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The Spanish Inquisition - Part I
May 4, 2012

The European sovereign debt crisis has come under renewed pressure in recent weeks after having stayed out of investors' scrutiny since the European Central Bank's Long Term Refinancing Operations (LTROs) and the completion of a restructuring of Greek debt brought it some respite. Under the spotlight now is the nation of Spain.

Author : iFAST Research Team

The Spanish Inquisition - Part I
  • Spanish sovereign bond yields have come under renewed scrutiny following a relatively peaceful 1Q 2012
  • The root of Spain's issue lie within its high unemployment rate and its property sector
  • High unemployment and the weak property sector is causing a negative feedback loop
  • The Spanish financial sector has several issues to deal with and appears to be vulnerable
  • S&P's 2 notch downgrade of Spain's rating bears watching
  • Part II of the article will focus on Spanish sovereign debt and its yields.. Stay tuned!

The European sovereign debt crisis has come under renewed pressure in recent weeks after having stayed out of investors’ scrutiny since the European Central Bank’s Long Term Refinancing Operations (LTROs) and the completion of a restructuring of Greek debt brought it some respite. Under the spotlight now is the nation of Spain, famed for bullfights, sangria and having some of the best beaches in the world, financial markets have awoken from their siesta and have begun to turn the screws on the Mediterranean country. In the first half of a 2 part article, we take a close look at the key issues plaguing Spain and analyse the implications for the tapas loving nation’s financial sector.

the roots of spain's problems

Spain’s current underlying problems stem mainly from 2 sources: an astonishing high unemployment rate, and, a real estate market/sector that is in free-fall.

Spain’s unnervingly high unemployment rate stems from the weakness in its economy following the global financial crisis and its labour market. Spain’s labour market has suffered significantly from its two-tiered employment system and the liberalisation of temporary contract workers performing regular activities in the 1980s, something which was previously not allowed. These temporary contracts significantly lowered dismissal costs and magnified the employment-cyclical factor, boosting employment in periods of economic expansion, and, hastening lay-offs and magnifying unemployment in busts (such as the time Spain is in now). With approximately 31% of Spain on temporary contracts just prior to the financial crisis (4Q 2007), it was thus easy for employers to scythe down their workforce to cut costs and keep their companies afloat.

Other factors such as wage indexation, high unemployment benefits which provided a strong disincentive to work, a strong mismatch between job requirements and the skill sets of the labour market, as well as the strong unions in the labour market all contributed to the unemployment situation in Spain, with the total number of contracts (both permanent and temporary) shrinking by -12.14% from 4Q 2007 – 4Q 2011, pushing up the unemployment rate to 24.4% in 1Q 2012.

As the global financial crisis hit the world, banking and other service sector jobs in Spain vanished, industrial and construction output contracted, leaving plenty without a job, and playing its part in the collapse of the real estate sector.

The collapse of the domestic property market has also contributed heavily to Spain’s current predicament. While construction of new property was the main driver of Spanish economic growth for much of its modern history, the simple fact of the matter is that it was unsustainable and was never going to be a true driver of long term growth. The end of the construction bubble saw construction starts come to a standstill, leading to many a construction worker unemployed, with the number of people working in the construction sector contracting by 80% from 4Q 2007 to 4Q 2011. With more unemployment and a large over-supply of homes in Spain, property prices began to fall and a vicious self-reinforcing loop developed.

Chart 1: Prices Fall, Home Starts Stop

Prices Fall

Chart 2: home starts stop, jobs vanish

Jobs Vanish

Thus, the twin problems of unemployment and a falling real estate market have intertwined to feed off each other and drag Spain into its current day predicament.

the current malaise

With unemployment at dizzy heights, consumers have been hit hard and economic data are showing their pain. Household income (at least for those who are employed) has had no reason to cheer as wages adjust downwards to absorb the massive unemployed numbers. This decrease in disposable income has manifested itself in consumer spending, which has further suffered since the financial crisis, as evidenced by retail sales, which has only seen 2 months of year-on-year growth since December 2007, and contractions in all the others.

Chart 3: No Jobs, No Sales

no jobs no sales

As the real estate sector continues to fizzle, property prices have continued to slide. Home prices have contracted by -7.25% from 1Q 2009 to 1Q 2012, with the price correcting by -2.90% in the past quarter alone, continuing its decline in a free-fall fashion, and leading to many mortgages being underwater (current value of a home is worth less than the mortgage).

the fiesta is over for spanish financials

The Spanish financial sector has been punished badly by markets, and perhaps, rightly so. Extremely loose lending criteria saw banks generate strong loan growth during the property bubble, at the expense of questionable loan quality, and the latter is now coming back to bite them. Non-performing loans (NPL) and mortgages have grown over the past few years from rates of less than 1% for both NPL and for mortgages to reach 8.16% and 2.77% respectively as of end March 2012. Given that property prices have continued to fall and further reductions in household disposable income are expected given the recession, we expect the NPL rates to mount as the economy contracts and loan quality further deteriorates.

Chart 4: High NPLs Rising

High NPLs rising

The announcement by the Bank of Spain (BOS) that bad loans had risen by EUR 3.8 billion in February to reach EUR 143.8 billion highlights the size of the problem on the Spanish banks’ balance sheets. A prior announcement by the BOS that the sector would require EUR 53.8 billion worth of financing in order to meet new capital requirements standards, with EUR 29 billion to be used for provisions, seems precariously inadequate given that bad loans have accelerated since the debt crisis began to rumble in June 2011 and have risen by EUR 8 billion over the past two months alone.

With an already weakened balance sheet and difficulty in accessing financial markets for funds, Spanish banks have turned to the central bank for funding needs. As seen in the chart below, Spain’s dependence on central bank funding has grown at a staggering pace to reach EUR 316 billion in March, almost doubling from February’s EUR 170 billion figure. With the funding, Spanish banks have been increasing their holdings of their nation’s sovereign debt, with the figure rising by 25.4% since September 2011 to reach EUR 220 billion in January 2012. As Spanish yields continue to rise, losses on their holdings might manifest themselves in the profit & loss statements of the banks, leading to greater concerns over the health of the sector, and in turn, sending yields on Spanish sovereign debt higher, a potentially tricky cycle to escape from.

Chart 5: Requiring Money From The Central Bank

requiring money from the centra bank

Adding further concern on the sector has been data showing that deposits in Spanish banks contracted by -4.1% in February on a year-on-year basis, with the BOS’s Head of Banking Regulation explaining that it was due to multinational companies shifting their deposits out of Spain and into other countries, leading to whispers of a potential flight on deposits. While yet to be confirmed, the threat of a bank run is alot more distant threat for Spanish banks as it was for Greek banks.

Given the continued deterioration of the economy and the health of the balance sheets of banks, we believe that the measures done thus far might not prove sufficient given Spain’s structural economic problems and the on-going recession, which will see more consumers, homeowners and businesses defaulting on their debt obligations. Thus, further deleveraging of and capital raising activities in the Spanish financial sector should be anticipated, while mergers and acquisitions should not be ruled out.

As of the time of writing, Spain's sovereign debt rating has just been downgraded 2 notches by Standard & Poor’s to reach a rating of BBB+ and added a negative outlook, with the reasons for the downgrade extremely alike our analysis.

Stay tuned for Part II where we look at the implications and impact on Spanish sovereign yields...


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