In the aftermath of Fitch further downgrading Italy and Spain on Friday to A- and A respectively, it is worth comparing the two largest troubled European sovereigns. Market consensus seems to point to Italy, the world's third biggest debtor, as being the more troubling situation, but unique elements of the Spanish fiscal and economic condition appear to make it more likely to underperform its Italian brethren than the market is currently indicating.
The most oft cited statistic, regarding the relative health of sovereigns, national debt to national income, makes it appear at first blush that the Spanish fiscal situation is far superior to that of Italy's. Italy's debt/GDP stands at 120% and Spain's debt/GDP measures just 64%. The differences in governmental structure however accounts for some of this disparity. Since the Constitution of 1978, Spain has operated with a more decentralized form of government with some power devolved to 17 autonomous regions and 2 autonomous cities. These autonomous subdivisions themselves carry debt equal to 14% of national gross domestic product, a figure that is rising rapidly. With these autonomous communities and cities responsible for providing social welfare services, spending has been increased in these times of fiscal stress. While the central Spanish government's debt rose by 17% in the last year, the autonomous regions saw their debt grow by 26%. In early 2012, the most indebted region, Valencia, was late on a loan repayment to Deutsche Bank making the market ponder if the central government would soon have to begin backstopping rising debts from their own sub-sovereigns.
Rising debt levels seem unlikely to abate at the central government level or at the regional level giving sustained unemployment levels that are the highest in Europe. At nearly 23%, Spain's unemployment level is at a new eurozone record and nearly 3x that of Italy. The unemployment rate is likely to continue to rise as the country undergoes continued austerity to meet EU-imposed deficit targets. The unemployment of Spaniards under the age of 25 stands at almost 50%, an unheard of level for a developed country, and a figure that raises the specter of a generation of an inexperienced and less skilled workforce.
Real Estate Bubble
Fueled by low interest rates after joining the eurozone, government policy that encouraged home ownership, and speculative excess, construction peaked at 15% of Spanish GDP in the mid-2000s. At that time, 45% of new construction in Europe was occurring in Spain.
As the real estate bubble burst, unemployment surged as this large part of the domestic economy cratered, further pushing down already flagging real estate values. Today, 13% of Spain's residential properties are vacant. Domestic lenders hold 308 billion euros of real estate loans, half of which are troubled, according to the Bank of Spain, portending further re-capitalization of the nation's financial institutions at a time when the sovereign is under its own well-publicized stress. Numbers on the decline of residential real estate values peak to trough are in the 25% - 40% range.
On the other hand, residential real estate prices in Italy, according to the Italy ISI Property Price Residential Index complied by Scenari-Immobiliari SpA, are down only 8% from their April 2006 peak. Both the high and still rising unemployment and the still deflating real estate bubble in Spain seem like tremendous headwinds for the Spanish economy that are not nearly as troublesome in Italy.
History of Managing Debt Position
Italy has a successful history of being able to de-lever its economy when debt-to-GDP has reached current heights. From 1994-1996, debt-to -GDP in Italy was higher than where it stands today, but moderated after a technocratic government led by economist Lamberto Dini took charge. Whether Italy's current technocratic government under Mario Monti can achieve the same feat remains to be seen. Italy was able to de-lever its economy in part due to the joining of the single-currency in 1999, an ascension that is obviously not replicable this time. Whether the Spanish central government and its autonomous regions can slow the rise in government debt does not have a historical precedent in the post-Franco era.
Relative Market Performance
Like its sovereign bond yields, Italy's equity markets have underperformed that of Spain's. At current valuations, Italy's broad market index appears to be priced at lower multiples of forward earnings, book value, and sales.
While these comparisons are only a small piece of a convoluted economic mosaic in Europe, it still appears that the market has not fully priced in Spain's challenges to the extent that it has priced in the struggles and debt overhang of Italy. In both an upside case and a downside scenario, I see Italy outperforming Spain.
There is an emerging bull case in Europe that has led stocks higher in 2012, and seen sovereign yields drop dramatically in the front-end of the curve. Market bulls believe that the ECB's LTRO operation of lending euros, limited only by availability of collateral, at 1% to member banks will enable troubled sovereigns like Italy and Spain to roll over their looming debt maturities, buying time for fiscal consolidation and economic growth to rebound.
In this case, Italy seems better positioned. Its banking system is not polluted by soured property loans like that of Spain. The Italian banks also do not have outsized amounts of sovereign debt of the other peripheral eurozone sovereigns. This could give them additional capacity to buy their own sovereign debt, which could hopefully lead to a virtuous cycle of lowering sovereign yields while further capitalizing Italian banks as they earn a spread over the ECB advances.
In the downside case of continued economic uncertainty in Europe and rising sovereign yields, the fiscal challenges of Spain appear to loom larger. Further fiscal austerity can only increase unemployment given the size of the government sector in the Spanish economy, which could add further pressure on flagging real estate prices and the domestic banking sector. In the near-term, Spain's better balance sheet has allowed its equity markets and government bonds to relatively outperform Italy's. However, in both the upside case and the downside case, Spain looks to be the laggard going forward.