic collapse. Secondly, an ageing population spiralling into deflation may have great problems escaping its claws, and thirdly, because of the pains associated with the medicine the patient may be very reluctant to acccept the treatment. Especially, the last point is very important to note from a policy perspective and was made abundantly clear recently in the context of Latvia where The Constitutional Court ruled that the very reforms demanded in the context of the IMF program to reign in costs through cutting pensions would violate the Latvian constitution. And as Edward further points out, the situation is the same in Hungary where voters recently (and quite understandably one could say) decided to reject a set of health charges that were exactly proposed as part of a reform program designed to reign in public spending. We are about to see just how willing Spain and Greece are in the context of accepting the austerity measures that must come, but similar dynamics are not alltogther impossible.

Consequently, and while I agree with Edward as he turns his focus on the inadequacy of the political system in Spain and Greece to realize the severity of the mess; it remains an inbuilt feature of imposition of internal devaluations through sharp expenditure cuts that they are very difficult to sustain given the political dynamics. This is then a question of a careful calibration of the stick and carrot where the former especially in the initial phases of an internal devaluation process is wielded with great force.

Internal Devaluation, What is it All About Then?

If the technical aspects of an internal devaluation have so far escaped you it is actually quite simple Absent, a nominal exchange depreciation to help restore competitiveness the entire burden of adjustment must now fall on the real effective exchange rate and thus the domestic economy. The only way that this can happen is through price deflation and, going back to my point above, the only way this can meaningfully happen is through a sharp correction in public expenditure accompanied with painful reforms to dismantle or change some of the most expensive social security schemes. This is naturally all the more presicient and controversial as both Spain and Greece are stoking large budget deficits to help combat the very crisis from which they must now try to escape. Positive productivity shocks here à la Solow's mana that fall from the sky may indeed help , but in the middle of the worst crisis since the 1930s it is difficult to see where this should come from. Moreover, with a rapidly ageing population it becomes more difficult to foster such productivity shocks through what we could call "endogenous" growth (or so at least I would argue).

With this point in mind, let us look at some empirical evidence for the process of internal devaluation so far.

In order to establish some kind of reference point for analysis I am going to compare Greece and Spain with Germany. This is not because Germany, in any sense of the words, stands out as an example of solid economic performance as the burden of demographics is clearly visible here too. However, for Spain and Greece to recover they must claw back some of the lost ground on competitiveness relative to Germany. This highlights another and very important part of the internal devaluation process. Spain, Greece etc will not only be fighting their own imbalances; they will also fight a moving target since they may not be the only economies who face deflation or near zero inflation as we move forward.

Beginning with the simple overall inflation rate measured by the CPI we see that the level of prices (100=2005) has risen much faster in Greece and Spain than in Germany. Compared to 2005 the price level in Germany stood 7.1% higher in Q3-09 which compares to corresponding figures for Spain and Greece at 11.5% and 10.3% respectively. However, this does not tell the whole story about the build up of imbalances since the inception of the Eurozone. Consequently, since Q1-00 the price index has increased some 15% in Germany whereas it has increased a healthy 29.3% and 27.2% in Greece and Spain respectively.

Turning to the bottom chart which plots the annual quarterly inflation rate a similar picture reveals itself with a high degree of cross-correlation between the yearly CPI prints, but where the German inflation rate has been persistently lower than that of Greece and Spain. The average inflation rate in Germany from Q1-1997 to Q3-2009 was 1.6% and 3.5% and 2.8% for Greece and Spain respectively. It is important to understand the cumulative nature of the consistent divergence in inflation rate since it is exactly this feature that contributes to the build-up of the external debt imbalance. From 2000-2009(Q3) the accumulated annual increases in the CPI was 57% for Germany versus 109.4% and 104% for Greece and Spain respectively. Assuming that Germany remains on its historic path of annual CPI readings (which is highly dubious in fact), this gives a very clear image of the kind of correction Greece and Spain needs to undertake in order to move the net external borrowing back on a sustainable path which in this case means that these two economies are now effectively dependent on exports to grow.

If the divergence in Eurozone CPI represents a general measure of the built-up of external imbalances and the need for an internal devaluation through price deflation two other measures provide more direct proxies. These two are unit labour costs and the producer price index (PPI) which are both key determinants for the competitiveness of domestic companies on international markets. Intuitively one would expect unit labour costs as an important input cost to drive the PPI which measures the price companies receive for their output. Yet this is only going to be the case if the companies in question have market power on the domestic market. Consequently, if you regress the quarterly change of the PPI on the quarterly change on unit labour costs you get a negative coefficient in Germany and a positive coefficient in Greece and Spain (highly significant for Spain and not so for Greece). This is exactly what one would expect since German companies are highly exposed to the external environment (where they enjoy no market power) and thus has to suffer any increase in the cost of labour input through a decline in their output price. Conversely in Spain, the connection between an increase in unit labour costs and the PPI is strongly positive which suggest that Spanish companies has enjoyed considerable market power due to a vibrant domestic economy [1]. It is exactly this that must now change.

If we look at unit labour costs and abstract for a minute from the increase in German unit labour costs from Q2-08 to Q2-09 in Germany [2], both Greece and Spain have seen their labour cost surge relative to Germany since the inception of the Eurozone. Since Q1-00 the accumulated change in the German index has consequently been 15.2% which compares to 97.7% and 105.6% for Greece and Spain respectively. More demonstratively however is the fact that since the second half of 2006 the labour cost index of Spain and Greece have been above the Germany relative to 2005 which is the base year. Consider consequently that the labour cost index in Greece and Spain was 13.3% and 16.4% below the German ditto in Q1-2000 and now (even with the recent surge in German labour costs), the Greek and Spanish labour cost index stands 7.2% and 5.2% above the German index.

Turning finally to producer prices the similarity between the three countries in question are somewhat restored which goes some way to support the notion of persistent lower labour cost growth relative to fellow Eurozone members as the main source of the build-up of Germany's "competitive advantage" and in some way the build-up of intra Eurozone imbalances.

Essentially, and while definitely noticeable the divergence between Greece/Spain and German on the PPI is less wide than in the context of unit labour costs and the CPI. Consequently, and if we look at the index, the divergence which saw Spanish and Greek producer prices increase beyond those of Germany came very late in the end of 2007. Moreover, the correction so far has been quite sharp in both Greece and Spain relative to Germany with the PPI falling 14.8%, 5.7% and 2.8% (yoy) in Q2-09 and Q3-09 in Greece, Spain and Germany. The accumulated increase however, in the PPI, from 2000 to Q3-09 has been 85% in Germany and 136% and 101.7% in the Greece and Spain respectively.

If the numbers above indicates the extent to which intra Eurozone imbalances have manifested themselves in divergent price levels and rates of inflation, the concept of internal devaluation concerns the net effect on the prices in Greece and Spain relative to, in this case, Germany. On this account, and if we put the beginning of the financial crisis as Q3-07 (i.e. when BNP Paribas posted sub-prime related losses) the butcher's bill look as follows.

From Q3-07 to Q3-09 and in relation to the CPI the average quarterly inflation rate in Greece in Spain has been 1% and 0.66% higher than in Germany. The accumulated excess inflation rate over the German inflation has been 8% in Greece and 5.29% in Spain. Only in the context of Spain do we observe some indication of the initial phases of a relative internal devaluation as Spain has seen an accumulated inflation rate lower than that of Germany to the tune of 1.28%.

Turning to unit labour costs the picture changes quite a lot depending on the time horizon. Using the same period as above, the average quarterly excess increase in unit labour costs of Greece and Spain relative to Germany has been 1.75% and 0.3% in Greece and Spain respectively. The accumulated increase in unit labour costs has consequently been a full 14% and 2.8% higher in Greece and Spain relative to Germany. However, if we focus the attention on the period from Q4-08 to Q2-09 and due to the fact that labour hours in Germany have gone down further than in Greece and Spain, labour costs have corrected sharply in Greece and Spain relative to in Germany to the tune of -5.2% and 13.7% (accumulated) and -1.7% and -4.6% respectively. The fact that German producers have so far cut down sharply on labour hours could mean that Germany should claw back some of the lost ground vis-a-vis Greece and Spain if and when these two economies follow suit.

Finally, in relation to producer prices the picture is very much the same as in the context of unit labour costs with the notable qualifier that the relative excess deflation observed in Greece and Spain from Q4-08 and onwards is likely to be less "technical" and thus more "real" than in the case of labour costs. In this way the period Q3-07 to Q3-09 saw the excess rate of produce price inflation reach 14.8% and 6.8% (accumulated) and 1.8% and 0.8% (quarterly average) in Greece and Spain respectively. However, if we focus the attention on Q4-08 to Q3-09 the picture reverses and reveals a substantial degree of excess deflation over the Germany PPI in Greece and Spain to the tune of 16.1% and 5.2% (accumulated) and 5.4% and 1.7% (quarterly average) for Greece and Spain respectively.

The End of the Beginning

As we exit 2009 it is quite unlikely that we will also be able to leave behind the effects of the economic and financial crisis and this is not about me being persistently negative or even a perma-bear. Things have definitely improve and much of this improvement owes itself to rapid, bold, and efficient policy measures. However, some economies are in a tighter spot than others and this most decisively goes for Spain and Greece who now have to correct to the fundamentals of their economies with rapidly ageing populations.

As this correction largely has to come in the form of an internal devaluation the following conclusions are possible going into 2010.

  • The extent, so far, of the internal devaluation process depends on the time period used for analysis. Using Q3-2007 as the beginning of the economic crisis suggest that Greece and Spain have not corrected relative to Germany as a benchmark. However, if we look entirely at the worldin a post-Lehmann context the picture is different with Greece and Spain having observed excess deflation relative to Germany to the tune of -1.7% and -4.5% respectively for unit labour costs and -5.4% and -1.7% respectively for the PPI.
  • The correction observed in the context of unit labour costs appears technical as German unit labour costs have increased sharply since Q4-2008 due to a large reduction in working hours and an increase in short time work. In comparison, the relative correction in the PPI looks more solid.
  • The internal devaluation has not yet trickled down into the overall price level represented by the CPI. Both using the period Q3-07 to Q3-09 and Q4-08 to Q3-09 as the relevant time horizon reveals that there has been no meaningful internal devaluation in Greece and Spain measured on the CPI.
  • While the analysis presented here may go some way to quantify the intra-Eurozone imbalances and the course of the internal devaluation so far it is impossible to say precisely how far (and for how long) Greece and Spain (and indeed Latvia, Hungary etc) have to go here. More importantly, it is impossible to say exactly which measures that must be taken albeit that they have to be severe in the context of reigning in public spending and, ultimately, the public debt and ongoing deficit. Likewise, it is difficult to quantity just how high unemployment should drift and for how long it should stay there in order to grind down past excess.

In this sense, 2009 will not go down as the end in any sense of the word, but more likely as the end of the beginning.


[1] - Naturally, this argument assumes non-sticky prices and thus a 1-to-1 relationship in time between a change in input costs and output prices of companies. Since contractual arrangements are likely to make both sticky in the short run and likely with divergent time paths too, the quantitative results are not robust. The results for Germany are significant at 10% whereas those for Spain are significant at 1%. Mail me for the estimated equations if you really want to see the results.

[2] - The index rose 7.8% over the course of the year ending Q2-2009 which is way above 3 standard deviations of the "normal" annual change in the index from 1997 to 2009. The explanation is really quite simple and relates to the fact that German manufactures (in particular) has sharply cut overtime work and short time work has been rapidly extended (see e.g. this from Q2-09) which is obviously not the case in Greece and Spain. The fact that German producers have so far cut down sharply on labour hours means that Germany should claw back some of the lost ground vis-a-vis Greece and Spain if and when these two economies follow suit.

Friday, December 25, 2009

Marching Separately But Striking Together Over At the ECB

Well first of all, a very Happy Xmas to any of you foolish enough to be reading tiresome posts like this one on such a special day as this - a tiresome post which simply starts by going into some nitpicking follow-up detail to my earlier post on ECB liquidity and monetary policy separation - That Which The ECB Hath Separated, Let No Man Join Together Again! - but then starts to explore the rather more torrid topic of what exactly Latvia's Regional development minister Edgars Zalāns might have had in mind when he told the Delfi news portal that the Latvian agreement with the IMF and other lenders could "easily be amended given its shaky legal grounds" (there, that made you hiccup-back-up some of your xmas-pud, now didn't it?) or what Prime Minister Valdis Dombrovskis might have been getting at when he warned that “We will just go bankrupt if we observe all legal norms.”

But first some really tiresome (but important) details on the ECB, since the bank effectively wound up its anti-crisis program of extraordinarily long-term lending to banks last week with a final one year funding operation that is likely to keep short-term euro interest rates ultra-low at least for another six months. The general opinion is that the tender outcome suggested that much of the banking system can now live without the ECB's life-support mechanism, although a number of banks are still highly dependent on it.

The ECB injected 96.937 billion euros into the banking system in the third and last of its 12-month lending operations. As in the previous two 12-month tenders, the ECB gave banks all the money they asked for. However, in contrast to earlier tenders, it said the effective interest rate wouldn't be a fixed 1%, but rather would be tied to the average rate at the main one-week refinancing operations over the next year.

The general opinion is that last week's allotment - which will increase the total amount of ECB money in the market by around 14% - will keep the Euro Overnight Index Average, or EONIA (the key rate for interbank overnight money), around its recent level of 0.30%-0.35%. Actual overnight rates have barely moved from this level since the ECB's first 12-month tender - the whopping 442.24 billion euros allocated in June - created a structural surplus of money in the market (this was obviously the intention) and reduced the cost of borrowing well below the ECB's own targeted refi rate of 1%. And it is here that that tiresome little detail comes into play, since while the EONIA rate is unlikely to move from its present levels in the short term, once the funds from this first 12-month tender mature next June (thus removing much of the excess liquidity currently in circulation), the EONIA rate will in all probability start to move back towards the level of the refi target rate, which is where it normally stands.

So, I want to qualify a point I made in my previous post, since this upward movement in EONIA which will be provoked by the ending of the one year funding programme will constitute some form of monetary tightening, albeit a rather marginal and insignificant one.

At the same time, the recent decisions do not mean a complete termination of ECB lending operations to banks in the Eurosystem, since while the six-month tender due in March will also be the last, the three-month tenders the ECB had offered since its inception in 1999 will still continue, although it is not clear at this point whether these will have ceilings or not. Basically all these move form part of the bank's plans to end its non-standard policy measures over the course of 2010, even if it is unlikely to intentionally do anything to make matters worse for the troubled banks, provided that is, their national governments play ball with the structural reform programmes being advocated by the EU Commission.

Fewer Banks Borrowing More Money - And No Prizes For Guessing the Culprits

The number of banks bidding (224) was down by more than 60% on the 589 who participated in the previous 12-month operation in September, indicating that fewer banks now need such help. The banks that do remain dependent on the ECB, however, appear to be even more dependent than they were three months ago, since the average bid rose from 128 million euros to 433 million. While the ECB refuses to comment on which banks participated in the tender, it seems pretty clear that they were concentrated in countries on Europe's periphery (Greece, Spain, Ireland, possibly Austria), and indeed last month, the Greek central bank specifically urged Greek commercial banks to show restraint in the coming tender, and not increase their dependence on ECB funding.

Credibility Under Strain

Which brings us all the way round to Latvia. It is hard to assess the likely impact of the Latvian constitutional court decision that pension cuts included in the recent IMF-EU package are not legal, but personally I find the decision rather significant (for a discussion of the background see my post of yesterday - Latvia Is Back In The News, And Expect More To Come) since pension reform lies at the heart of the whole structural reform programme currently being demanded of "risky" EU states by the IMF, the EU Commission and the Credit Rating Agencies. Indeed the whole credibility of the EU's ability to manage it's own affairs could be called into question here. As Angela Merkel recently said:

"If, for example, there are problems with the Stability and Growth Pact in one country and it can only be solved by having social reforms carried out in this country, then of course the question arises, what influence does Europe have on national parliaments to see to it that Europe is not stopped.....This is going to be a very difficult task because of course national parliaments certainly don't wish to be told what to do. We must be aware of such problems in the next few years."

Well, I am sure some of our leaders must be becoming more and more aware of the problems presented with every passing day. Prime Minister Valdis Dombrovskis seems to understand the gravity of the situation “We will just go bankrupt if we observe all legal norms.”

My considered opinion is that it is the political pressures inside those countries (whether inside or outside the Eurozone) forced down the road of internal devaluation which can ultimately cause the agreements they enter into to fall apart, ultimately leading - in the Latvian case, and as Dombrovskis recognises - to sovereign default, bringing others (in the Latvian case, Estonia and Lithuania, or in the Greek one Spain) crashing down behind them.

As Baltic reports rightly put it:
The Constitutional Court’s ruling Monday that the decision by Latvia’s government earlier this year to lower pensions had violated the Satversme will, at the very least, force a new round of talks with international lenders and could trigger a new wave of political instability.

And as we should also note, the Constitutional Court also ruled that the government’s agreement with international lenders was also unconstitutional in that it hadn’t been approved by parliament, which takes us back to Merkel's point, and the absence of institutional mechanisms for the EU - under defined circumstances - to over-ride the sovereignty of national parliaments (what a hot potato that one).

Not Simply A Latvian Issue

And the issue isn't simply confined to Latvia, since we should not forget that Hungarian voters held their own referendum in March last year, where they effectively threw out a set of health charges introduced by the government as part of an "austerity programme" designed to bring Hungary's surging public deficit under control. And the long term financing of Hungary's health system has still not found a satisfactory solution.

I would also draw attention to this paragraph from my last review of the situation in Greece:
"We should also not fail to notice that Greece also had to raise 2 billion euros in debt via a private placement with banks last week, against a backdrop of credit downgrades and steadily rising spreads. The ECB undoubtedly agreed to this given the degree of policy coordination which must exist behind the scenes, since they are the ones who are financing the Greek banks, but it does highlight just how things have moved on in recent months, since only last year it was imagined that the Eurozone in and of itself gave protection from this kind of financing crisis, which was why only eurozone non-members, like Latvia and Hungary, were sent to the IMF. Now it is clear that while the ECB could keep protecting Greece from trouble till the cows come home, they cannot simply keep financing unsustainable external deficits and retain credibility. In this sense the financial crisis has now “leaked” into the Eurozone. And this has implications I would have thought, for countries like Estonia, who see eurozone membership as a “save all”. And obviously, the EU authorities badly need to plug this hole in their armour, or the entire concept of the eurosystem can be placed at risk, which is why I think we won’t see an explicit slackening in the minimum acceptable rating criteria."
So a very large credibility issue is now looming, and one which is leaving a gaping hole waiting to be plugged in the outer defences of the Eurozone.

Where Ireland Fearlessly Treads, Spain Fears To Wander

One of the policies which will undoubtedly be applied by the EU authorities in an attempt to bring this situation under control will be one of being seen to favour the "good students" against the flunkers. By good students here we may think in terms of countries like Estonia and Ireland. Estonia is clearly going to be "rewarded" in some way or other for its "solid performance" in the face of the crisis (if that is, it isn't inadvertently dragged kicking and screaming off that same cliff from which Latvia seems destined to fall), while Ireland, will receive all the protection the ECB is able to offer, and that, as I am stressing, is plenty. M Trichet's strident insistence that EU countries were like US states would end up being rather hollow if the eurosystem were to prove incapable of offering aid to one of its members who was following instructions and struggling for survival.

As in the case of Spain, a large part of the Irish debt is owed to foreign banks and bondholders who, rather than domestic Irish depositors, were responsible for funding the property boom. And, as the FT's John Murray Brown points out, the net indebtedness of Irish banks to the rest of the world rose sharply, from 10 per cent of GDP in 2003 to 60 per cent by early 2008.

But while the very survival of both Irish banks and Spanish Cajas has been increasingly questioned, the Irish government has stepped in to shore up their asset side by agreeing to take over the worst of the sector’s property loans, via the creation of the new National Asset Management Agency (NAMA), in way which contrasts strongly with the Spanish authorities who have simply limited themselves to denying there was any real problem.

Despite all the jitters about Irish sovereign debt in the light of the forthcoming annual fiscal deficits, what debt investors are really concerned about is the state’s huge contingent liability following the decision in October last year to guarantee all deposits and most debt of the five biggest banks. Analysts calculate that if there were a run on the Irish banks, the state would not realistically be able to find the 400 billion euros – an amount twice the size of Irish gross domestic product – the might need to meet their potential obligations under the guarantee. But this nervousness is to miss the central role the ECB would play in just this situation (should it arise, which it probably won't due to the credibility of the ECB guarantee). If the ECB were not able to shore-up Irish finances in times of crisis, then I think the Eurosystem would already be history.

But Spain is a very different problem, and a much bigger threat, not only because of its size, and the size of the debts, but also because Spain, unlike Ireland, is turning a deaf ear to European Council "advice". The banks have accumulated large quantities of houses and land on their balance sheet, and no one knows their actual value. And there is a stock of around one and a half million unsold new properties awaiting buyers who may never arrive. And with the continuing inaction, the nervousness only grows. As Bloomberg's Charles Penty points out in an excellent review article, the “skeletons” on the balance sheets of Spain’s banks are making many fund managers averse to the acquisition of stocks with a strong dependence on the Spanish internal market . He cites the case Alvaro Guzman, Managing Partner with Bestinver Asset Management, whose funds have been the best Spanish performers over the past decade.

“We are very pessimistic on Spain because we think there are still skeletons to come out of the cupboards -- basically marking to market the true value of real estate on the balance sheets of the banks,” Guzman says, “It’s not just the banks we’re out of but anything that has a Spanish cyclical component.”
Among Bestinver's concerns is the fact that the crash of the Spanish real estate market, which caught banks with 324 billion euros in loans to developers, will limit economic growth and tax revenues (an echo here of S&P), perhaps forcing the need for an eventual bailout by Germany (or France). And, of course, Bestinver's view is far from an isolated one. Penty produces another telling quote, this time from Jim O'Neill, Chief Global Economist with Goldman Sachs, who told Bloomberg radio that it was going to be important to see whether further damage to Greece’s credit ratings sparks a “cascading game” where the “market just starts going after Spain or Portugal." You bet it is going to be important!

Testing Days Ahead

Evidently Europe's institutional structure is in for a very testing time, and new and imaginative initiatives are going to be needed. Sovereign risk has now spread from non-Eurozone countries like Latvia and Hungary, straight into the heart of the monetary union in cases like Greece and Spain. Mistakes have been made. As I argued in my Let The East Into The Eurozone Now! piece back in February 2009, the decision to let the Latvian authorities go ahead with their internal devaluation programme never made sense, and the three Baltic countries and Bulgaria should have been forced to devalue - the writedowns swallowed whole - and admitted into the Eurozone as part of the emergency crisis measures. This situation has simply been allowed to fester, and in addition the much needed change in the EU institutional structure - to allow Angela Merkel the power she is asking for to intervene in Parliaments like the Latvian, Hungarian, Greek and Spanish ones, as and when the need arises - has not been advanced, with the result that we are increasingly in danger of putting the whole future of monetary union at risk. It is never to late to act, but time is, inexorably running out. As the old English saying goes he (or she) who dithers in such situations is irrevocably lost.

Tuesday, December 22, 2009

Why The Ratings Agencies Are Right And George Papaconstantinou Is Wrong

The Greek government is having a hard time of it at the moment. Only today the Finance Ministry issued a statement that it was ready to "intensify its efforts to restore the viability of fiscal and economic trends in Greece" in response to the Moody's decision to downgrade the country's credit rating, while just one week ago the Finance Minister was accusing Standard & Poor's of failing to "assess correctly" new moves by Athens to tackle its swollen budget deficit - echoing a similar response from Spanish Prime Minister José Luis Rodriguez Zapatero. George Papaconstantinou's critical outburst followed the earlier downgrade decision by the rating agency of the nation's long-term sovereign debt. Today, the Greek Government got the answer they should have expected, since Moody's effectively followed the path of the other two main agencies (Fitch already have the Hellenic Republic on BBB+) and downgraded Greece to A2 from A1. The move means Greek debt is one step closer to being cut off from eligibility as ECB collateral, since Moody's have put the rating on negative outlook, which means they consider a further downgrade more likely than an upgrade over the next twelve to eighteen months, while the ECB are scheduled to revert to the pre-crisis criteria of only accepting Sovereign Bonds which retain at least one A- from one of the main ratings agencies as collateral for lending. Certainly Lucas Papademos, ECB vice president, said last week that the ECB would not change plans to tighten its collateral rules in December 2010 simply to accommodate Greece.

My reading of the situation is that Greece now has till December 2010 to convince the Ratings Agencies, the EU Commission and the ECB that they mean business and have a viable plan, or they are off to the IMF. And in fact I am not very optimistic they can comply with this constraint. Moody's takes a rather different view however.

“Moody’s believes that Greece is extremely unlikely to face short-term liquidity/refinancing problems unless the European Central Bank decides to take the unusual step of making the sovereign debt of a member state ineligible as collateral for bank repurchase operations — a risk that we consider very remote,” according to Arnaud Mares, Senior Vice President in Moody’s Sovereign Risk Group.
What I can't see is how the ECB can credibly avoid taking this step, since when it announced back in 2005 that it would not accept collateral without the A- rating, it was exactly this sort of situation it had in mind. Any backtracking now would be perceived by markets which are becoming extremely nervous about the topic of long term sovereign risk as a sign of weakness, one which was likely to open the door to more fiscal abuse in other states, and indeed it would be a decision which would be hard to understand for voters in Germany and France who may at some stage be asked to chip-in, and sort the growing mess out. So, indeed, I can't see how the ECB could credibly afford to not implement its threat.

Reading between the lines in the EU Commission documentation at this point, I would say that EU institutions are steadily trying to put a procedure with teeth in place in order to avoid the need to send countries to the IMF, but this institutional hardening may not come in time to save Greece from humiliation. I believe that while there is not a complete consensus at this point, the eventuality of sending a eurozone member state over to Washington, while not being desireable, and being a sign of weakness, would in fact be seen as a lesser evil to that of allowing the situation to deteriorate further. It will have escaped no one's notice that Spain is very much in the early stages of a similar procedure, with any slippage in deficit targets putting the country straight back into the Excess Deficits Procedure with a fast-track enhancement, and what I feel no one wants to see happen is the situation in Spain deteriorating to the point it has now reached in Greece.

We should also not fail to notice that Greece also had to raise 2 billion euros in debt via a private placement with banks last week, against a backdrop of credit downgrades and steadily rising spreads. The ECB undoubtedly agreed to this given the degree of policy coordination which must exist behind the scenes, since they are the ones who are financing the Greek banks, but it does highlight just how things have moved on in recent months, since only last year it was imagined that the Eurozone in and of itself gave protection from this kind of financing crisis, which was why only eurozone non-members, like Latvia and Hungary, were sent to the IMF. Now it is clear that while the ECB could keep protecting Greece from trouble till the cows come home, they cannot simply keep financing unsustainable external deficits and retain credibility (see this post for more background on all this). In this sense the financial crisis has now "leaked" into the Eurozone. And this has implications I would have thought, for countries like Estonia, who see eurozone membership as a "save all". And obviously, the EU authorities badly need to plug this hole in their armour, or the entire concept of the eurosystem can be placed at risk, which is why I think we won't see an explicit slackening in the minimum acceptable rating criteria.

Fiscal Restraint No Longer Enough

On Wednesday last week S&P reduced Greece's sovereign rating from A- to BBB+, and explicitly stated the measures announced the previous Monday were "unlikely on their own to lead to a sustainable reduction in the public debt". Moody’s add their weight to this and stress that the Greece's longer-term sovereign risks have only partly been offset by the government’s announced policy response. Fitch Ratings cut Greek debt to BBB+ on December 8.

George Papaconstantinou, finance minister, responded in fighting spirit, and is quoted as saying "we don't think this [the S&P rating downgrade] reflects the efforts the new government is making to stabilise public finances which had derailed" - a reference to a collapse in revenue collection and excessive spending under the previous government. "It didn't take into consideration and didn't assess correctly what is happening at this point." But the whole point is that it was not only Greek finances which became derailed over the last decade, but the whole economic model on which Greek society has been based, and it is this derailment which needs to be fixed, and it is in this context that the measures which have been proposed fail to convince.

Strangely many analysts seem to think today's decision by Moody's offers respite, and almost aid and comfort, to a hard pressed Greek government, simply because they only downgraded by one notch. Certainly Greek bond markets rallied sharply on the news, and the benchmark 10-year Greek government bonds jumped in price, pushing their yields down 22 basis points to 5.724 per cent, while 2-year yields fell 10bp to 3.359 per cent. This left the spread between German and Greek 10-year yields – a widely followed measure of european sovereign risk – at 2.5 percentage points, its lowest since last Thursday.

Basically such observers seem to have been worried that if Moody's downgraded Greece into 'B' territory, as Fitch and S&P have already done, then Greek banks would no longer be able to exchange Greek government debt for cash in ECB refinancing operations. But I feel that these observers have - as is so often the case - gotten ahead of themselves. It was never really probable or credible that Moody's would go the whole hog in one foul swoop. The ECB strategy of cajoling Greece into making changes rests on the "carrot and stick" approach, and it is hard to see how the stick would work, if the carrot was suddenly removed. But remember, the threat is still there, since as I say, the outlook is still negative, and as Moody's themselves point out "the question of whether the negative outlook will evolve into a stable outlook or into a further downgrade will depend on the Greek government’s plan being followed through — as demonstrated for instance by a sustained increase in tax revenues and/or the effectiveness in reining-in expenditure".

It's Long Term Liabilities and Low Growth That Are The Real Problem

Prime Minister George Papandreou had vowed “radical” measures to fix Greece’s finances, and Finance Minister Papaconstantinou lifted the 2010 deficit-reduction target to 4 percentage points from 3.6 percentage points. That would lower the deficit to 8.7 percent of gross domestic product, still almost three times the EU limit of 3 percent, but a sizeable chunk of reduction for one single year, and a reduction which will almost certainly ensure that Greece remains mired in recession for most of 2010.

Moody's however, seem to be focused on much longer term issues, like demography:
The combination of a global post-crisis environment that is less favourable to Greek public finance dynamics (with increased risk discrimination and muted global demand) and an equally challenging domestic environment (with accelerating demographic pressure on public finances in coming years) will make any fiscal adjustment increasingly difficult and costly to postpone.

Basically Greece is one of the EU countries which will be most severely affected by the ageing process, as can be seen in the two comparative pyramids below. Simply put, in the space of thirty years it will move from being a society with a preponderance of young people to being one, where the over 50s predominate (the charts come from the US Census Bureau IDB population data base).

The principal reason for this dramatic shift has been the sharp fall in Greece's underlying fertility rate.

This, and increasing life expectancy mean that the median population age is projected to rise rapidly, making Greece - with a median age of over 45 - one of the oldest European societies (as well as civizations) by 2020.

The older cohorts of the Greek Labour force will start retiring at a rapid pace after 2015, without an offsetting inflow among the younger cohorts. Total population is projected to peak in 2017 at over 11 million, and than to decline gradually to just around 10 million by the late-2050s. Working-age population will in fact peak in 2010, before declining somewhat faster than overall population. The structure of the population thus gradually shifts to more dependents (especially elderly). The dependency rate increases over time, implying additional pressures on pensions, health, and other entitlements. As can be seen in the chart below, without those much needed pension reforms, Greek pensions will consume a far higher proportion of national output in the years to come than the average level for the rest of the EU 15.

So the Greek crisis is about much more than short term fiscal deficit issues, it is about the long term sustainability of a whole economic and demographic model. As such, Moody's are surely right, the short term liquidity problems undoubtedly have solutions, and it is the long term solvency ones we should be concerned about. During the years of easy borrowing, Greek industry became very uncompetitive, and Greek society dependent on imports. As a result the external debt went up and up, and currently stands at about 160% of GDP (gross) and 85% of GDP (net). Meanwhile Europe's leaders are caught between trying to reassure financial markets Greece won’t default on its debt while at the same time keep up pressure on the country to put its house in order. German Chancellor Angela Merkel said on December 10 Europe has a “responsibility” to help Greece. The following say, European Central Bank President Jean-Claude Trichet said the country must take “courageous action.” Both things are needed, but how I wish those responsible for policymaking in Greece would show more awareness of just how complicated this is going to be, for all of us.

Other background posts to this situation are:

Europe Needs Action Not Words From The Greek Finance Minister

So What's It All About, Costas?

The Velocity Of Modern Financial Crises

That Which The ECB Hath Separated, Let No Man Join Together Again!

It's All Greek To Me

Podcast On The Present State Of The Spanish Economy

Caveat emptor, Spanish-based blogger Mathew Bennett and I have started doing podcasts, and you can find the first one here. At this point in time we are concentrating on Spain. Among the points we cover are:

- How does what’s happened in Dubai affect the economic situation in Greece, Spain and the EU?

- Are left- or right-wing political parties causing or solving more problems during the recess...ion?

- Will the Germans, the French or the EU be able to bailout several European countries at the same time if there are several sovereign defaults?

- Are the ECB and the EU trying to pre-empt the IMF in Greece and Spain?

- What are the underlying structural problems with the eurozone funding plan?

- Why is the ECB channelling funds through monetary and financial institutions to buy up government debt in the eurozone?

- How the ECB is trying to use a carrot and stick approach with eurozone governments to control national government deficits and public policy?

- Is IMF intervention now inevitable in Greece?

- Will the ECB will try to play politics and pressure Zapatero in the run up to the 2012 general elections in Spain?

- Is the situation in Spain similar to the situation in Greece?

- Why don’t Zapatero and the Spanish government seem to be reacting?

- Why is there no coherent plan to get Spain back on its feet?

- What is going on with Spanish banks?

- Will unemployment in Spain reach 25% by the end of 2010?

- Which is more important in Spanish economics: image or hard data?

- Will it be possible for the Spanish government to reduce the deficit from over 10% of GDP to less than 3% by 2012 or 2013?

- What state will the Spanish economy be in by the end of 2010?

- What will happen to Spain when the ECB raises eurozone interest rates?

- Might Spain soon be in a worse economic position than Greece?

- What are the ratings agencies trying to achieve with their warnings on Spain?

- Why won’t the Spanish government tell the Spanish people the truth about what’s going on with the Spanish economy?

- Is José Luis Zapatero really the biggest problem for the Spanish economy right now?

Obviously many of these points run parallel to those raised in my recent post "Why Standard and Poor’s Are Right To Worry About Spanish Finances", but maybe, if you have 40 minutes or so to spare, you might enjoy listening to them being made in Podcast format.

Why Standard and Poor's Are Right To Worry About Spanish Finances

"Spain's weaknesses over the developing crisis reflect mainly the reversal of the continuous domestic demand expansion of over a decade, which was associated with high indebtedness of the private sector, large external deficits and debt, an oversized housing sector compared with the euro area average and fast rising asset prices, notably of real estate assets."
European Commission assessment of Spain's Response to the Excess Deficit Procedure, Brussels 11 November 2009.

“The latest services PMI data suggests that the Spanish economy remains on a downward trajectory. The fact that variables such as activity, new orders and employment all fell at sharper rates during November is real cause for concern, with the prospects for 2010 becoming increasingly gloomy. Businesses report that consumers remain cautious of making any major purchases, particularly those requiring credit. It appears that any economic recovery over the next twelve months will be gradual and drawn-out.”
Andrew Harker, economist at Markit commenting on the November Spanish Services PMI survey.
According to Spanish Prime Minister José Luis Rodriguez Zapatero Spain's government is firmly committed to reducing its fiscal deficit, and is intent on lowering it as requested by the EU Commission by 1.5% of GDP annually, until it finally brings it within the EU 3 per cent of gross domestic product limit by 2013 at the latest. What's more he is quite explicit about how this is going to be possible: Spain is right now, and even as I write, on the verge of emerging from the long night of recession in whose grip it has been for the last several quarters. As such it will soon resume its old and normal path onwards down the highway of high speed growth. There is only one snag here: few external observers are prepared to share Mr Zapatero's optimism.

“The return to growth and the expected fiscal consolidation will allow us to reach the stability pact objectives by 2013,” Mr Zapatero said in a speech last week, using a rhetoric by which few outside Spain are now convinced, and indeed only the day before the credit rating agency Standard & Poor’s had revised its outlook for Kingdom of Spain sovereign debt to negative from stable. The decision followed their earlier move last January to downgrade Spanish debt by revising their long term rating from AAA to AA+. S&Ps justified their latest decision by stating that they now believe Spain will experience a more pronounced and persistent deterioration in its public finances and a more prolonged period of economic weakness versus its peers than looked probable at the start of the year. So things have been getting worse and not better, and indeed, the EU Commission themsleves seem to take a similar view, since while they have lifted their immediate excess deficit procedure in the short term (see below) their longer term worries have only grown.

Standard and Poor's feel that reducing Spain’s sizable fiscal and economic imbalances requires strong policy actions, actions which have yet to materialize, and the EU Commission and just about everyone else agree, and the only people who seem to take the view that the current policy mix is "just fine" are José Luis Zapatero, and the political party that maintains him in office.

Effectively S&P's are concerned about two things: i) growing fiscal deficits; and ii) growth prospects:

The change in the outlook stems from our expectation of significantly lower GDP growth and persistently high fiscal deficits relative to peers over the medium term, in the absence of more aggressive fiscal consolidation efforts and a stronger policy focus on enhancing medium-term growth prospects.

Compared to its rated peers, we believe that Spain faces a prolonged period of below-par economic performance, with trend GDP growth below 1% annually, due to high private sector indebtedness (177% of GDP in 2009) and an inflexible labor market. These factors, in turn, suggest to us that deflationary pressures could be more persistent in Spain than in most other Eurozone sovereigns, which we expect would further slow the pace of fiscal consolidation in the medium term.
Even some inside Spain are now openly questioning the viability of the government's strategy. The downward revisision in Spain's credit outlook, was "hard to deny," according to Spanish representative on the European Central Bank Governing Council, Jose Manuel Gonzalez-Paramo - "The ECB is not taking issue with whether Standard & Poor's should cut Spain's rating, but the report that accompanies this warning is hard to deny" he told the Spanish Press agancy EFE, adding that he was "convinced that the Spanish authorities share this analysis and will do whatever is needed to avoid S&P's negative outlook resulting in a change in rating". However Standard and Poor's explicitly justified the negative outlook by referring to the fact that Spain was not showing signs of taking adequate action to cut its longer term fiscal deficit as required by the EU Commission, and Spanish Prime Minister Jose Luis Rodriguez Zapatero himself stated he could see no no reason why ratings agency Standard & Poor's should downgrade the long-term sovereign debt rating of Spain. So it is hard to share Gomez-Paramo's (rather diplomatic) optimism at this point.

The World Turned Inside Out

Just how realistic is the view being taking by the Spanish administration at this point, and just what are the prospects of that imminent and sutainable return to growth in the Spanish economy on which everything seems to depend? That is the question we will try to ask ourselves in that follows. Certainly the situation we are looking at is a rather peculiar one, since Mr Zapatero's recovery hope seems to be a widely shared one inside Spain. Certainly, if the ICO Consumer Confidence reading is anything to go by, Spaniards are feeling pretty hopeful at this point that the worst of the economic crisis is now behind them. Evidently confidence is still not back to its old pre-crisis level, but it is now well up from its July 2008 lows.

What is even more interesting is to look at the breakdown of some of the ICO consumer confidence index components. According to the ICO data series I looked at, the expectations index has only been above the present level three times since the series started in January 2004 (in September 2004, in January 2005, and in August 2009). That is, the Spanish people currently have the third highest level of expectations about the future registered at any point over the last five years. I find that pretty incredible. Evidently Mr Zapatero is not alone in assuming that S&P's have it wrong.

But is such a viewpoint rationally founded, and even more to the point, is there any economic justification which lies behind it? What could explain such dyed-in-the-wool optimism? It is hard to understand, unless, perhaps, the alternative - that Spain is in for a long and difficult economic correction, after many years of relatively "painless" economic growth - is very hard to contemplate for a population who are severely unaccustomed to such pressures.

Possibly the Financial Times' Victor Mallet puts his finger on another important ingredient - after two years of being told that they have been living though the worst crisis in recent memory, many Spaniards have quite simply never had it so good, so how could anything horrible possibly happen now?
The pre-Christmas mood in Madrid is a curious mixture of pessimism and cheeriness.On the one hand, anxious Spaniards are told they are suffering the worst economic crisis in 50 years and fear for their jobs. On the other, those still in employment have rarely had more money to spend. It is not surprising that the city’s restaurants are packed with noisy but neurotic diners as the holiday season approaches.

The reasons for this odd combination of economic gloom and robust personal consumption are no secret. Unemployment has risen sharply – to 18 per cent of the workforce in Spain – but emergency measures around the world to avert another depression have kept economies flush with liquidity and cut interest rates (and monthly mortgage payments) to historically low levels. Inflation is low or negative.

Low interest rates, safe jobs (or pensions) and salaries rising faster than the rate of inflation all combine to make "the worst" not that bad at all, especially if the government are shelling out 12% percent of GDP per annum to pay for it all. But as Javier Díaz-Giménez, economy professor at IESE business school says (and S&P's well know) “It is easy to raise the deficit to 10 per cent of GDP....But we really don’t know how to get back down to a deficit of 3 per cent of GDP.” This then is the problem, especially as a reducing deficit, rising taxes and utility charges, and eventually rising interest rates all make the task of restoring economic growth seem a rather daunting one.

Think about it this way: Spain's construction industry amounted to around 12 percent of GDP, now government borrowing of around the same size has stepped in to fill the gap, but once this poly-filla solution no longer holds, where is the employment creating activity to come from? As Michael Hennigan, Founder and Editor of Finfacts Ireland says in the (similar) Irish context:

"The scale of the task of creating sustainable jobs in the international tradable goods and services sectors, is illustrated... by stark statistics from State agency, Forfás, which show that in the ten years to 2008, less than 4,000 net new jobs were added by foreign and Irish-owned firms, while overall employment in construction, the public sector, retail and distribution, expanded by over half a million......Total Irish employment in December 1998 was 1.54 million and was 2.05 million in December 2008 - a surge of 33 per cent. In the peak boom year of 2006, 83,000 new jobs were added in the economy while direct job creation in the export sectors was less than 6,000."
I don't have the comparable Spanish figures to hand, but the situation is surely not that different.

Meanwhile Spanish Industry and Services Show No Real Signs Of Recovery

There was no let up in the contraction in the Spanish manufacturing sector in November, and PMI data pointed to a further deterioration of operating conditions. Moreover, the rates of decline of key variables such as output, new orders and employment all accelerated during the month, with the seasonally adjusted Markit Purchasing Managers’ Index falling to 45.3, from 46.3 in October. The Spanish manufacturing PMI has now been below the neutral 50.0 mark for two years, with the latest reading being the lowest since last June.

Commenting on the Spanish Manufacturing PMI survey data, Andrew Harker,
economist at Markit, said:

“The Spanish manufacturing sector looks set to endure a bleak winter period, characterised by falling new business, job cuts and heavy price discounting. The glimpse of a possible recovery seen during the summer appears to have been only a temporary reprieve, with even the stabilisation of demand now seeming some way off again.”

The impression gained from the PMI data is broadly confirmed by the monthly output statistics supplied by the Spanish statistics office (INE) to Eurostat. True, in October the output index was up fractionally over September (a preliminary 0.29% on a seasonal and calendar adjusted basis), but there is no sign of any sort of recovery and the drift is still downwards.

Output has now fallen around 32% from its July 2007 peak.

Nor is the situation in the Spanish services sector much better, and November PMI data indicated that operating conditions among Spanish service providers worsened again during the month, and at a sharper pace than in the previous survey period. Business activity, new business and employment all fell more quickly than in October. The headline seasonally adjusted Business Activity Index – which is based on a single question asking respondents to report on the actual change in business activity at their companies compared to one month ago – dropped to 46.1 in November, from 47.7 in the previous month. The latest reading pointed to the fastest rate of decline since August.

The situation is also confirmed by the Spanish INE Services Activity Index, which shows that activity was down 7.9% in October over October 2008, following a 9.8% drop in October 2008 over October 2007.

Which means that activity was own a total of 17.4% from the July 2007 peak, or an average of 23% over the three months August - October, just better than the 25% average drop registered in January to March. Which means that while there is plenty of evidence that the contraction has stabilised during the last six months, this seems to be stability with a negative (and not a positive) outlook, given that things have now started to deteriorate again, and we must never forget that this stability has been achieved via a massive fiscal injection from the government, an injection which cannot be sustained indefinitely.

Construction Activity and House Prices Continue to Fall

Activity fell around one percent in October over September.

While total output is now down nearly 35 percent from the July 2006 peak. That is to say, this Christmas Spanish construction output will have been falling for nearly three and a half years, and this decline is going to be permanent, the only outsanding issue is what activity is going to replace it.

Spain's Employment Minister Celestino Corbacho was widely quoted in the Spanish press last week as saying that he could see clear signs that the housing market had "bottomed". I would really badly like to know where he is finding such signs.

In the first place Spain’s residential construction sector continues to shrink at an unprecedented rate. Housing starts fell by 47% (to 33,140) in Q3 compared to the same period in 2008, according to the latest figure from the Ministry of Housing. If we exclude social housing the fall was much greater - 61% less homes started in the period, and even 20% down compared to the second quarter.

At the other end of the production line the Housing Ministry reported 83,500 construction completions in the third quarter (excluding social housing), 41% down year on the same time last year and 13% down on the previous quarter. Over a 12 month period construction completions were down 35% to 444,544, and this in a market where sales of new properties are running at a rate of something like 200,000 properties a year. That is to say, the stock of unsold houses continues to swell.

And prices continue to fall, since even though the Tinsa property price index for November showed that average prices fell by only 6.6% over the previous 12 months (down from 7.4% last month - the smallest annual fall in a year) this piece of data is not that illuminating in a market where prices have now been falling for more than twelve months. So while TINSA's own annual price graphs make for a very encouraging looking trend line, you need to remember that they plot the percentage change in house prices on an annual basis. If we look at the overall index (below) we see pretty much the same picture as with everything else, slower decline, but decline nonetheless. No bottom hit yet.

And, of course, if we look at the peak to present chart, then the percentage fall simply continues, and house prices are now down 14.75% on the December 2007 peak.

And it isn't only sceptics like me who think there is still a long, long way to go with Spain's house price adjustment. According to the latest report on the housing market by BBVA, Spanish property prices were 30% over-valued at the end of 2007, since they only fell by something like 10% in 2008, they have another 20% or so to drop before the correction is over. BBVA thus expect prices to fall by 7% in 2009, 8% next year, and 5% in 2011 Prices won’t stabilise until 2012, and the price correction is likely to be a protracted and long drawn out affair. What the likely impact of this on the real economy, and on their balance sheet, is likely to be they don't say.

BBVA mentions another key reason why the fall in Spanish house prices is far from over - the high ratio of house prices to annual disposable income. This ratio (house prices / annual disposable income) rose to 7.7 years at the height of the boom, and has now fallen back to 6.6 years. But that is a long way off the historical average of 4, not to mention the 3.5 it has fallen to in the US.

Meanwhile, a new report from BNP Paribas Real Estate, the real estate arm of French bank BNP Paribas, argues that banks in Spain (currently the largest holders of unwanted real estate) will need to start offering bigger discounts (of up to 50% in 2010 they suggest) if they are to really start to move their stock of property. Spain's banks claim to be offering discounts to buyers, but as BNP Paribas Real Estate argue, judging by the growing inventory they hold, these are not big enough to attract the volume of sales they really need.

In fact, after several months of dithering towards a recovery the Spanish housing market fnally relapsed again in October, with the number of houses falling by 24% compared to the same month last year, according to the latest figures from the National Institute of Statistics (INE).

In fact sales in October fell below the 30,000 transactions per month rate for the first time since last April. Sales were down by 10% over September. According to Mark Stucklin of Spanish Property Insight the explanation for this relapse is to be found in the breakdown between new build and resales. During the first half of 2009 sales of newly built homes were significantly higher than resales, whereas in normal years it’s the other way around. Indeed, if new build sales hadn’t been higher this year the market crash would have been significantly worse. But many of the new build sales recorded this year were actually sold off plan during the boom, and many others were banks buying properties from developers to keep them afloat, so not they were not really sales at all. Naturally, as those sources of sales start to dry up (either as the stock of sold off plan evaporates, or banks cannot accept too many more), then new build sales begin to head south.

As you can see from the above chart which Mark produced for his post, new build sales dropped sharply in October, almost to the level of resales. And if we look at the rate of monthly house sales in the P2P chart below, you will see that monthly sales have now dropped by neary 60% from their peak. That is to say, we are still having something over 400,000 new houses coming off the production line, and only a maximum of 200,000 new home purchases. Even as output drops towards an annual 100,000, this level of sales would only clear off the backlog at a rate of something like 100,000 a year, which mean we would be well over a decade clearing off that massive backlog, and meantime who foots the bill for maintaining such a large stock?

The chart above tells the story eloquently. It shows cumulative sales over 12 months to the end of every quarter, and you can see how the market has shrunk from just above 1 million sales over the 12 months to the end of Q1 2006, to just above 400,000 sales at the end of Q3 this year. In terms of transactions, the market has shrunk by around 60% over that period.

And we get a similar picture on the mortgages front, with the volume of new residential mortgages signed in September being 62,411, down 4.2% compared to the same month last year. In value terms the fall was more pronounced, with new residential mortgages dropping 16% to 7.3 billion Euros. The good news is the annual decline in new mortgage lending has been bottoming out in the last few months. It fell 31% in June, 19% in July, 7% in August, and 4.% in September.

And looking towards the future again, the number of new homes started in the third quarter was down 54% compared to the same period in 2008, according to the latest figures from Spain’s College of Architects. Excluding social housing, there were just 17,500 planning approvals in the third quarter, compared to 28,400 last year. To put this into perspective, planning approvals were down by 94% from the 287,000 granted in the third quarter of 2006, at the height of Spain’s construction boom. The chart (below, and which comes again from Mark Stucklin) shows just how dramatically Spain’s residential construction production chain has collapsed in the last few years. This year there are likely to be a total of just over 100,000 planning approvals, the lowest level in more than 20 years.

Unemployment Rising Towards the 20 Percent Mark and Beyond

Spain's registered jobless total rose for the fourth consecutive month in November according to data from the employment office INEM, and is obviously bound to rise further as the recession drags on and the multi-billion euro stimulus package gradually loses steam. Seasonally unadjusted data showed Spanish jobless claims rose by 60,593 in November from October to reach a total of almost 3.9 million people, almost a million more than a year ago.

The rise was milder than the almost 100,000 layoffs in October and leap of around 170,000 seen in November 2008, but this should not be taken as a sign the economy will begin to create jobs any time soon. Data showed the jobless rate in the service industry rose 1.7 percent month-on-month and by 1.3 percent in construction. Joblessness also increased by 0.6 percent in the industrial sector and by 2.6 percent in agriculture.

The Spanish government has injected some 8 billion euros (nearly one percent of GDP) into the economy this year in order to create more than 400,000 mostly low-skilled jobs in order to put a temporary patch on the hole left by the paralysed housing sector. The 30,000 or so infrastructure contracts created under what is know as plan E will be completed by the end of the year, and with little sign of a general return to growth, or a revival in job creating activity the majority of those employed on these projects will surely soon be finding their way back onto the dole queues. The government has announced plans for a new 5 billion euro stimulus plan for 2010, but this, in theory, will be aimed at sustainable long-term growth sectors like renewable energy, environmental tourism and new technologies.

November's 1.5% rise in jobless claims is nonetheless weaker than the 2.6 percent rise in October, the 2.2 percent in September and the 2.4 percent in August. And the annual rate of increase fell sharply, from 42.7% in October to 29.43% in November. But does the month mark a new trend, or will we see renewed deterioration as the winter advances? The Spanish administration officially provides only quarterly (unadjusted) data on the unemployment rate but does forward a monthly (and seasonally adjusted) rate to according to the European Union statistics agency Eurostat, based on the Labour Force Survey (which is generally regarded as a more accurate (and internationally comparable) assessment of the true level of unemployment than simple Labour Office signings. This stood at 19.3 percent in October, the second highest rate in the entire EU, and behind only Latvia.

Of course, as ever with this administration, hope springs eternal. The Spanish economy will likely return to growth early next year and start creating new jobs toward the end of next year, according to Finance Minister Elena Salgado: "I think there is a high probability we will start to grow in early 2010," she told the Cadena Ser radio station, although she did admit that the trend of rising unemployment will not likely be broken until late 2010 or early 2011. "We think we will start to see net job creation in some sectors at the end of 2010, and more clearly in 2011," she said. This realism about job creation is, of course, a by-product of the very low 2010 growth rate envisaged by even the optimistic forecast of the Spanish government (less than one percent), which given the need for drastic productivity improvement in Spain would evidently not be enough to create new employment. And, of course, others are less optimistic, with both the EU Commission and the IMF foreseeing negative growth in 2010. Indeed the EU Commission still anticipates unemployment to be over 20 percent in 2011.

Basically the outlook is bleak, and unemployment is far more likely to continue rising than it is to fall. My own current estimate (which in part depends on how much consumer prices fall, on how seriously the government follows the agreed 1.5% reduction in the fiscal debt, and on how rapidly interest rate expectations rise at the ECB) is that we should be moving towards the 25% range around next summer.

Domestic Consumption Continues To Decline

Despite the best efforts of the Spanish government stimulus programme household consumption continues to decline, at a slower rate in the third quarter, but still decline. The quarter on quarter drop was 0.1% as compared with a 1.5% drop in the second quarter, and a 2.4% fall in the first one. On an annual basic household consumption was down 4.2% in the third quarter following a 7.5% drop in the second one (see chart).

And retail sales simply keep falling, more slowly than before, but down and down they go.

In October they fell back again over September, and were down a total of 10.3% from their November 2007 peak.

So Why Should We Expect Recovery In 2010?

Or better put, why should we suspect that we might not see a Spanish economic recovery in 2010? Well, let's take a quick look at some of the structural features of Spanish GDP. As the Spanish administration never lose an opportunity to point out, Spain's economic contraction to date has been significantly less extreme than both the Eurozone 16 and the EU 27 averages. GDP never actually declined as dramatically as it did in some other countries.

But looking at the situation in this way is rather misleading, since in fact, as can be seen in the chart below (which comes from the Spanish statistical office - the INE - as does the chart above) in fact domestic demand in the Spanish economy fell every bit as rapidly as in other European countries, but this was offset by changes in the external balance which moved in such a way as to add percentage points to the final GDP reading.

On analysing the two main components of Spanish GDP from the expenditure side in in the third quarter, the INE found, on the one hand, that national demand reduced its negative contribution to annual GDP movements by nine tenths as compared with the previous quarter, from minus 7.4 to minus 6.5 points, whereas conversely, the external balance reduced its positive contribution to aggregate growth by seven points, from 3.2 to 2.5 percentage points.

Now all of this is, as I say, rather strange to those unaccustomed to the niceties of GDP analysis, since the positive contribution from external trade to GDP growth has got nothing to do with extra exports, but rather it is a product of the fact that Spain was running a whopping trade deficit, and simply reducing this trade deficit gave the positive impetus to GDP, whereas the third quarter negative impact of external trade was the product of, guess what, a further deterioration in the trade balance as imports once more started to rise more rapidly than exports (see chart below). It is this dynamic - of yet another deterioration in the trade balance as the ression slows and as the government pumps demand into the economy - which raises concerns about long term economic stability, since obviously no susbtantial recovery in competitiveness has taken place.

The thing is, behind this whole situation there lies the problem of debt, and indebtedness. Basically, despite the fact that many, many Spaniards have never had it so good as they did in 2009, Spanish living standards have actually been falling since the amount of money available for current spending has been falling. What we need to take into account here is the sum of actual earned income PLUS what Spanish citizens are able to borrow during any given time period. Essentially when you borrow you shift disposable income from one time period to another. This is why Franco Mogigliani advanced what has come to be called the life cycle theory of saving and borrowing, since patterns change across the age groups, and naturally as whole populations age the pattern of any particular country changes. A younger country - Ireland, the US - is much more likely to be a net borrower, while an older country - Japan, Sweden, Germany - is much more likely to be a net saver.

So why is all this important. Well, during the years you borrow, you spend more. I think this is obvious, and this is also why when there are less capital inflows there are less imports. Capital flows are to finance borrowing, and borrowing improves living standards in the short term, until it has to be paid back. Remember the saying, "I am a rich man till the day I have to pay my debts". Spain was rich in this sense, as José Luis Zapatero never ceased to remind its citizens. But Spain's citizens were rich based on very heavy borrowing levels - households owed about 100% of GDP, and corporates around 120% - borrowing which had been used to inflate land, house and commercial property values to well beyond their true market equivalents, and hence these "riches" were in fact very unreal.

The impact of the sort of capital flows Spain was receiving is that in the short term your disposable income goes up (someone gives you money to spend), while later on it goes down (as you have to subtract from earned income to pay back). This latter situation is where Spain is now. The capital flows have been sustained in the short term via the ECB liquidity process, which has fuelled domestic demand via government borrowing and spending, but at some point all of this needs to be reversed and the debts need to be paid down, and that will mean lower disposable income (in terms of money to spend) for the internal population as a whole, which is why without sales abroad domestic consumption will only continue to fall and unemployment will continue to rise. The only way to compensate for this is to export and run a trade surplus, since in this way the debt payments can be made without subtracting from current income. Indeed, as we can see from the chart below, despite the fact that households and corporates have now started deleveraging, total Spanish indebtedness (as a % of GDP) continues to rise, thanks in part to the growing indebtedness of the state (which is, in the end, a liability for all Spain's citizens), and in part to the fact that GDP is itself contracting. This is Keynes paradox of thrift at work if ever there was a case, since the more Spanish savings rise, the more indebted Spain becomes. And now, as the fiscal stimulus is withdrawn, if GDP falls faster, then the position may well not improve, especially if prices fall and Spain enters a deflationary spiral.

Of course, borrowing is not income neutral in the longer term either, since it all depends what the borrowed funds are spent on. If you spend the borrowed money on infrastructure, education and new productive capacity (ie useful investment) then evidently you can raise the trajectory of GDP in the longer term, while if you only use it to finance short term consumption - or invest in a lot of houses no one really needs - then you simply get a destruction of internal productive capacity, massive price distortions and long term GDP on a lower trajectory. This is where Spain, Greece and much of Eastern Europe are now.

Basically, for those countries who lack their own currencies there is now real alternative to a rather painful “internal devaluation” to restore export competitiveness and the trade surplus. And this of course is why everyone from Standard and Poor's to the EU Commission and the ECB are now insisting not only on a return to fiscal order, but deep structural reforms to restore competitiveness.

EU Excessive Deficit Procedure Now The Key

On 27 April 2009 the European Council (Ecofin, the Finance Ministers of member states basically) decided, in accordance with Article 104(6) of the Treaty establishing the European Community, that an excessive deficit existed in Spain and issued recommendations to correct the excessive deficit by 2012 at the latest. At the time this appeared to imply an average annual fiscal reduction of 1.25 % of GDP would be required over the period 2010-2013. The Council also established a deadline of 27 October 2009 for effective action to be taken.

According to the Commission January 2009 interim forecast, Spain's GDP was projected to decline in by 2 % in 2009 and by a further 0.2 % in 2010. However, Spain's economic outlook deteriorated rapidly during the course of 2009 and the Commission autumn forecast projected a GDP decline of 3.7 % in 2009 and a further decline of 0.8 % in 2010 (basically the same as the IMF October outlook). As the Commission stress, the downward revision in nominal (current price) terms has been even stronger, since prices (and the GDP deflator) have been falling over the period, and this is a strong negative factor for both revenue and outstanding debt to GDP levels.

Spain’s fiscal outlook also worsened in the course of 2009 reflecting this sharper-than-expected fall in economic activity. Notably, the Commission autumn forecast project the 2009 general government deficit to come in at 11.2 % of GDP, compared with the 6.2 % deficit envisioned in the January forecast. In particular, revenue has fallen sharply more than expected, as the result of the stronger-than-assumed fall in activity and of the fact that tax proceeds are reflecting falling activity much more strongly than the normal long-term tax elasticity considerations would have suggested.

Thus in the Commission review of the Spanish Excess Deficit Procedure carried out at the end of October, they found that the plans for government expenditure foreseen in the January 2009 update of the Spanish stability programme had been broadly observed (and this is the big difference with the Greek case) although the expenditure-to-GDP ratio increased on account of the lower-than-expected nominal GDP level.

The Commission now expect the 2009 deterioration in the fiscal outlook to continue into 2010, although the discretionary fiscal measures adopted by the Spanish government post January 2009 were considered to have played no role in the intervening deterioration in the fiscal outlook. They thus took the view that "unexpected adverse economic events with major unfavourable consequences for government finances" had occurred and thus recommended a provisional lifting of the Excess Deficit Procedure, conditional on substantial further progress in bringing the deficit within the 3% of GDP limit by 2013.

Looking ahead to 2010, the Commission took the view that the draft 2010 Budget Law published in late September 2009, which targeted a general government deficit of 8.1 % of GDP in 2010. was credible, given that the combined impact of the withdrawal of the temporary stimulus measures, on the one hand, and of the new discretionary measures presented in the draft 2010 Budget Law, on the other, could yield a significant improvement of the fiscal balance by some 1.75 % of GDP in 2010. Further in the light of the unanticipated deterioration in Spanish government finances an average annual fiscal effort in excess of that originally recommended - at least 1.25 % of GDP - is needed between 2010 and 2013 in order to bring the headline government deficit below the 3 % of GDP reference value by 2013. The Commission aregue that this correction would represent an average annual fiscal effort of above 1.5 % of GDP over the period 2010-2013.

The Commission autumn forecast, projects a government deficit of 11.2 % of GDP in 2009 and 10.1 % of GDP in 2010. Assuming unchanged policies, and GDP growth of 1 % in 2011, the deficit would then be 9.8 % of GDP. A credible and sustained adjustment path thus requires the Spanish authorities to implement the budgetary plans outlined in the draft 2010 Budget Law; ensure an average annual fiscal effort of above 1.5 % of GDP over the period 2010-2013; and, most importantly, to specify the measures that are necessary to achieve the correction of the excessive deficit by 2013.

As the Spanish administration constantly point out, Spain's accumulated national debt is a lot lower as a percentage of GDP than that of many other EU member states, and even after 2011 will remain below the EU average. However, as given the difficult situation likely to be faced by Spanish banks and the heavier than average weight of ageing in Spain, the burden of Spain's finances in the context of an economy which may struggle to find growth over the next decade should not be underestimated.

According to the Commission autumn forecast, general government debt is projected to reach 54.3 % of GDP in 2009, up from 39.7 % in 2008. Although it is currently still below the 60 % of GDP EU reference value, debt is expected to increase further in 2010 and 2011 to 66 % and 74 % of GDP respectively. And evidently there is strong downside risk here should growth be lower than anticipated, and/or prices fall, this number could rise significantly, and it could should Spain's banks need a substantial bailout at some point.

As the Commission point out, the long-term budgetary impact of ageing in Spain is well above the EU average - mainly as the result of a projected high increase in pension expenditure as a share of GDP over the coming decades. The budgetary position in 2009 compounds the budgetary impact of population ageing on the sustainability gap. The Commission thus stresses the importance of improving the primary balance over the medium term and of further reforms to Spain's old-age pension and health-care systems in order to reduce the risk to the long-term sustainability of public finances.

Indeed, the Council of Finance Ministers (Ecofin) specifically "invited" the Spanish authorities to improve the long-term sustainability of public finances by implementing further old-age pension and health care reform measures when they lifted the Excess Deficit Procedure at the start of December. The Council also invited the Spanish authorities to implement reforms with a view to raising potential GDP growth.

As Standard and Poor's stressed, their decision to revise the Spanish sovereign outlook to negative reflected the perceived risk of a further downgrade within the next two years in the absence of more aggressive actions by the authorities to tackle fiscal and external imbalances. It is the continuing silence which surrounds this absence which is so ominous, and makes the concerns of the EU Commission and the various ratings agencies at this point more than understandable.