In late April, Standard & Poor’s became the first credit rating agency to downgrade Spain. The downgrade, from a single A rating to a BBB+, shadowed a negative outlook on the country. The downgrade was quickly followed by the others, such as the one by Fitch Ratings, who cut its rating three notches all the way down to BBB (just two levels above junk status), and now by Moody’s, who cut Spain’s Sovereign credit to Baa3 and put the country on review for possible further downgrade. Reasons cited: the need/cost of recapitalizing the country’s banking industry, the government debt load and a recession, which is expected to last through 2013.
We think Spain’s recovery is possible if it is viewed as a marathon, not as a sprint. But how quickly it can recover depends on a multitude of factors. For U.S. investors, this is a lesson learned. Private systemic greed and government complacency during boom years have led to a disastrous scenario in Spain. There is great danger but there is hope.
Spain’s economic crisis began by the burst of two bubbles: property and wages. During the euro formation, interest rates fell to a historic low which encouraged Spain’s banks to lend and property buyers to borrow beyond their means. As world financial crisis hit in 2008, construction has decreased, so has the demand for concrete, which was previously one of Spain’s most profitable industries and drivers of growth; it is very unlikely that this industry will revive any time soon. Real estate portfolios continue to make up the majority of credit losses, as real estate activity and property prices continue to decline. Banks are now burdened with a large amount of bad mortgage debt. Spain’s government did little to correct the imbalances during the boom years. After the burst, the government began borrowing and spending a great amount to attempt to stop its economy from completely collapsing.
Additionally, during the boom, wages increased too rapidly. After a burst in the labor market bubble, Spain became less competitive. It now overspends because imports are cheaper than exports. Spain’s current labor laws make it difficult to fire employees; as a result, its unemployment is the highest in Europe. But the country is also saddled with a high number of temporary workers. This means that the actual unemployment rate exceeds the 24% official tally. Due to high unemployment, fewer people pay income taxes and more people demand unemployment benefits.
Unlike Greece, Spain’s crisis was not caused by excessive government spending, but in a big part by decreases in revenue. Austerity programs have slowed Spain’s economic growth and have resulted in a weaker economy. Cuts, specifically those in public investment, worsen the overall economy with more job losses, higher unemployment, and lower tax revenues. The private sector’s increasing debt, weak external financing, attempts to reduce its deficit, and trying to limit public debt will hinge Spain’s ability to turn its economy around.
The cost of Spain’s borrowing has been quickly increasing. Its 10-year government bond yields have quickly risen to nearly 7%, a euro-era record. In comparison, the yield on 10-year bonds in Germany has hit all time low of 1.42%. Spain is struggling to sell new debt, and the cost to insure its debt is at all time high. While public debt is at acceptable levels, private debt is over 220% of GDP.
On June 9, Spain became the fourth member of the euro union to seek a bailout. To rescue its bank, it will receive as much as 100 billion euro sovereign bailout. While the devil is in details, and the details are still being worked out, the money is considered a loan. Just how much money Spain will give to banks, how much will be used as a cushion against future shocks, and how much money is coming from the EFSF and ESM are still unknown. If the money comes from the EFSF, bondholders will become subordinated, and if it comes from the ESM, new senior debt will be created. There are strings attached to this loan, including higher retirement age and higher VAT tax. There is also hope that the bailout will keep Spain stable if Greece’s new elections lead to Greece exiting the euro.
Although Spain received more than twice the 40 billion euros the IMF estimated it needed to prevent an economic collapse, it is still in great danger. The relief and optimism following any bailout is historically short-lived, and for Spain this is likely to be true as well. The bailout will increase sovereign liabilities, Spain’s ratings are further downgraded, and cost of borrowing will continue to increase. Investors are still unwilling to buy Spanish government bonds and there is a great possibility that Spain will not find enough buyers for their bonds in the long term.
Finally, Spain, and thus its taxpayers, is responsible for repaying the loan and its interest. There are great concerns about Spain’s ability to repay the loan as the country is still not on a path of growth.
In previous years, banks in countries like France or Germany would lend to Spain to ease its overspending and help to avoid an economic collapse. However, now these banks doubt Spain’s ability to repay debt and want the return of their money. If cautious investors pull cash out of the Spanish banking system, the banks may not have enough money to keep lending to the government. Spanish central bank borrows from ECB, who borrows mostly from Germany’s central bank, the Bundesbank. As of the end of April, Germany has lent out 644 billion Euros, so the likelihood of it lending money to Spain directly is low. Additionally, Spain’s main export markets in Europe have also agreed to austerity.
Although unlikely, as a long-term solution Spain can leave the euro in order to regain its competitiveness and devalue its currency. By devaluing its currency, Spain would make its workers and its products less expensive and more competitive internationally. A downside is that the money others lent to Spain could be frozen, converted into new pesetas, and then devalued. Spain’s cost of imports would soar but spending cuts would be more proportionate to incomes of importers. Currently, as part of the euro, there is great discrepancy between countries like Spain, whose weak economies suffer from the de-facto overvalued currency, and countries like Germany, whose strong economies further benefit from the de-facto undervalued currency.
Remember the advice to buy when there’s blood in the streets. This can be well extended to buy real property as precious metals and select real estate present attractive deals today. For U.S. investors and/or speculators, the safe zone seems to reside in real estate in wealthy, developing socio-economic areas. Another important, potentially hugely profitable solution for investors lies in precious and even industrial metals. Commodities still may dip even further in price, as the need for liquidity during chaotic times grows, but should benefit long term nevertheless.
In order for Europe to rebuild its economic system, the best solution is to print more money, which will drive up demand for gold.
In shedding light on what this bailout brings, Spain and other European nations are indeed still in tremendous trouble. However, there is a rainbow over the horizon. There are currently great buying opportunities in real assets. Gold is a proven and terrific hedge against inflation but also does well in deflation.
