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.