Future of the euro balanced on a Spanish knife edge

With banking clean-up costs in Spain at just 2 per cent of GDP, could it be that we don’t have the full story yet?

WITH THE three weakest peripheral euro zone economies already on a lifeline, Spain is now closest to the precipice. A Spanish bailout would dramatically increase the chances of the euro breaking up. The probability of a disorderly disintegration of the world’s second-largest currency would rise from low to near even if Spain goes.

The capacity of the Spanish state to fund itself is a central question not only for Europe, but for the world. It is difficult to see how a global depression could be avoided in the wake of the utterly unprecedented levels of default that would accompany euro break-up.

Can Spain hang on?

Holders and purchasers of sovereign debt appear to think so. Since the middle of last year, yields on Spanish government bonds have tracked those of the strong core economies. Before that they had moved in unison with the yields of the three weakest countries.

The reason for the decoupling can be attributed, in part, to the actions of the Spanish government in bringing the budget deficit down (to below 10 per cent of GDP in 2010) and to the country’s comparatively low public debt levels. By the end of last year, government debt, at 60 per cent of GDP, was lower than the euro area average. It compared with 142 per cent in Greece, 96 in Ireland and 83 in Portugal. But the bond market has not priced sovereign debt well in the euro era. If sentiment were to change, Spain could suffer the fate of the peripheral three. Much will depend on how the economy performs and what happens to property prices and banks.

Of the weak peripheral economies, Spain is the most similar to Ireland, both in the nature of its woes and in the existence of real economic strengths (Greece and Portugal have few strengths, while Italy’s traditionally strong medium-tech industries are proving highly vulnerable to competition from low-wage economies).

From the mid-1990s, Spain enjoyed strong economic growth, both because of real advances and because of an unsustainable housing boom, which has ended in tears.

The positives first. Spain’s greatest success has been its strong corporate sector. As a closed economy until the 1960s, its businesses were inward looking and uncompetitive. After opening up, things changed only very gradually. Since the 1990s, though, the pace has accelerated as Spain’s conquistadores have taken on the world and, in many cases, won.

Telefónica is now a leading global player. It owns 02 here and elsewhere in Europe and, having acquired many of Latin America’s telcos, its logo is to be seen emblazoned on call boxes across the continent. Repsol’s petrol pumps are almost as ubiquitous in the Spanish- speaking world, and beyond. Iberdrola is a world leader in renewable energies, running wind farms from Brazil to Scotland to China. In fashion retailing, Zara and Mango have overtaken the likes of Italy’s Benetton. In their global reach, they rival US giants such as Gap. The country’s banks have diversified successfully, with Santander becoming the largest bank by market capitalisation in the euro area.

From an economy-wide perspective, the conquistador phenomenon is to be seen in the foreign direct investment (FDI) figures. From almost a standing start in the 1990s, when the stock of Spanish outward FDI was piffling, it has grown rapidly. By 2009, it was larger relative to the size of the Spanish economy than German outward FDI is relative to that economy.

Spain, however, has a number of underlying weaknesses, many of which were ignored when times were good. Despite many fast- growing and globalising companies, Spain’s competitiveness was eroded during the boom years. One reason for this was its dysfunctional labour market, which went unreformed for too long. Both the centre-right administration from 1996-2004 and the centre-left one in office since did not take on vested interests. The result was that, even after more than a decade of boom, during which Spain attracted proportionately almost as many immigrants as did Ireland, the unemployment rate never fell below 8 per cent.

Now unemployment stands at more the 20 per cent – the highest in the developed world. In reaching that point, the numbers at work in the Spanish economy have declined by nearly one tenth, the worst performance in the OECD after Ireland.

Just as in Ireland, the reason for the unusually large employment shock has been the collapse of the building industry. By the height of the boom, average annual housing completions peaked at three times the long- run average (compared to more than four times here).

Despite this huge addition to supply, property prices rose rapidly. As in Ireland, prices were driven upwards by a credit bubble far more than the “strong fundamentals” so beloved of property cheerleaders. Mortgage debt rose to 65 per cent of GDP by 2009, up from 25 per cent a decade earlier (in Ireland the ratio hit 90 per cent).

But because debt, housing output and prices never reached dizzying Irish heights, Spain has not fallen as far.

At its worst, in 2009, investment spending contracted by 15 per cent on the previous year. Here it contracted by 31 per cent. While house prices have fallen by 40 per cent in Ireland, the decline has been less than half that in Spain – and the property developer class has not gone bust en masse.

According to the IMF, the net direct cost of the banking clean up in Spain has amounted to just 2 per cent of GDP – below the average for advanced economies and a fraction of Ireland’s world-leading 28.7 per cent.

But such a small bill looks fishy. Could the authorities and institutions be hiding something? Far stranger things have happened. The forthcoming Europe-wide stress tests might give more certainty.

And even if nothing is awry, with further falls in residential property prices all but certain, a 20 per cent unemployment rate and rising interest rates, the amazingly low percentage of banks’ loan books not performing looks certain to swell. If Spain were to see anything like the repeated upward revisions to its banking costs that Ireland has experienced, holders of its sovereign debt would drop it like a hot brick.

But that is not the only cloud hanging over Spain. Its public finances might also be hiding something nasty. Since the Franco era, centrifugal political forces have been pushing power from Madrid to the regions. Among the powers devolved has been public spending. Spain has become a de facto fiscal federation.

The regions now account for as much public spending as they do in the de jure German federation, but without the same transparency. Rumours are rife of off-balance sheet spending by sub-national levels of government.

The euro crisis was triggered by revelations in Greece that its public finances were much worse than the official figures had claimed. If such a surprise were to emerge in Spain, it could be the beginning of the end for the euro.