Spain feels the strain

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By Ian Fraser

Published: Accountancy Magazine

Date: 2 September 2008

Though glowing from a number of recent sporting triumphs, Spain is struggling under the weight of a complex economic crisis. Ian Fraser reports.

“Spain: Great at football; disastrous at economics” was the headline in La Gaceta de los Negocios on June 30, the day after Spain’s momentous victory over Germany in the Euro 2008 final. The country’s other summer sporting triumphs – including Rafael Nadal at Wimbledon and cyclist Carlos Sastre in the Tour de France – brought further cheer to Spanish sporting fans. In economic terms, however, there is precious little to celebrate at the moment.

Last year it all looked very different for Spain’s economy, the fourth largest in the eurozone. Between 1993 until 2007 the country lived through an unprecedented infrastructure, construction and real estate boom. Fuelled by EU subsidies in the first years of this period and unprecedentedly cheap credit in the latter years, the boom has also lifted other economic boats  –  including the country’s banking, automobile, consumer goods and services sectors. For much of the period, Spain’s economy was the one of the fastest-growing in the eurozone. Growth was 3.8% in 2007.

While the boom persisted, no-one bothered to question whether it might be sustainable. In his first term of office, the country’s socialist prime minister José Luis Rodríguez Zapatero behaved like some latter day Tony Blair, preferring to focus on social and constitutional reforms such as the devolution of power to Spain’s truculent regions and the legalization of homosexual marriage. But he paid scant attention to the economy.

Bursting bubbles

The suddenness of the bursting of the property and construction bubbles initially wrong-footed Zapatero and his government, which was elected for a second term in March. Until quite recently Zapatero and his finance minister Pedro Solbes were keen to downplay the severity of the country’s predicament.

However in July finance minister Solbes finally acknowledged things were getting serious. He said: “This crisis is the most complex we have ever lived through given the plethora of factors on the table at the same time.” Solbes later warned that Spain could suffer its first recession since 1993, possibly starting in the fourth quarter, saying the economy “may have at some point practically zero growth.” He predicted the pain would continue well into 2009. “Economic activity will remain weak for several quarters more,” he told the Madrid parliament.

Edward Hugh, an economist based in Barcelona, says: “Everything about the Spanish economy is either going dramatically up or coming dramatically down. On the upside, we have consumer price inflation, producer prices, unemployment, unpaid bills of exchange and the current account deficit. Going down fast we have retail sales, industrial output, services activity, bank lending and of course mortgage lending and construction activity.” Hugh believes the economy has become a “complete horror story”.

Spain’s economic crisis owes its origins to the replacement of the peseta by the euro in January 2002. The single currency removed responsibility for monetary policy from the Bank of Spain and shifted it to the European Central Bank, 1,434km away in Frankfurt. Spain had to contend with a “one-size-fits-all” interest rate, which was dangerously out of synch with its own needs. The country had interest rates of 9.25% in 1995 but by 1998 it had lowered them to 3% in preparation for euro convergence. Between early 2002 until the autumn of 2006 the country effectively had negative real interest rates.

Housing bust

Spaniards responded by withdrawing money from deposit accounts (which suddenly started paying what they deemed to be derisory rates of interest) and invest in property. Others, many of whom would previously have been unable to obtain home loans, borrowed to the hilt to buy new homes. The country also became obsessed with property speculation.

The whole thing started to go pear-shaped after the ECB embarked on a process of monetary tightening in 2005 that was aimed at tackling eurozone inflation. By July 2008 the central bank had more than doubled interest rates to 4.25%. Rising borrowing costs started to hurt both Spaniards and 100s of thousands of foreigners who had bought into the dream of second or retirement homes on the Costas.

The property crash, magnified by over-supply in the Spanish housing market, caused developers to down tools and even to re-hire redundant workers to demolish unwanted homes. Overall Spain’s manic housebuilding spree has left an estimated 1.5 million unsold homes across the Iberian peninsular. It has been exacerbated by the fact is coincided with the global credit crunch and soaring oil prices.

House prices, which started to slide last year, have now fallen by between 7% and 20% since the market peak. Ben May of London-based Capital Economics, says they will drop by at least 15% overall. “And you could see sharper falls than that,” he said, “Twenty, 25, even 30 per cent falls are not out of the question.”

The slump’s biggest casualty so far has been Martinsa-Fadesa, a Madrid-based developer of hotels, shopping malls and condominiums. The company went into administration in July as a result of aggressive expansion at the height of the property bubble fuelled by high gearing. The expected firesale of Martinsa-Fadesa’s assets, which include a landbank once worth €6bn, will soften Spain’s property market still further. Other indebted developers are likely to follow suit. Already the country’s construction industry has shed 300,000 jobs, pushing Spain’s unemployment rate up to 10.4%.

Rising inflation

The property crisis is already infecting other parts of the country’s manufacturing and services sectors. Inflation rose to 5.1% in June 2008, its highest level in 13 years. Industrial output fell by 9% year-on-year in June and production of consumer goods  –  including white goods and cars  –  fell by 20% year-on-year in the same month. Also in June, retail sales slid by 7.9% which has had dire consequences for retailers including the clothing group Cortifiel (owned by buyout houses Permira, PAI and CVC Capital Partners).

It has also emerged Spain’s services sector shrank once again in July, with companies pessimistic as they shed further staff. The Markit Research Services PMI index crept up to 37.1 from June’s record low of 36.7. Veronique Riches-Flores, European chief economist at Societe Generale in Paris, says: “To me the Spanish economy is in recession, there’s absolutely no doubt. Domestic demand is extremely weak.”

There are fears damage from the housing bust could spread to the country’s banking sector – which, unlike the banking sectors in the UK and US, has been largely immune thus far. Analysts at Morgan Stanley recently warned that Spain’s second-tier banks, including Banco Popular, Sabadell and Banesto, are particularly vulnerable to defaults and delinquencies related to the country’s imploding property sector.

Spanish banks are regarded as having been largely unaffected thus far thanks to the tough line imposed by the Bank of Spain towards the use of off-balance sheet vehicles and provisions back in 1999. From that date the central bank forced them to take provisions at the time loans were issued, in case of defaults. In some cases this gave the banks provisions five times greater than peers in Italy and the UK ahead of the credit crunch.

“The other central banks looked at us and said, ‘This is just silly,’” Luis-Angel Rojo, 74, the former Bank of Spain governor who imposed the tough rules, told Bloomberg. “I thought a system was being built that was going to blow up, and it was better to be forewarned.”

Since the credit crunch Spanish banks have been particularly heavy users of an ECB facility that enables them to swap dodgy mortgage-related assets for funding. Large banks such as Banco Santander and BBVA have also been protected by their geographical diversification into the more resilient economies of Latin America. But bank analysts suggest even these titans could be humbled as defaults and delinquencies mount.

Cushioning the downturn

So what now for Spain? Zapatero’s government has already announced measures aimed at cushioning the downturn, which have involved increased government spending and tax cuts. Zapatero is also offering redundant migrant workers a state-funded bonus to return to their homes in North Africa and Latin America – which could potentially stoke up racism.

A programme of tax cuts and spending increases is likely to mean the country’s current account surplus – Spain had a budget surplus of 2.2% GDP in 2007 according to the IMF – into a deficit by 2009. Salbes recently conceded as much, saying: “If growth next year is less than this year, we will possibly have a deficit. My objective is to keep the debt around the current levels and that is something that is achievable.’’

However some forecasters believe Spain may avoid an outright recession. The IMF, for example, recently predicted that Spanish growth will fall to 1.8% in 2008 before slumping further to 1.2% in 2009. However, a survey of economists by Bloomberg recently identified 50-50 chance of recession before the end of 2009.

Some economists argue that the time has come for Spain to embark on a much more radical restructuring of its economy, including a shift in the focus of social spending away from old-age pensions, and amending employment policies so that it becomes much easier to fire people who are already in work.

Diana Choyleva, director of Lombard Street Research, thinks Spain is poised for a five-year slowdown in which it is going to have to massively restructure its economy, in much the same way Germany did in the 1990s. “A lot of people and companies exposed to the Spanish economy are going to feel the pinch,” she predicts.

Already several UK-based consumer-focused companies including Vodafone, Taylor Wimpey and Unilever have caught a cold as a result of weakening sales in Spain. There will to be more where these came from.


This article was published in the September 2008 issue of Accountancy, the magazine of ICAEW.

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