Remember Spain?

Until two weeks ago all eyes were on Spain as the country that, if it required a bailout, threatened to pull the eurozone apart at the seams. Events seem to have leap-frogged Spain and moved straight to Italy as the latter rushed to force an austerity programme through parliament last week. Now that the Italian austerity budget has been passed and Italian finance minister Giulio Tremonti’s position in the government seems more stable, investors are likely to focus on Spain as a potential flash point once again.

Are investors right to worry about Spain? Spain is unique among the PIGS (Portugal, Ireland, Greece and Spain) in that it has a liquidity problem and is not (yet) insolvent. If Spanish debt is shunned by investors, however, the country could quickly become insolvent, the repercussions of which for the rest of the eurozone would be severe.

Why Spain is different
Up until recently, Spanish government bond yields had decoupled from those of the other PIGS. There are a few reasons that Spain stood out among the peripheral countries as having stronger fundamentals.

First, Spain’s overall public debt burden is relatively low, reaching only 60.1% of GDP in 2010 and 63.6% of GDP at the end of the first quarter of 2011. This compares with public debt at the end of 2010 of over 140% of GDP in Greece, around 96% of GDP in Ireland and around 80% of GDP in Portugal.

Second, Spain’s current-account deficit has fallen from 10% of GDP in 2007 to 4.5% of GDP in 2010. This is a sharper adjustment than has taken place in the other peripheral countries, owing largely to a collapse in imports.

Third, the swing from primary deficit (deficit excluding debt servicing costs) to primary surplus that Spain must achieve to stabilize its debt levels in 2011 is 6.2 percentage points, smaller than in any of the other peripheral eurozone countries (11.5 percentage points in Greece, 15 in Ireland and 8.3 in Portugal).

Concerns about Spain
Despite these factors, there are good reasons to remain concerned about Spain’s debt sustainability.

Spain has 17 autonomous regions, nine of which missed their deficit targets last year. In 2010, over one-half of the fiscal adjustment was focused on tax hikes, which can be controlled by the central government. In 2011, over two-thirds of the adjustment will come from expenditure cuts, around one-third of which comes from the autonomous regions.

Catalunya (which has an economy roughly the size of Portugal’s) has a 2011 budget that from the outset planned to miss the central government’s targets for the overall regional deficit. Castilla-La Mancha is also set to miss its budget deficit targets. The credit ratings agency Moody’s has threatened that, if the regions do not implement new measures, the overall regional deficit could rise to 2% of GDP, above the target of 1.3% of GDP. Given that the central government is set to exceed its deficit targets in 2011, however, this would not be dramatic.

In addition to having higher than expected regional deficits, there may be a significant amount of hidden debt at the regional level. Companies owned by regional governments have issued debt off balance sheet or left bills unpaid. Analysts estimate that hidden regional debt could amount to up to €26bn. This is however a small amount compared with almost €500bn of central government debt.

Another significant concern in Spain is the state of the country’s banking sector. Spanish banks have been increasing their reliance on ECB liquidity since April 2011. The largest banks, such as Santander and BBVA, are reasonably healthy with almost half of their profits coming from activities in Latin America. The cajas sector, on the other hand, contains significant rot and is in the process of being restructured.

The banking sector could see further losses crystallize as the property market in Spain finds a floor. In a recent blog post, Namawinelake pointed out that the average fall of property prices in Spain from the peak in 2008 to the trough in the first quarter of 2011 is 15.4%, compared with an average fall of 41% in Ireland. The Spanish property market may therefore have much further to fall.

Additionally, the two greatest triggers for mortgage defaults are unemployment and interest rates. Unemployment in Spain rose from 20.1% in 2010 to 20.9% in May 2011, the highest in the eurozone. The ECB indicated earlier this month that we can expect further rate hikes unless economic growth and inflation in the euro area decelerate significantly.

Contagion
Even if all of our worst assumptions were to come true with respect to soaring regional budget deficits, hidden debts and losses in the banking sector, I still think Spain would be solvent. If investors refuse to purchase Spanish debt, however, this could change quickly.

As I explained in another blog post here, if Spain were to need a bailout, it would put inordinate pressure on Italy’s public finances. The fates of Spain and Italy are therefore inextricably connected. There is no way the eurozone could afford to bail out both of these countries. Consequently, a market attack on Spanish debt could mark the beginning of the end of the euro area.

This post is a summary of a presentation I delivered on July 11th on a panel sponsored by Open Europe and the Spanish think tank FAES, entitled “Too big to bail-out? Spain and the future of the eurozone”. To see my powerpoint presentation, please click here.