Spain Following in Ireland’s Footsteps

Watching developments in Spain since the beginning of April has been source of non-stop déjà vu for anyone who spent 2010 watching events unfold in Ireland. There are a number of striking similarities between the position in which the Spanish government now finds itself and the Irish government’s situation in November 2010, just before it was forced into an EU/IMF bailout programme. Based on Ireland’s experience, a bailout for Spain seems inevitable.

The trifecta of problems
While many have deemed the eurozone (EZ) crisis to be fiscal in nature, it has never been that simple. It is true that neither Ireland nor Spain were as fiscally healthy as the headline numbers they were posting may have suggested. But that fiscal vulnerability was largely a reflection of other problems in the two economies. Both Ireland and Spain had allowed their public finances to become reliant on property bubbles that had also seen the countries’ banks over-extend themselves and their construction sectors grow unsustainably large.

When the property bubbles burst, this house of cards fell in on itself. Banks in the two countries faced massive losses and in some cases were pushed to insolvency, while in the real economy unemployment spiked as construction activity ground to a halt. The Irish and Spanish governments were left to pick up the tab, just as government revenues started to slump.

With debt and deficit levels soaring, the Spanish and Irish governments were forced to retrench, adding yet more pressure to their economies. What started out as a property bubble underpinned by cheap cross-border credit quickly turned into a trifecta of inter-related problems in both Ireland and Spain: banks needing government recapitalisation, ever-greater demands for austerity to bring the public finances back under control, and the drag of austerity on economic growth.

Banks
This trifecta brought Ireland to its knees in late November 2010 when it was forced into an EU/IMF bailout programme. Irish residential property prices had fallen 36.3% from peak to trough by that time (and have since fallen a further 20.5%), but it was disastrous commercial-property lending that had made the Irish banking sector a black hole for recapitalization.

Eye-watering losses on banks’ commercial property loans were crystallized over the course of 2010 as they were transferred to NAMA, the bad bank for Ireland’s worst non-performing loans. To prevent these losses collapsing Ireland’s banking sector and undermining the wider EZ financial system, the Irish government was forced into a series of recapitalizations totaling €46bn by early 2011, including €31bn in promissory notes provided to Ireland’s zombie banks Anglo Irish Bank and the Irish Nationwide Building Society (now merged as the Irish Bank Resolution Corporation).

With each bank bailout, the Irish government promised in vain that this would be the last. Credibility was only restored when the EU/IMF bailout programme was put in place and Blackrock was brought in to run independent stress tests on Ireland’s banks. These tests identified the need for up to €24bn in further capital, leading to the effective nationalization of all but one of Ireland’s banks.

Spain’s residential property market has only collapsed around 22% from its peak in 2007 to the end of 2011 and will probably fall an additional 15-20%. The more gradual fall in Spanish property prices (relative to the collapse of those in Ireland) means that the Spanish government has not poured as much into its banking system as Ireland has. Spain’s bank recapitalization costs have also been smaller as a percentage of GDP than those in Ireland because Spain’s bank resolution institution, FROB, does not force banks to crystallise bank losses up front.

This unfortunately does not mean Spanish banks are any healthier today than Irish banks were back in late 2010. As Spanish property prices fall further and unemployment continues to soar—Spanish unemployment reached 23.6% in February, with youth unemployment exceeding 50%)—mortgage defaults will rise. Spanish banks will almost certainly require further recapitalization from the government.

As was the case in Ireland, it is extremely difficult to estimate the size of the hole in the Spanish banking sector, and this uncertainty is deeply corrosive of investor confidence. As long as the health of Spain’s banks remains a huge source of doubt, investors will shun Spanish sovereign debt and borrowing costs for Spain will remain elevated.

Austerity vs growth
Throughout the EZ crisis, the first response demanded of countries in difficulty has been austerity. But this has caused more problems than it has solved. While fiscal adjustment is undoubtedly necessary in the medium term, on the scale and at the pace that we have seen it implemented during this crisis, it has choked off growth.

The Irish government has used successive budgets to announce a steady stream of draconian austerity measures with a view to reining in its budget deficit—a key requirement of the EU/IMF bailout agreement. Coming at the same time that banks, companies and households have been forced to rebuild their balance sheets, the government’s severe fiscal squeeze has served to deepen and prolong the economy’s slump.

A similar dynamic is playing out in Spain. Its budget deficit ballooned to 8.5% of GDP in 2011, and the Spanish government has agreed with the European Commission to cut it back to 5.3% of GDP in 2012 and 3% of GDP in 2013. But we have already witnessed in Ireland what happens to GDP when the government is forced to retrench alongside every other level of society. There is no reason to expect a different result in Spain, and indeed the country slipped back into recession in the second half of 2011.

The government can’t win
In late 2010, Ireland had reached a point at which nothing it could do would shift market sentiment in its favour. The combination of uncertainty in the banking sector, an increasingly unsustainable fiscal dynamic, and ongoing economic contraction was more than a match for the beleaguered Irish government’s attempts to reassure investors.

In early November 2010, the Irish government announced the size and pace of its planned fiscal adjustment over the next four years. It had little chance of pleasing the markets with this announcement.

A small fiscal adjustment would have been perceived as a lack of seriousness about the need for fiscal sustainability. A big fiscal adjustment, on the other hand, would raise concerns about the impact of retrenchment on growth.

The Irish government opted for the latter strategy, front-loading its fiscal plan with a €6bn adjustment in 2011, out of a four-year total of €15bn. Investors were not impressed. Bond yields rose further after the announcement and within weeks Ireland was forced to enter its bailout programme.

Spain’s current trajectory looks eerily similar. In early April this year, Spanish bond yields started to creep upwards to unsustainable levels once again. In an effort to reassure investors, the Spanish government announced an additional EUR10bn in savings. But the news of a bigger Spanish fiscal adjustment only served to unnerve investors, who fretted about the implications for economic growth. Consequently Spanish government bond yields edged upwards even further.

Does Ireland offer a sneak preview for Spain?
If the Spanish government cannot regain market confidence, it will be forced to request access to official funding. This may initially come in the form of support for Spanish banks, but recapitalizing the banks only addresses one piece of the puzzle. In the absence of economic growth, the Spanish sovereign will need a bailout too.

Given the similarities between the Irish and Spanish cases so far, one has to wonder if the success of the Irish bailout programme could be a sneak preview of things to come in Spain.

Let’s hope not.

Ireland has been held up as a success story by the European Commission, the ECB and the IMF (the so-called troika). This is true in a relative sense—conditions in Ireland are better than those in the other two bailout countries, Greece and Portugal. But Ireland dipped back into recession in the second half of 2011, and with domestic demand set to contract further and foreign demand weakening, it is unlikely the country will find sustainable growth in the next few years. Consequently, Ireland will almost certainly require a second bailout programme when its first programme expires.

This highlights a crucial difference between the Irish and Spanish cases: size.

Ireland is small enough for a second round of EU/IMF funding to be affordable if it is needed. Spain is not.

There is only enough money in the EU/IMF arsenal to bail Spain out once. If Spain were to fail to find sustainable growth during the course of a first bailout, it would get no second roll of the dice. Instead, we would face a debt restructuring in one of the EZ’s largest economies, with detrimental effects on global growth.

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8 Responses to Spain Following in Ireland’s Footsteps

  1. Dr Dan Wilsher says:

    Thank you Megan for this very thoughtful analysis.

    I wonder if you think that in the end real wages must fall dramatically in the periphery and that eurozone exit is the quickest way to do this ? Is the current process of grudging hand-outs destined to fail because money wages will not fall fast enough and the current account cannot therefore rebalance? Certainly restoring competitiveness through supply-side reform seems to be a very uncertain and long process. Is there any data to show how ‘much’ liberalisation can increase competitiveness in Europe’s periphery?

    Ironically then the claims that Germany is squeezing too hard, might actually be wrong – they aren’t squeezing hard enough. The TARGET2 economists in Germany seem to be saying this.

    This suggests that the present arrangements suit (a) Germany (or at least the finance and export sectors), because they prevent a sudden shock of default/exit and (b) governments in the periphery, who would see huge falls in real wages upon exit.

    This is sustainable as long as (a) the bail-out bill is contained (b) the ECB can continue to find enough collateral in the periphery to print money (c) fiscal austerity can be politically imposed.

    This could be a long time. Will German inflation have exceeded that in the periphery so as to rebalance trade naturally over say 5 years?

  2. FXiC says:

    A worrying comparison indeed, with perhaps one distinguishable difference. Courtesy of the ECB’s LTROs, Spain’s banks have pumped their balance sheets full of sovereign debt which will likely only make matters worse.

  3. Oguz says:

    The Euro Crisis is driving the continent to become the next Japan, in my view. ECB’s Keynesian-influenced monetary policy will provide capital flows to the financial markets but not support the real economy as planned. As a result of this, we will see a years-lasting recession in most part of Europe, and economies that are addicted to more liquidity, e.g. today we saw the Spain 10y bonds surge over 7%, a green light for LTRO III. It seems funny but aside of joking, Spain is the new and bigger Greece, and all Greeces are desperate, shortly I can say.

  4. David says:

    Important to note that the need for bank re-capitalization is driven in large part by the insistence of the holders of bank debt (mostly German and French banks) to insist on being paid 100 cents on the dollar for their loans. If the institutions that lent to Spanish (or Irish) banks and cajas were willing to accept a write-down on the debt, the need for re-capitalization of the Spanish banks and cajas would be mitigated, easing pressure on the Spanish government and restoring some confidence in the country’s fiscal health.

  5. Pingback: Eurozone | Pearltrees

  6. Jeffrey N says:

    “There is only enough money in the EU/IMF arsenal to bail Spain out once.”

    I’m not so sure about this. It is my understanding that the ECB bought about €50bn of Spanish sovereign debt via the SMP, and that Spanish banks bought another €50bn via the LTRO program. Doesn’t this mean that only about one quarter (€150bn ) of Spanish sovereign debt remains in foreign hands?

    As for the banks, wouldn’t the ECB simply continue to support them, as it has done up until now?

  7. Tom says:

    Megan

    Do you see the fact that Spanish banks hold so much domestic debt now is an impediment to any Spanish debt restructuring in the future? I read a report this morning that Spanish banks holding so much domestic debt actually reduces the risk of default, in a similar comparison to how Japan has survived for so long with such large levels of debt.

    Many thanks

    Tom

    • Megan Greene says:

      We’re seeing a domestication of debt in all the peripheral countries and there is definitely a home bias in Spain, but in Spain external debt is still 115% of GDP. Now that isn’t just held by the banks, it’s across the entire national balance sheet. But that’s still a very high ratio and will need to come down if Spain wants to put itself on sustainable footing. That can be done with an adjustment in the current account balance, but the size of the adjustment needed over the next few years is unrealistic and would be self-defeating. It can also be done with capital inflows, which I think will come in the form of a bailout package (and some ECB operations). But when that money runs out, I think it will have to be achieved with a debt restructuring.

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