SERIOUS MONEY:ON THE morning of December 7th, 1941, Japan launched an aerial attack on the US Pacific fleet at Pearl Harbor. The aggression was precipitated by the US decision to embargo all exports of oil to Japan, following the aggressor's invasion of French Indochina.
The embargo threatened to derail the energy-dependent nation’s military ambitions; in response, the Japanese not only attacked Pearl Harbor, but simultaneously launched offensives against the Philippines, British Malaya, Java and Sumatra. The region’s territories conceded defeat to Japan one by one. Within a year, the Japanese ruled over one of the largest maritime empires in history.
Fast-forward to today and bond market vigilantes have launched an offensive upon the euro zone’s weakest links. The Greeks cried for help earlier in the year, and in the latest round of turbulence, the Irish – whose Government will present an austerity budget to the Dáil, somewhat ironically, on the anniversary of Pearl Harbor – became the second nation to surrender to the vigilantes and call for rescue.
The Portuguese are unlikely to resist the onslaught much beyond the new year, and the markets have already set their sights on a bigger target – Spain.
The Spanish economy is the fourth-largest in the euro zone and is almost twice the size of the Greek, Irish and Portuguese economies combined. The Mediterranean country faces a number of daunting challenges, including mass unemployment, excessive private sector debt burdens, a disturbing loss of competitiveness, an ailing banking sector and a large fiscal deficit. Could Spain become the euro zone’s Pearl Harbor?
Spain benefited considerably from EMU membership and economic growth outpaced the OECD average in nine of the 10 years before the crisis. Investors became convinced in the mid-1990s that adoption of the euro was virtually assured, and the more than three percentage point premium attached to government bond yields relative to their German counterparts disappeared.
The sharp drop in borrowing costs provided considerable stimulus to the housing market, which was compounded by the removal of currency risk and the subsequent increase in the number of foreign buyers.
The resulting construction boom contributed to serious macroeconomic imbalances, as both investment and labour were pulled away from the tradable sectors. Construction contributed 17 per cent of GDP at its peak, at which time the sector employed 13 per cent of the workforce.
The economy became heavily dependent upon the fortunes of one sector and vulnerable to a potential deflation of a property bubble that saw house prices increase by more than 140 per cent in real terms in just 10 years.
Strong labour demand in concert with low interest rates triggered a boom in domestic demand as both households and non-financial businesses leveraged their balance sheets. Indeed, household debt as a percentage of gross disposable income soared from less than 80 per earlier in the decade to more than 120 per cent at the peak, while non-financial corporate sector debt jumped from less than 50 per cent of GDP in the mid-1990s to more than 130 per cent in 2007.
The debt-fuelled demand boom contributed not only to inflation rates that far exceeded those of its trading partners, but also a surge in the current account deficit to some 10 per cent of GDP at its peak.
Amid the boom in domestic demand, the Spanish government pursued a pro-cyclical fiscal policy that added to the expansionary conditions. The fiscal position remained in surplus and public debt-to-GDP was maintained well below the euro zone average, even though government expenditures increased rapidly. The fragility of the underlying fiscal position, however, was simply masked by the housing-fuelled bubble.
The Spanish economy’s structural imbalances were exposed once crisis struck. The continuing deflation of the property bubble has seen the unemployment rate soar to more than 20 per cent, leaving households with little option but to deleverage their balance sheets, while the decline in domestic demand has forced businesses to do likewise.
Meanwhile, the drop in windfall tax receipts saw the fiscal position swing from a surplus of almost 2 per cent of GDP in 2007 to a deficit of more than 11 per cent in 2009.
The government has responded with an austerity programme and looks set to achieve this year’s deficit target of some 9 per cent of GDP. Objectives for both next year and the intermediate future objectives look far too ambitious and are predicated on growth assumptions that seem overly optimistic. Economic growth is likely to be sluggish for several years, as the private sector continues to deleverage and the economy shifts to a more sustainable growth model.
Spain’s fiscal position is not all that troubles investors, however; the health of the banking sector is also of genuine concern, even though the savings banks have already been provided with capital injections of €15 billion.
Total exposure to property development and construction loans amount to almost €450 billion, and the resulting losses combined with write-downs across the rest of the aggregate loan book could lead to further recapitalisation needs of as much as €120 billion or roughly 12 per cent of GDP.
Both the investment and political elite believe that the country’s fiscal position is manageable, even after allowance is made for worst-case losses arising from the ailing banking sectors. The bond vigilantes beg to differ and are currently pricing a default probability of more than 40 per cent. Spain is certainly too big to fail, but it may also be too big to rescue. The euro zone’s moment of truth looks set to arrive in 2011.
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