March 24, 2011

And now Portugal... But hunters already looking for their next prey

Here comes the latest member (it is almost there) to join the euro-bailout club: Portugal. This is not breaking news, as everybody was expecting this to happen sooner or later. It is not frightening either, as Portuguese contribution to the whole European GDP is relatively low; it is lower than that of the Irish and clearly the eurozone did not break because of Ireland's (or Greece's) bailout. Belgium is mentioned too, but that would not pose a much bigger problem than Portugalm, but what IS frightening economists worldwide is the possibility of Spain or Italy being next.
Portugal 10-year Bond. Credit: Bloomberg
The pattern on European bailouts is becoming worryingly clear. One country's economy begins showing signs of slowing down and continues with its excessive debt issuing. Rating agencies notice (thus making the yields go up), international investors notice (and ask for bigger yields on said sovereign bond) and last but not least speculators notice and try to take advantage of the situation. The death spiral has begun and everybody knows the results... The same moment this happens, the whole financial world locks in to their next target; the most suitable candidates being now Spain and Italy. The first expression that comes to mind when mixing the word 'bailout' and the name of Spain is 'too big too fail'. The expression is already familiar for American people but European people have not suffered it yet. The falls of Greece and Ireland were manageable for the European rescue fund, but a crash in Spain, or Italy, would pose an enormous problem to the whole eurozone. But disregarding what the hunters (speculators) want, is really Spain in need of a bailout? 
The immediate answer would be 'not now'. Spain has done some good fiscal work lately, specially regarding the 'Cajas de Ahorros' (savings banks) recapitalization requirements, which show a good level of responsibility by the regulator and the government and can help avoid future surprises in the sector. But the problem is that few people (this author included) believe the announced amount, a 15.000 million euro package; a really manageable amount, would be enough to cure the wounds of the broken housing market.

Cajas de Ahorros exposed themselves the most to the housing market bubble, they found an easy and profitable business in selling mortgages to anyone that asked for one. In some cases some entities were offering mortages with monthly payments amounting to more than 70% the wage of the solicitor! Interest rates were on the ground and the market was booming so nobody at the Cajas de Ahorros seemed to care about this (plainly stupid) plan on the long-term. The housing bubble burst, and the special treat about the Spanish reaction to this is that the economic adjustment was done mainly by destroying jobs. Cajas de Ahorros were then left with a lot of real estate assets on their balance, all of them valuated at pre-crisis prices which as of today is quite unrealistic. 
Nobody really knows what the recapitalization package for said Cajas de Ahorros would be if they were to realistically price their real estate assets.
Spain 10-year Bond. Credit: Bloomberg
Even if the Cajas needed some extra money, Spanish biggest banks Santander and BBVA are seemingly showing good health, and their international diversification also gives extra security that the Spanish banking system will not drown the entire country to a bailout, as it happened in Ireland. What worries about Spain's finances is its breathtaking 20% unemployment rate, 40%+ among young people, and the excessive government spending, mainly due to an abnormally high number of civil servants in relationship with the number of citizens of the country. Those are the main weapons the 'hunters' will be using to corner Spain.
The problem for the Spanish government is, reducing those civil servants now would only make unemployment matters worse in the short term. On the other side, the ECB is expected to rise interest rates in April, which can make Spain's debt issuing even more expensive.

What the Spanish government should do, and what the markets will ask for, is a sign that it can change the tide to avoid any future need of a bailout, mainly keeping its income but reducing public spending at the same time. The usual go-to solution from the socialist government to keep its income has been rising income taxes and/or VAT, but with commodities rallying hurting consumption by rising taxes would only slow down the economy. The equation to reduce spending and keep income has only one solution: creating more employment. Of course this is easier said than done, but investing in creating employment would be a far better solution than investing it in keeping more civil servants on the payroll... The Spanish government still has the power to avoid a bailout, but a lot of things must be changed.

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