By: David Veitch
Recent comments by Spain's PM should be taken with a grain of salt
In poker, it is standard practice for players to never reveal weakness during a hand. If they do, they risk being bullied out of a pot by their opponents. As a result, players often don a mask of strength in order to avoid falling prey to this. One could say that in the midst of the current Eurozone crisis, Spanish Prime Minister Jose Luis Rodríguez Zapatero is playing a high-stakes game of poker with bond vigilantes. On Nov. 26, in an attempt to portray the finances of the Spanish government in a positive light, Zapatero came out and said that “those who make short term bets against Spain will be making a mistake." However, this comment needs to be taken with a grain of salt as Zapatero has a strong incentive to not appear weak when discussing Spain’s financial problems, lest he lose the confidence of the bond market. Looking forward, what makes this developing story different from a poker game is that eventually all the cards will be revealed, and the Spanish PM will not be able to talk his way out of the coming Spanish debt crisis.
Spain Looks to be Next in Line
Over the past month the financial community has intensely focused on the problems of Ireland which have culminated in a €89 billion bailout of the country and its banking system. As well, jitters have resurfaced over the finances of Greece and Portugal, which face problems similar to those of Ireland. However, what will be the main factor behind the continuation of the Eurozone crisis is the situation in Spain, an economy much larger than Greece, Ireland and Portugal combined. In short, Spain is “too big to be bailed out.” Also, the implications of a Spanish default would be far reaching within the Eurozone as Spain is the fourth largest economy in the EU.
How did it come to a point where markets are worried Spain may have to be rescued? The story behind Spain is strikingly similar to that of Ireland: a decline in interest rates upon entering the EU, a housing boom and bust, and banks which currently face heavy exposure to souring construction loans. All of these factors have contributed toward the slew of problems Spain currently faces.
Reason for Worry
First among Spain’s problems is the rampant unemployment which exists in the country. As it sits today, Spain’s unemployment rate is above 20%, with the level among young people at 40%. Much of this rise can be attributed to the bursting of the construction bubble. Spanish Labor Minister Valeriano Gomez went so far as to say that “three out of four jobs lost in the crisis are in construction and related sectors." To bring down this unemployment level, Spain needs to implement structural labor market reforms and return to growth. This looks unlikely on both counts.
On labor reform, Spain made some progress over the summer when the Greek crisis was at its peak. One example of this is the wage cuts to civil servants implemented over the summer. Unsurprisingly, these were met by protest. However, pressure on the Spanish government has eased since the summer and Zapatero has shown less willingness to cut where needed, partially because of a decline in support for his government. With the appointment of Valeriano Gomez as Labor Minister in October during a surprise cabinet shuffle, labor market reform has been set back. Gomez, member of the General Union of Workers and one of those taking part in the September general strike, has been criticized by The Economist as an “incongruous” feature of the cabinet shuffle. According to the Bank of Spain’s Q3 report, unit labour costs have recently been declining, but with Gomez’s appointment it would be unsurprising if they are not able to adjust as briskly as needed.
The Spanish economy is expected to remain sluggish throughout the year, and the consensus estimate for GDP growth is 0.6% for 2011. Weighing on growth will be the deleveraging of Spanish consumers as well as general sluggishness in the Eurozone. Recent developments regarding Portugal's and Greece’s inability to control their deficits point to further austerity measures being implemented, which will further weigh on growth. As well, the euro’s strength from September to November will most likely drag on Q4 growth numbers in the region.
April, July and October of 2011 will serve as crucial tests for Spain as it goes to the market to raise €18bn, €23bn, and €18bn respectively - its largest borrowings in 2011. What makes Spanish borrowing different from the borrowing of other peripherals is the sheer size of it. According to The Economist, while comparable in terms of borrowing as a percentage of GDP, Spain’s absolute amount of debt (€805bn) is larger than Greece (€367bn), Ireland (€146bn) and Portugal (€172bn) combined. As of late, the yield on 10-year Spanish notes has risen to 5.5%. This, compared to 4.7% in May when Greece was in turmoil, reflects investor anxiety over Spain's finances.
According to Nomura, Spain funds a large number of its obligations via short term T-Bills. While in most instances this allows Spain to easily roll-over its obligations, there is a risk that such short-term borrowing could lead to a failed auction if markets become nervous. There are four foreseeable scenarios that could lead to such nervousness: Social unrest due to unemployment, hidden loses in Spanish caja’s (savings banks') €323bn of construction loans, a lack of will on the part of Spain’s government to reform, and deterioration in other peripherals. Many of these scenarios can be seen developing as of now.
According to This Time is Different, when a country has a large group of lenders that are each small individually (i.e. a single lender cannot provide enough money for the country to meet its payments, as in Spain’s “too big to rescue” case), a crisis of confidence can produce a “default” and “no-default” dual-equilibrium, increasing the chances of failed auctions. Spain must cross its fingers over the next year that none of these scenarios are enough to cause a crisis in confidence (or at least coincide with the dates of borrowing).
The Months Ahead
Given that Spanish debt as a proportion of GDP remains relatively low compared to other peripherals, there is still the possibility for Spain to get its financial house in order, and ultimately prevent a default. However, with the escalation of the peripheral debt crisis, such a scenario seems unlikely.
The pressure that will be put on Spain in the coming months will be tremendous. One only needs to look at the lack of confidence amongst investors after the Irish bail-out to see this. Referring to poker again, it appears that Zapatero has just been raised by his opponents with several cards to come. His best move now would be to push all-in with a credible fiscal plan and the implementation of measures to improve competitiveness, especially in the labor market. If he fails to do this, a number of “outs” (i.e. lurking risks) could mark Spain’s economic demise, and serve as a big win for bond vigilantes.
Further Reading - Q3 Report on the Spanish Economy
Disclosure: No positions