Tuesday, June 19, 2012

Spain: It is worse than is imagined

First of all, my apologies for the limited posting. I have been working on a project which has seen me working fourteen hours a day, and which still has some time to run. My second apology is that, despite my good intentions, this post will again be about the Euro crisis. The first point is that, after the election, the Greek crisis has (at least temporarily) moved off the centre stage, to be replaced with Spain. In particular, the bailout of Spanish banks indirectly through a loan to Spain saw the loan given preferred creditor status:

More worryingly, for holders of Spain’s national debt, this new bank-bailout debt (which is owed by the country of Spain, remember, since the money isn’t going directly to the banks) carries something known as preferred creditor status. That means that if push comes to shove, Spain will repay the bailout debt before repaying any of its bonds.

To take a simplified example: if Spain has €100 billion in bailout debt due and another €200 billion in bond payments due, and only has €150 billion on hand, then an equitable treatment would be to ask each of its creditors to take a 50% haircut. But with preferred creditor status, Europe will get its €100 billion back in full, and bondholders would have to take a 75% haircut. So holding Spanish bonds just became significantly riskier, this weekend.
That this would ratchet the crisis upwards was predicted by many commentators, and the sharp increase in the cost of Spanish borrowing proved the critics to be correct:

As Spain’s creditworthiness deteriorates, bondholders are wary of being subordinated to the EU agencies that might demand priority repayment for supplying aid to the nation. Lenders to Greece lost more than 70 percent of their investments when the nation restructured its debts, while the ECB and other official lenders were exempt from the discounts. 

What finally dragged me back to the posting was the mooted bailout of Spain at the G20 summit. This from the Guardian:

Angela Merkel is poised to allow the eurozone's €750bn (£605bn) bailout fund to buy up the bonds of crisis-hit governments in a desperate effort to drive down borrowing costs for Spain and Italy and prevent the single currency from imploding.

Germany has long opposed allowing the eurozone's rescue fund, the European Financial Stability Facility, to lend directly to troubled eurozone countries, fearing that Berlin would end up paying the bill, and the beneficiaries would escape the strict conditions imposed on Greece, Portugal and Ireland.
But Merkel has come under intense pressure as financial markets have pushed up borrowing costs for Spain to levels that many analysts see as unsustainable.

Analysts are likely to see the decision as the first step towards sharing the burden of troubled countries' debts across the single currency's 17 members, though it falls short of the "eurobonds" proposed by the European commission president, José Manuel Barroso.
A spokeswoman for Merkel said: "Nothing has been decided yet."
The key point in the report is the final point about nothing being decided yet. As Ambrose Evans-Pritchard correctly identifies, there is a big gap between rhetoric and reality:
From what we know, the eurozone's leaders aim to deploy the European Stability Mechanism (ESM) to cap borrowing costs for Spain and Italy by purchasing sovereign bonds on the open market.
Unfortunately, the ESM fund does not yet exist. It has not been ratified by Germany and Italy. When it does come into being, it won't have much money. It has a theoretical limit of €500bn -- a nice wish -- but its paid up capital will start at just €22bn.
Of course, the rescue may be possible, but it nevertheless remains improbable. The major concern that the proposed bailout raises is that any such bailout, should it take place, will serve to spread the problems of Spain into the core of the EU. That this dangerous solution is now being discussed only highlights the degree of the crisis in Europe. My own belief is that the prospects of such a bailout are remote, and that the scale of the problems in Spain have not yet been fully acknowledged. In particular, there are concerns about the true scale of losses for Spain's banks. As the Economist reports, construction and real estate loans grew from 10% of GDP in 1992 to 43% in 2009. The same report highlights the degree and severity of the real estate bust in Spain, and the various (self-defeating) methods the Spanish banks are using to hide or delay the losses.

It perhaps comes as no surprise that there are rumours of delays of an audit of the Spanish banks, although the government denies any delays and is still promising to publish results at the end of July. Even when published, it is not clear how real estate assets might be valued in the context of the broadening problems and downwards spiral of the Spanish economy; the spiral will continue to impact upon real estate prices, and any assessment will only reflect, at best, a guess at the non-performing and underwater loans going forward. In other words, the losses in the Spanish banks are likely to be far greater than is currently accepted, and the Spanish economy likely has a long way to fall yet. When so much of an economy is dedicated to real estate, and real estate goes bust, the damage is going to be huge. As such, even if a large rescue fund were put together, however improbable that prospect remains, the scale of the rescue needed may be larger than is currently imagined.

One of the themes of this blog has been the potential for borrowed money to see a restructuring of an economy to utilise the borrowed money. In the case of Spain, the economy restructured around a real estate boom, and the economic structure is now unwinding. When seeing the Economist figures, it is apparent that the only way that Spain's economy can avoid a horrendous crash is to maintain the levels of borrowing that supported the economic structure. However, to do so would be to further entrench the problem that the lending is supposed to solve. At some point, Spain must restructure its economy away from real estate, and that is a transition which must, absolutely must, be a painful process. Too much of the economy was directed at activity that was almost entirely reliant on borrowing, and there is no escape from the fact that this is inherently unsustainable. The problems of Spain run deep, and the best case scenario is to delay the resolution of the problems a little longer, and in doing so just make the problems even greater in the end. The solution to too much borrowing, is not to borrow more.


  1. Hi Cynicus. Thanks for continuing to post, even when extremely busy.
    If the Spanish bailout puts the Spanish government in an untenable position, it would make sense for the government to turn the offer down, and seek to negotiate a direct EU/ECB bail-out for the Spanish banks instead. If that can't be obtained, each bank would then have to fend for itself. Presumably, most would fail, because their problem is not just lack of liquidity but insolvency. Would this be a disaster for the rest of the Spanish economy, or just for investors in and creditors of the banks, and holders of CDSs based on loans to Spanish banks?

  2. 30 years ago Spain's economy was highly based on agriculture and fishing, ergo it was a poor country.

    But thanks to a few decades of borrowing and real estate bubbles, Spain because "rich", skyrocketing standards of living, overtaking other countries (remember the fanfare over Spain overtaking Italy in GDP a few years ago?), and getting its former politicians into supranational bodies.

    We now know that meteoric rise was a house of cards based on 'a funny view of wealth'...

    So what happens now? Does Spain go back to being poor again, an agricultural, fishing nation?

    On a wider scale, does the entire world go back to being poorer? Will we see 50% unemployment, as there's an implosion of the industries that arose to absorb reckless consumer borrowing?

    We've seen a massive period of growth. Now it appears time for a massive period of impoverishment - but I'm struggling to visualise how that will happen in practice. Or maybe I'm struggling because I'm terrified and my brain will run away screaming as soon as I seriously attempt to do so

    1. I was thinking of this exact point on a recent visit to the North of England.
      I saw signs of decline and increasing poverty everywhere. To me it looked like a possible global future; slow economic collapse and erosion of the social fabric.

      This area (and beyond) saw the birth of the Industrial Revolution, so there are constant reminders that this was once one of the richest, most innovative places on earth.

      I have never been to Detroit, but I guess that might indicate a possible future for an urban environments post-whatever-it-is-that-is-a-coming.

      It was around that time, that I read this from CE;
      "I, on the other hand, believe that wealth is, in the end, created by creating a framework in which individual endeavour creates real wealth. This individual endeavour, whether from a bricklayer or a the CEO of a multinational, is the real source of wealth creation. They make products and services that people want, and can pay for the goods and services as a result of their own individual endeavours. The relative success of these individual endeavours, in aggregate, in terms of productivity, and in relation to other countries, determines the real wealth of a country."

      I never got around to commenting on it, but the above shows a major problem of CE's/EMH/libertarian worldviews.

      He talks about "a framework in which individual endeavour creates real wealth", but then ignores the framework aspect, which is absolutely crucial, and focuses solely on these heroic individuals.
      My visit told me that when the framework is as dire as it is in the North of England, there will be very few individuals with sufficient mental/physical/other resources to create wealth for themselves or others. Ayn Randian peans and homilies will not change the fact that much of Britain is a million-miles from being able to create much wealth - and this is a result of both Centre–Left/Right govt. policies over the last decades.

      Consider the vast framework a builder needs to work profitably and productively; a construction industry, supported by a housing market, recourse to law, sound money, a source of bricks and so on and on ... ignoring the network of activities and systems (created by both companies and government) actually let's these lousy UK govts. off the hook for the creation of a battered UK underclass.

    2. Why would someone need a framework to know that he needs a shelter from the weather? After all, isn`t a home a basic necessity, just like food. We don`t need to be shown we need food. If I decide not to consume all my resources on food and rent, then I can make or pay someone else to increase wealth. I take it when you talk about framework you mean burocracy. We have poor management in this country. In the north-east of England we have one of the best car firms, Nissan. The workers are far more productive than when we had car companies owned by the British. The north created the wealth in Britain. The City of London leverages money up and they have created the financial crisis. Governments and other burocrats allocate resourses to the wrong places. It should be allowed to be left to the market.

    3. Thank you for illustrating my point;
      if it had been left to the market, Nissan would NEVER have built cars in Tyne & Wear. It only happened beacuse the British government offered huge incentives to build (and later keep) the factory there.

      "Why would someone need a framework to know that he needs a shelter from the weather?"
      An absolutely irrelevant metaphor.

      "I take it when you talk about framework you mean burocracy"
      You 'take it' incorrectly ... Did you take it that CE meant bureaucracy when he wrote framework?

    4. Spain receives massive subsidies for the fishing and olive oil industries. Olive oil is being hit, with the price dropping http://www.ft.com/cms/s/0/47ba2bf6-741c-11e0-b788-00144feabdc0.html#axzz20X9wszmR
      There's also talk of the olive oil subsidies being cut.

      Funnily enough, the old Greek president complained that before Greece joined the EU, it was a net exporter of food. Once it joined it became a net importer. I believe olive oil was one of the industries hit.

      Spanish trawlers still get massive EU subsidies, though.

      Just found this. IT says the EU will take away agricultural subsidies from those going over the 3% deficit limit. http://www.oliveoiltimes.com/olive-oil-business/europe/aid-to-olive-oil-producers/4013

  3. I'm not sure I wholly agree that the position of bondholders was affected adversely by the latest "bail-out".

    Taking the position at its simplest, the bondholders were facing the risk of simply not being repaid. All sorts of interesting questions could arise about their ability to enforce their claim for repayment against Spanish nationalised assets but the reality is that, as in any insolvency, it is creditors who lose and have to draw a line under their losses. Perhaps they would have been able to recover 50% or more of their "investment", perhaps they would not.

    As things stand time has been bought for Spain to improve its position and increase the creditors' chance of substantial repayment. I doubt that it will happen because the structure of the Spanish economy does not produce sufficient wealth to allow it to happen.

    The figures given in the first passage you cite appear to me to be incomplete. The example given was of Spain owing 100bn in bail-out cash and another 200bn on maturing bonds and having 150bn with which to make repayments. This misses one point, namely, how much would it have had for repayment had it not received the 100bn bail-out? The answer cluld be 50bn, in which case the bondholders are in exactly the same position they would have been in without the bail-out; or the answer could be more but without the benefit (such as it is) of the bail-out cash helping to stabilise the economy and increase the chance of future prosperity.

    When the idiot Brown decided to bail-out the UK banks I wrote that the better option was to let losses lie where they fell and rebuild from a position that reflected the reality of the economy rather than pretending a problem caused by making too many bad loans could be solved by making more bad loans. I stand by that argument today.

  4. Perhaps CE could explain to us what he means be restructuring the economy. I have noticed that CE throws around this magic phrase quite a lot in his posts whithout revealing its real meaning and practical steps to apply this meaning in practice.
    I have read all of CEs posts but have not found a single one where the phantom solution of restructuring the economy is explained in concrete, practical steps.

    1. That phrase chimes with my comment above. Restructuring our economies will mean being poor again, because all the activity of recent decades is based on consumer spending funded by borrowed money and real estate bubbles

      Look forward to a century of impoverishment for the 99%, while the 1% continue seizing more and more of the wealth.

      The least they could do is give us peasants religion again as a sop, so we have something to live and hope for amidst our lives of poverty and misery. Jesus loves you!

  5. A fair question.

    I think we are in the process of trying to actively structure the economy right now. Massive interventions to ensure that certain aspects of the economy are maintained at their status quo.

    Restructuring of another kind is what is being demanded economically speaking as one poster above pointed to. And we are throwing tonnes of new money at it to prevent that from taking hold.

    This is leading to waves of deflation but, as each new round of QE is forced upon policymakers, who, in their short term need to retain votes cannot, by any means, allow GDP to fall.

  6. Dollar collapsed? nope still hasnt...be back next year again.

  7. Been a long time since you posted.

    I hope all is well with you.

    I am trying to get my head around whether we are headed for severe inflation and/or deflation.

    Any thoughts on this?


  8. Am very much missing your commentary Cynicus. I guess now we're just watching it all play out as you said it would. Everyone else is slowly cottoning on, this from today's Telegraph:

    'The consequences of this Asian industrialisation present a major challenge to Western economies, even threatening the UK with the risk of becoming a next Greece, Mr McWilliams said on Thursday evening in his inaugural lecture as the Mercers’ School Memorial Gresham Professor of Commerce.'



You are more than welcome to comment on the posts, but please try to stay on topic....I will publish all comments, excepting spam and bad language, and my moderation of the comments is just to exclude these.

Please allow up to two days for the comment to appear.

I have had a request for an email address for the site and have created the following:


I have ommitted the @ symbol to avoid spam....

For general purposes I would suggest using the comment form, but will occasionally look at this email account. Please be clear what is for publication and what is not, though I will also not guarantee publishing of email comments, unlike the comments through the form! Thanks.