Monday, June 16, 2014

Sunday, June 8, 2014

The Hot Labour Phenomenon

Strong growth. Rising real estate prices. Rapid job creation. Surging immigration. This list sums up the Switzerland of 2014 down to a tee. However, it also sounds like a description of what things were like in Spain in 2007 - shortly before the country's economy fell off a cliff. What follows is a conversation between financial journalist Detlef Gürtler and economist and crisis expert Edward Hugh about possible parallels and differences between the two booms, and the role of a new phenomenon which Hugh describes as "Hot Labour".

Hugh argues that this is a new phenomenon, and on the increase as a result of central bank bubble inducing activity. While immigration is a vital tool aiding economies to manage the population ageing process, it is important that economic activities be balanced. Immigration fueling boom/bust cycles is far from innocuous, and harm a country just as much as a sudden stop in capital flows if the immigration is followed by emigration.   

Detlef Gürtler: Well Edward, you personally lived through one of the most important real estate booms in European history - the recent Spanish one. Is the real estate boom we are witnessing in Switzerland in any way comparable?

Edward Hugh: Before I start, I think it's worth pointing out that it goes without saying the Swiss are quite different from the Spaniards; and the Swiss economy is completely different from the Spanish one. In this sense every boom or crisis is in its own way different from anything before. That said, such "trivia" doesn't normally stop economists like me from trying to draw comparisons, even if in this case I have to be extremely careful, since while I know quite a lot about Spain I know much less about Switzerland. So perhaps you will help me.

Detlef Gürtler: Yes, economists do make comparisons, and you were even so bold as to draw one between the German 1990s housing boom and the one which took place in Spain after the start of the century.

Edward Hugh: Well this comparison isn't so strange as it may seem. Many talk today about Spain becoming the new Germany - in the sense of an export powerhouse - and while this idea may have a rather dubious basis in reality the shift from domestic consumption to exports is quite striking.

In both cases the subsequent "regeneration" was preceded by a significant consumer boom, in both cases there was a strong increase in real estate prices including a construction boom, in both cases there was an increase in household indebtedness, in both cases the current account deficit deteriorated. And then in both cases there was a rude awakening. The only real difference was one of scale, and in this case scale is important. Spain had what was at the end of the day the mother of all housing bubbles.

Detlef Gürtler: But in each case there was  a completely different historical background and there were very different underlying motifs.

Edward Hugh: Yes, of course. But does that really make a difference when it comes to economic ambition? East Germany's citizens in 1992 - just like their Spanish equivalents in 2002 - saw how big the distance was between their consumption level and the western (or northern) one, and since they could in each case contract debt on what was for them fairly favorable terms they decided to put history straight and to carry out a rapid catch up in consumption. Really, Europe as a democratic political project has some of the responsibility here, since there was no equalizing mechanism put in place, but at the same time people felt they were entitled to similar living standards.

One of the new MEPs from the newly formed Podemos party put it like this in a recent interview: "they have sold us a system in which they told us we would all be rich and we were all going to live very well, and there was a period like that, but all that’s over now."  

Detlef Gürtler: The Germans, on the other hand didn't find themselves with mortgages well below the actual value of the relevant property, while Spaniards are already facing this problem.

Edward Hugh: No, you're right, but this isn't the whole picture. Weren't there massive tax breaks for builders and developers in East Germany, tax breaks which were rapidly converted into 100% financing whereby the government effectively assumed the cost of write-down?.

Detlef Gürtler: Only in the prospectuses of tax-saving-scheme promoters. In fact, many investors ultimately remained sitting on a mountain of debt, debt which was higher than the long-term obtainable sale price for the property.

Edward Hugh: I see. In Spain, instead, creative valuation techniques were used. The economic end  result is the same: you lose the property but get stuck with a large part of the debt.

Detlef Gürtler: And how does Switzerland fits into this picture?

Edward Hugh: Well lets start with something which at face value seems positive. For many years there was virtually no inflation in Switzerland, sometimes the situation was more like deflation. Now a bubble economy without inflation, surely that would seem to be a novelty.

Unfortunately, when you come to look into things a bit more it isn't quite the novelty it seems to be. In fact Larry Summers, in his secular stagnation speech to the IMF 2013 research conference drew attention to this phenomenon. 
"Many people believe that monetary policy was too easy. Everybody agrees that there was a vast amount of imprudent lending going on. Almost everybody believes that wealth, as it was experienced by households, was in excess of its reality. Too easy money, too much borrowing, too much wealth. Was there a great boom? Capacity utilization wasn't under any great pressure. Unemployment wasn't under any remarkably low level. Inflation was entirely quiescent. So somehow, even a great bubble wasn't enough to produce any excess in aggregate demand."
So it seems bubble economies without inflation are becoming more common. The big question is why.

Detlef Gürtler: But if we look at real estate itself we see a different picture. In many market segments show annual price increases of more than ten percent.

Edward Hugh: Well, that is presumably in no small part due to investors from around the world seeking a safe haven for their money in Switzerland.

Detlef Gürtler: Yes. But especially since the franc was coupled to the euro these investors switched from the Swiss currency into Swiss real estate.

Edward Hugh: And obviously this increase is not (or is only insufficiently) taken into account in the consumer price inflation rate. Here again we find a similarity with Spain where the large rise in house prices was not reflected at all in the official consumer inflation rate. So despite official price stability life feels like it is becoming significantly more expensive, especially for those looking for a new apartment.

Normally when addressing the question of whether a real estate bubble exists or not, it is important to think about leveraging, about  whether the home purchases are financed by credit. If real houses are paid for with real money paid, and this money comes from the outside, the economic effect could be seen as more economically similar to exports: A foreigner buys a piece Switzerland. If the price falls back, it is largely a problem for the external investor, not for the Swiss themselves or the Swiss banks.

On the other hand, if all this "speculative" activity drives up property prices in a deflationary environment where wages are stationary, the affordability problem creates a different issue for Swiss nationals.

Detlef Gürtler: And what about the British market? Would you say this is currently more driven by "irrational exuberance" than Switzerland ?

Edward Hugh: Great Britain has at the present time  the fastest growing economy among all industrialized countries. But why should Britain suddenly have become a stellar economy, an exceptional out-performer? Again all this euphoria in the UK really reminds me of Spain, since Spain in its day was also considered to be an "out-performer", experiencing a major economic miracle.

 London house prices are up 18% year on year, and the current account balance is worsening. At the moment national insurance data indicate that roughly 600,000 economic migrants are arriving in the UK annually. Not as many as in Spain during the boom times - either in absolute terms or proportionally - but still a significant number. Because the immigration is mainly focused on London, it is leading to large distortions which affect the whole economy. The new arrivals need homes, but naturally they start without work and are not looking to buy. They end up renting - in maybe groups of 3 or 4 - and are thus able to collectively pay rental prices which a normal family cannot afford. Hence the buy to rent business become interesting.

Sadly many of the young Spaniards arriving (maybe 60,000 a year) are fleeing the consequences of one bubble only to inadvertently fuel another.

Detlef Gürtler: But isn't this an example of exactly the kind of labour mobility the EU in general and (the euro zone in particular) wanted to see? People move from countries and regions were there is little work to those where there is plenty? This pattern of behavior was legendary in the USA. Isn't it good that it now comes to Europe?

Edward Hugh: Well, yes and no. The key point is that the employment growth needs to be sustainable. Look at Spain, nearly half a million former immigrants left the country last year. And yet one more time it is important to understand that Euro Area countries have a different set of institutional arrangements to the ones which apply to US states. When Detroit went bust, the Federal Government was there to act as backstop.

When such activity is not sustainable there is a self perpetuating component which is highly undesirable. As Londoners feel better off since the value of their home has risen the borrow and spend more. They become more leveraged.  This boost to economic activity in turn attracts new immigrants, which push up rents even further and with them property values, making Londoners feel even richer, and so on. As a result you get what you could call an unbalanced but self-reinforcing economic recovery. Hence the "superstar economy" aspect.

So the point is that while developed economy societies need positive migration flows as they age, they don't need just any old kind of flow, otherwise you could end up with problem bigger than the one you started with.

Detlef Gürtler: Thus, labor mobility has a procyclical effect. Where the economy runs well , the process works through increasing migration with everything getting better and better and better, until that is the day bubble bursts.

Edward Hugh: What we are talking about here is a new phenomenon. When people say our economies are becoming "bubblier"  they normally are thinking in term of financial flows. This is the area first are in which the self-reinforcing dimension of the process was evident. Think of what happened to small countries like Iceland or New Zealand in the run in to the global financial crisis.The Danish economist Carsten Valgreen coined the phrase global financial accelerator to describe what was happening.

Detlef Gürtler: You mean the way in which large speculative inflows produced a boom, which the respective central banks tried to contain by raising interest rates, but somehow these increases in interest rates only served to attract more speculative funds. 

Edward Hugh: Yep this was the the original pattern, but it's different now. This is in fact the most important thing which has changed since the German property boom of the 1990s. Migration flows have started to  play a role which is just as important as the financial flows one. The migrant flows we are seeing today are exceptionally large, and have the characteristic that - just like capital flows - they may reverse rapidly. You could call this the global labour flow accelerator. I am convinced that we are dealing here with something new, with a hitherto hardly recognized phenomenon - namely speculative labour flows, or if you prefer" Hot Labour ".

Detlef Gürtler: "Hot Labour "? Never heard of it .

Edward Hugh: Neither had I, till I saw what was happening in Spain. As we mention above, I started speaking about this in 2006.

Detlef Gürtler: Did you invent the expression yourself?

Edward Hugh: No, I got the idea from someone called Pepe .

Detlef Gürtler: Pepe ? Which Pepe ?

Edward Hugh: Well I don't know him personally, or even his full name . Pepe was a commentator who showed up on my Blog. He used this term to distinguish those immigrants looking for a new home, a new life, and a new society to integrate in, from another group, those just moving for work or adventure without for any clear plan.  Locate work quickly, and if a crisis hits then change country.  Possibly this is not a conscious initial decision, but this is how it works out in practice.

Many young Spaniards working now in London or Berlin seem to fit this category. They don't really plan to emigrate, they just want to survive what they perceive as a "difficult period".  If asked in a survey about how they see their future they will normally say they are working abroad "temporarily" and will eventually return home. In fact they may never return home, emigration is a process which is not the product of a firm initial decision, but they also may be forced to move on quickly if the economic recovery where they have foudn work becomes volatile.

So the distinction between immigrants and Hot Labour could be thought of as following the same pattern as a similar one which describes in capital flows, where people have long distinguished between foreign direct investment and speculative investments , as in the expression " Hot Money ".

Detlef Gürtler: In the case of capital flows it is not so hard to differentiate one from the other : direct investment normally relates to plants and machinery, Hot Money is normally associated with securities such as stocks and bonds. How would you differentiate the various migrant populations?

Edward Hugh: First of all : not at all. The vast majority of immigrants change countries for economic reasons, but this does not tell us  anything about whether and how quickly they will leave the destination country if an economic crisis breaks out.

Detlef Gürtler: What would be " fast " in migration dimensions?

Edward Hugh: Well you could say a "fast " wave of migration today is one which turns around in a  period of say five years. Previously such waves were conceptualized in terms of generations. So now we should really not take for granted that all the immigrants who come in a boom phase will remain in the country in the longer term.

Detlef Gürtler: As were the experiences with the boom and crisis cycles in Germany and Spain?

Edward Hugh: The 1990s German phenomenon largely predates the modern phenomenon. At the end of the nineties immigration stalled but hardly reversed. This was probably largely due to the noticeable influx of people of German descent coming from Eastern Europe - they came because there was an opportunity to do so, but they were more like classical immigrants, they came to stay.

But now we are seeing a different phenomenon in Germany, suddenly we have seen a shift in the direction of migrant flows. During the early years of this century the number of people leaving Germany and the number arriving more or less balanced. In 2008 and 2009 in fact more people left than arrived. But since 2010 the number arriving (and the difference between those arriving and those leaving) has steadily increased. The result has been that the German population, which was expected to start falling, is now rising. And since most of those arriving are in younger age groups the same is true of the working age population.

Provisional estimates from the German Statistics Office,  suggest 1.226 million people emigrated to Germany in 2013, an increase of 146,000, or 13%, from 2012. The last time immigration on this scale was recorded in Germany  was in 1993. On the other hand some 789,000 people left Germany in 2013, 77,000 (+11%) more than in the previous year. The result was net immigration of 437,000 – also the highest figure since 1993.Naturally such a large number of people entering is producing a pressure on property prices in just the same way as in London, especially in Berlin and Bavaria.

Detlef Gürtler:  How does this recent German experience compare with Spain?

Edward Hugh: In Spain, both the growth and the subsequent decline have been very rapid. Between 2000 and 2010 the Spanish population grew by more than fifteen percent, from 40 million to 46 million. The number of non Spanish nationals in the country rose sixfold - from one million to 5.8 million .

Now all of this has completely inverted: in 2013 alone approximately half a million people left, most of them former immigrants. The National Statistics Office estimates that the country's population could fall by 2.5 million between now and 2023. The long term consequences for Spain, and the Spanish economy are hard to foresee at this point, but they are hardly going to be positive.

On the other hand people continue to arrive in Spain, principally from sub-Saharan Africa. This is a more classic immigration trend. People are not simply coming for work, they are also coming in search of a new life. Even though economic conditions are difficult most of these will stay and eventually take their lives forward.

Detlef Gürtler: Was the initial intention of most of the migrants who came to Spain during the first decade to stay?

Edward Hugh: I would say for the majority this was not initially the case. Back in 2002 I interviewed a group of Bulgarian immigrants about their intentions. The results were predictable enough. Certain groups who might have felt themselves disadvantaged in their own country - women, gays, religious minorities - wanted to make a long term change, but the majority felt they were in Spain temporarily, to earn some money and go home. This is what most of the literature on the topic explains. But most of the people I interviewed are still in Spain. This is normal. Time passes, you put down roots. Finally you have no real "home" to go back to.

Actually I would say that personally this is my own case here in Catalonia.

A somewhat similar phenomenon can be observed among the large number of female care and domestic workers who arrived from Latin America. This immigration was also a new phenomenon, since the women who arrived had largely been married and had children who were being looked after by grandparents. They sent virtually all their earnings home every month, possibly to buy a home. Some of these women have now left, but since caring for elderly at home is a growing occupation in Spain, and many Spaniards are reluctant to do it, the majority are still here, and increasingly they bring their children to Spain to live with them.

But many of the immigrants from Latin America , Romania and Morocco were employed in the construction industry and services sectors like bars and restaurants are leaving in large numbers. How long can they support themselves in a foreign country without work? So despite the fact they might prefer to stay, many are now leaving.

Detlef Gürtler: And how does all this compare with Switzerland ?

Edward Hugh: Well in  immigration terms Switzerland has a net population growth of about one percent per year (most European countries have very little natural population growth), putting it somewhere between the nineties German value (of about 0.7 percent per year ) and the most recent Spanish one (about 1.5 percent growth per year).

Detlef Gürtler:  Yes, and the immigration trend has recently accelerated. Already it is noticeable that something more than a normal recovery phase upswing is in motion. The older Swiss learned in school that their country had around six million inhabitants. The  younger ones found the number had already risen to seven million . In 2013 we found that for the first time the country had more than eight million inhabitants, and many forecasts now predict that the number can easily reach nine million. This in a country with a total fertility rate of around 1.5.

Edward Hugh: It is interesting to note that the Global Property Guide single out immigration for mention in the context of recent house price movements in Switzerland. "One factor has been an increase in the number of immigrants which has led to higher demand for houses. From 2007 to 2011, net migration into the country reached 365,500 people"

What Spain has shown us is that such trends do not necessarily last forever. Anyone with high rates of immigration and a nicely booming economy should also consider that substantial outward migration can occur when the economy weakens. If we are talking about a boom-bust then naturally things are much worse. Sustainability has to be a key idea we get our heads around in this context.

Detlef Gürtler: Unless, of course, the immigrants had come to stay, as was once the case in Germany , with the German-born migrants from Eastern Europe.

Edward Hugh: Yes, but this doesn't seem to be to be the Swiss case. Switzerland is very open when it comes to labor flows when there is work, but much less open when it comes to the subsequent integration of migrants.

Detlef Gürtler: And with an extremely liberal labour market jobs in Switzerland can not only be created  very fast, they can also be deleted very quickly.

Edward Hugh: Which makes Switzerland quite vulnerable to a Hot - Labour type phenomenon, with the capacity  for a very rapid job creation phase followed by a rapid job destruction one. If that were to happen, then people shouldn't be surprised if an economic downturn transforms itself into a veritable downward spiral. When there is work, the new migrants are made to feel somewhat welcome, but when they are without a job, just how much support is available for them? Very little it seems.

Detlef Gürtler: So it's like a game of Monopoly, where at some point you simply get sent back to "Go", the original starting point.  It looks like in Spain at the end of the recession many economic data  looked more like those of the year 2000.

Edward Hugh: Would that you only got sent back to the starting point! On some indicators - unemployment for example - Spain by 2020 may still be worse off than it was in 2000. The age structure would be another example. Those currently leaving the country in droves  in order to seek employment elsewhere  are predominantly young and well educated. Those who remain are either older,or without either skill or qualification. There is a massive human capital loss, and population ageing is accelerated.

Detlef Gürtler: How do such movements affect things like pension systems?

Edward Hugh: Well the initial inward surge is, of course, very positive. Pensions look much more sustainable, but if things go wrong then suddenly they aren't and pension reforms become urgently necessary. Spain has now had two of these since the crisis started.

Detlef Gürtler: But that is looking at things from the point of view of the receiving country. What about the sending one?

Edward Hugh: Well obviously, migrants moving from countries with very low fertility - like Eastern and Southern Europe - leave a serious hole behind them. One which threatens the future of the pension systems there.

Switzerland, with its island type location and the very Hot - Labour  type context can simply wring its hands over the situation as people who have contributed to the welfare system for years suddenly leave. But in the European Union, with its formal commitment to some sort of a politically shared project, there will inevitably be pressure for another kind of solution, one which involves some sort of common pension system.

People in the UK are want to complain about EU labour mobility, and arrivals from Eastern Europe, but countries like Latvia, for example, are hardly going to be sustainable if something isn't done.  It seems to me to be quite irrational for a country to enjoy a boom as a result of immigration, one which in addition means many urgently necessary structural reforms are pushed aside, while another country suffers only the negative consequences of emigration, getting stuck in a long depression while the entire pension system is pushed towards collapse. And then just a few years later the economic situation and the migratory pattern rotates one more reproducing the twin picture of complacency and collapse .

Detlef Gürtler: The technical term for the EU institutional change you mentioned is "intra-European Compensation", which probably means what the Germans call "Social union ".

Edward Hugh: Right. If the Euro and the EU are to continue then this would seem to be inevitable. Or do you expect the Germans to declare that they, in the future, will maintain their pension level thanks to the contribution of Spanish immigrants? And that this outcome is socially just, just because so many Spaniards have benefited from coming to Germany and are willingly depositing their contributions in the German pension box to show their gratitude?

But wouldn't it be totally economically irrational that a  common currency which is set up with totally inadequate institutional support, which overseas the generation of economic imbalances that cannot be corrected via either currency appreciation or depreciation, simply washes its hands of the search for a just solution. Other mechanisms must be established to allow these countries to recover and restore some sort of balance.

Detlef Gürtler: Balance? But don't many agree with George Soros when he argues that financial markets don't tend towards equilibrium, but fall into boom-bust cycles over and over again. Can it be that the the markets for human capital behaves similarly?
Edward Hugh: That could be, and that is the phenomenon I would like to draw attention to. However, the possibility has not been sufficiently explored so far,  so let's just leave this outcome today as an "educated guess". But whether we are talking about booming labor markets, like Germany, Switzerland, Great Britain, or busted ones, like those in Spain and Greece we are producing a lot of data with which it should be possible to either confirm or refute the conjecture.

And one last closing point. I have long favored (and continue to favor) sustainable immigration as one way to manage population aging (see my Message To Central Bankers Target Median Ages!: 2006, or my reply to Marty Feldstein "The Effects of the Ageing European Population on Economic Growth" of the same year). But for such a policy to work as intended we need to stop trying to reflate economies which for demographic reasons are trying to disinflate, and develop policies which are appropriate to the times we live in. The first step along this road is recognising that we have a problem.

The above is an adapted translation from German of an interview which originally appeared in the magazine GDI Impuls.

Tuesday, May 20, 2014

Spanish Banks; A Reality Check

Santiago López Díaz, CFA Exane BNP Paribas, European Equity Research

Bank of Spain published yesterday a EUR2.5bn decline in NPLs during the month of March to EUR193bn (-1.3% m/m). This is the first time since 2006 in which NPLs decline during two consecutive months. It seems we have already reached (or we are even past) the proverbial NPL peak. It is important to keep in mind, however, that banks usually wait until the last quarter of the year to book the “recurrent extraordinary” portfolio clean up….which happens consistently every year and has nothing extraordinary about it.

Reported NPL numbers need to be analysed in the context of the assets transferred to Sareb and in the context of the EUR211bn of restructured loans existing in the system (15% of total loans). In our view, the reported BoS NPL figure lacks: 1) NPLs transferred to Sareb (EUR38bn, according to our estimates); 2) foreclosed assets both in Sareb and in the private sector, which by definition are NPLs reclassified as other assets (EUR90bn, according to our figures); and 3) part of the restructured loan book still considered to be performing (an additional EUR51bn, according to our estimates).

When we add these figures to the BoS NPL figure, we reach a total adjusted stock of NPAs of EUR372bn (almost twice the reported figure) and an adjusted NPA ratio approaching 22%, which highlights the order of magnitude of the credit mismanagement during the crisis.

The most interesting data, however, was released last week in BoS’ Financial Stability Report. Total restructured loans in Spain increased by almost EUR30bn during the last quarter of the year (+16% q/q increase!). Banks are not just transferring assets from one category to the other but continue to aggressively restructure operations. We don’t have Q1 14 data at the nationwide level but we suspect (and we have the data for certain banks) that restructured loans continue to rise.

Last year BoS introduced new rules forcing the banks to reassess their restructured loans which led to a significant increase in NPLs (and provisions) by year end 2014. The new rules forced banks to consider a restructured loan as a NPL if the loan had been restructured more than once or if the restructuring conditions allowed the debtor not to pay interest and principal for more than 30 months. Both requirements were followed by a “except if the bank considers the debtor can pay” comment.

We think the rules allow banks a significant degree of discretion. In fact, the larger the company the more likely it is to be considered viable in the long term (because not doing so would imply heavy losses for the lenders). We know several companies which have been restructured more than once which we suspect are not considered to be NPLs.

Were companies still considered to be performing even if they were not supposed to pay interest or principal for more than two years? What restructuring conditions are we talking about here? 1% interest for 30 years? There is, in our opinion, a big conflict of interest because the banks are the ones assessing their own potentially problematic loans (and the track record in terms of credit quality is not really something to brag about).

The new Royal Decree allowing banks to exchange debt for equity in troubled companies (mainly SMEs) which “could be viable if not for an excessive debt burden” makes the Spanish Chapter 11 procedures more flexible from a legal point of view and it is a welcome development. Beyond the more flexible legal procedures this is quite tricky. To begin with, who decides whether a company is viable or not? We guess it is the banks. There is a clear incentive for them to label anybody as viable.

More interestingly, if the remaining debt is exchanged for equity, banks could be able to free provisions allocated to the debtor because they will no longer be lenders but equity holders (not to mention that NPLs will decline).

Good, if companies might be labelled as viable “except for an excessive debt burden” we are happy to announce that Real Madrid won its 33rd La Liga Championship during the weekend…”except for Atlético...and Barca”.

Maybe “this time is different” (although these words are the four most dangerous in investing). As Warren Buffett usually says; “if past history was all there was to the game, the richest people would be librarians”. Having said that, if past history is any indication of what we can expect in the future we would be cautious about what the companies label as viable (especially considering that, in our view, a widespread inefficient credit culture is the main reason behind the Spanish banking crisis).

Let us use a recent analogy used by Seth Klarman. It seems we are under the Truman Show Restructured Loan Dome. Everything looks fine under the artificially manufactured Sun… but it is an illusion (understanding we are already close to or even past the NPL cycle peak).

According to our estimates NPLs among the listed banks we cover declined by 1.9% q/q at the end of March 2014 (-EUR3.5bn) but the decline was just 0.6% once we include foreclosed assets in the picture. In the case of BBVA, CABK and BKIA (the companies who provided Q1 14 data) once we include performing restructured loans the total stock of NPAs has barely moved during the quarter.

Going forward the cost of risk should go down quite materially considering that; a) provisions seem to be adequate (albeit not excessive) in some areas, b) we are close (or even past) the NPL peak, c) some companies are partly front-loading future credit costs (although we do not expect material write backs) and d) provisions should be much lower than normal in the early stages of a new economic cycle. We struggle to understand, however, how the cost of risk is going to be close to (or even better than) the all-time low when most of the (theoretical) growth will be focused on SMEs. More importantly we do not consider the all-time low is a “normalised” level. All-time low = “normal level” is an oxymoron.

The key driver of future results will be (beyond the decline in the cost of risk) revenue generation. NII should benefit from the increase in retail deposit spreads and from the reduction in wholesale funding costs thanks to the recent debt issuances. That said, total revenues will also be negatively affected by the gradual reduction in unusually high trading gains. In SAB’s case, for example, trading gains in Q1 14 represented 57% of total revenues and were almost twice as high as NII.

From a regulatory point of view all these bonds (rated BBB- when they were acquired by the institutions) carry zero risk weighting. Yet we believe that anybody thinking these bonds carry zero risk from an economic perspective is fooling themselves. Note that during August 2013 the amount of sovereign paper on the banks’ books was equivalent, on our estimates, to 2.3x the tangible equity of the institutions we cover, leaving the companies quite vulnerable to a sovereign shock.

In an oligopolistic banking market with no loan growth, banking theory dictates that banks raise prices but clients might not be that willing (or able) to accept much higher prices with a sustained unemployment rate above 25% and a low savings rate. Spreads of new loans are in fact, according to our calculations based on bank of Spain data, falling already. CABK’s CEO recently mentioned during a press conference that “There is a price war going on although some companies might acknowledge it and some others might not". Like Yogi Berra used to say “In theory there is no difference between theory and practice. But in practice, there is”.

All factors considered we would have expected to see an improvement of the earnings outlook for the companies we cover but that has not been the case. 2014 and 2015 adjusted EPS have been in fact downgraded (Bloomberg consensus) by an average of 6% and 1% respectively since the beginning of the year with double-digit cuts in companies like BBVA or POP. Over the last month, according to our estimates based on Bloomberg data, all the companies we cover but BKIA (from a very low base) have seen their 2014e estimates cut and five out of seven institutions have seen their 2015e estimates cut too. Multiple expansion (and unlimited free money) seems to be the driving force behind the share price performance. With the stocks trading, on our estimates, at 14.0x 2015e P/E we maintain our Underperform rating across the board.

In situations like this the oldest trick in the book to justify higher share prices is to lower the cost of capital. Money is free and the Treasury is issuing debt at the lowest cost in history after all! Fair point.

Old fashioned as we are we continue to use a double-digit cost of risk for Spain (around 10%). We understand that the Spanish Treasury is issuing debt at the lowest cost in history. We also understand that; 1) the Spanish debt / GDP is at the highest level in history, 2) the different Spanish governments have systematically run large deficits (something unlikely to change, in our opinion, considering national elections in 2015) and 3) the black economy could be as high as 30% of the total.

We are reluctant to materially reduce our cost of capital in a country in which a third of the economy does not pay taxes (not to mention corruption). Regarding the banking industry if we talk about a “normalised” environment we guess we should also use a “normalised” cost of equity (not the theoretical one we would get using the current ultra-low interest rates).

Ah, yup, we forgot one small detail. Under no circumstance are we going to materially reduce the cost of capital in a bank in which the arbitrage and trading of BBB rated securities represents one of the main (if not the main) business activities.

Tuesday, March 4, 2014

¿Mariano Rajoy Realmente Puede Bajar Impuestos en 2015?

Según manifestó el Ministro de Economía Luis de Guindos en una entrevista concedida al Financial Times el verano pasado la incipiente mejoría económica que vive España demuestra la "calidad de las políticas" de austeridad aplicadas en la eurozona. Una declaración que no deja de sorprender dado que, según lo mires, la economía española podría muy bien haber salido de la recesión en 2013 gracias precisamente a la decisión de la Comisión Europea de relajar temporalmente la austeridad impuesta hasta entonces para ayudar al crecimiento a corto plazo.

De hecho, durante los dos últimos años se ha hablado mucho de cómo la austeridad es nefasta para el crecimiento, aunque no se ha comentado tanto cómo acumular deuda también lo es, por su tendencia de restar capacidad de crecimiento futuro. Menos austeridad tiene sentido ante un problema de corto plazo, de carácter cíclico o coyuntural, siempre que el margen de maniobra que proporciona se emplee en efectuar cambios de gran calado, que neutralicen la mayor deuda incurrida por causa del menor ahorro. ¿Pero qué clase de problemas está sufriendo España, y qué parte de la última recesión se debió a factores cíclicos y qué parte provino de problemas estructurales que no se solucionarán por si solos? Como veremos más adelante, los gobiernos españoles, empezando con el gobierno de Rodríguez Zapatero, siempre han negado rotundamente el alto nivel estructural del problema, aferrándose siempre a la idea de que la mayor parte de la enfermedad es cíclica.

Por otra parte, aunque la relajación de los objetivos de déficit durante los años 2013 y 2014 permite menores sacrificios para la sociedad española a corto plazo, el reto de alcanzar un presupuesto equilibrado no ha desaparecido, simplemente se desplaza un poco al futuro.

Entonces, ¿es factible la promesa de Mariano Rajoy de bajar impuestos en 2015? Según el programa de estabilidad adoptado por su propio gobierno , en 2015 el esfuerzo fiscal comportará reducir el déficit estructural en un 0,8% adicional del PIB, cifra que parece menor cuando se la compara con el 1,8% conseguido en 2012, pero que exigirá igualmente un gran esfuerzo, sobre todo si el arranque de la economía que estamos viviendo en estos momentos resulta ser más frágil que lo que el gobierno espera.........

Pero, para volver a la pregunta con la que hemos empezado este capítulo: ¿puede Mariano Rajoy realmente bajar los impuestos de forma material en 2015? La respuesta ha de ser que lo tiene muy, muy difícil, porque al margen de su pelea sobre el tamaño exacto del déficit estructural, el país todavía tiene un compromiso de reducir el déficit agregado por debajo del 3% en 2016, y este objetivo no se puede ir desplazando hacia el futuro indefinidamente, y sobre todo, no puede hacerse continuadamente para acomodar una agenda política.


Les ofrezco en primícia estas líneas precedentes que corresponden a un extracto del capítulo 5 de mi libro ¿Adiós a la Crisis? publicado por ediciones Deusto el 4 de marzo de 2014. 

Thursday, February 27, 2014

A Simple Chart Illustrating Why Japan Style Deflation Is Now More Or Less Inevitable In Spain

Here's one simple chart which illustrates why I think Japan style deflation is now more or less inevitable in Spain. Curiously it comes from the Ministry of Employment. It illustrates the relation between the movement in average wages caused by actual movements in the real wage and those caused by what is known as the "compositional effect". This latter has this name because it is the result of movements in the composition of the workforce, whether this be in terms of the average skill level or the average level of experience (or seniority premium, if you prefer). Seniority has historically played a very important part in the Spanish wage structure - ie the longer you have worked the more you are likely to earn.

Now if you look at the data superficially, you find that in the first years of the crisis average real salaries went up sharply (the blue line). This surge in average salaries was not due to salaries actually rising to this extent, rather it was the result of the composition of the workforce having changed (the average skill level went up) as unskilled workers in construction lost their jobs. Hence the 2009 spike in the composition effect.

According to Bank of Spain data in 2008 skilled workers represented 23.55% of the total while by 2012 the proportion had risen to 28.2%. On the other hand, over the same time period unskilled workers fell from 14.8% to 10.2% of the total.This naturally had an impact on average wage levels.

Now, however, the labour market has stabilised, and unskilled workers are no longer losing their jobs (at least not in net terms). According to the Spanish newspaper Expansion the Spanish statistics office estimate average hourly labour costs (not unit labour costs, note) fell in Spain by 2.9% en 2012, 1.9% in 2013 and they are expected to fall another 1.7% this year.

Again, looking at the chart you can see that the green (compositional effect) line which surged in 2009 has now flattened.  It has flattened but the impact is still there and has stabilised at a more or less constant rate. This is due to the impact of the 2012 labour market reform:  average salaries are no longer falling due to labour shedding producing a changing skill composition but due to AGE CHURN. Older workers with long term contracts and lots of seniority are being steadily replaced by younger ones on less well paid contracts, thus dragging down the average wage. The line if flat and extends out in to the future. This can go on for years now.This is exactly what has been happening over the years in Japan, and is the principal reason why Abenomics isn't working.

Incidentally, here I have been talking about average hourly labour costs NOT  those famous unit labour costs. These, as we all know, fell significantly in Spain after the onset of the crisis. What isn't so well understood is that this fall wasn't due to falling hourly wage costs (these didn't really start falling till mid 2010, see blue line in chart) but due to massive labour shedding. Spain's GDP has fallen by something like 7% while employment is down by around 20%.

On the surface this shows a large gain in productivity, but where this gain is actually coming from hasn't been analysed yet, but part surely comes from a compositional shift in the labour force. One thing is reasonably clear is that it hasn't come from industrial productivity, since industrial output is down by some 30% since the pre-crisis peak, even more than the reduction in employment.(I'm afraid you'll have to stare very hard at the industrial output chart if you want to see signs of the much proclaimed recovery - you'll have to stare very hard since there is so little sign of it).

So why do I think this suggests deflation may become endemic in Spain? Well, with average real wages falling, real pensions falling, and credit still shrinking by around 6% a year it is hard to see where the demand is going to come from, especially with very little happening in the way of new employment - the shortfall is becoming structurally implanted.

For more argument on all this (in Spanish) see my book which is being published by Ediciones Deusto next week. You can find a list of chapter headings here.

Wednesday, February 26, 2014

¿Adiós A La Crisis?

Hemos Superado La Recesión, Pero ¿Cuándo Llegará La Recuperación A La Economía Real?

Prefacio y Agradecimientos

Capítulo Uno – ¿Lo Peor Ya Ha Pasado?

Capítulo Dos – ¿De Verdad Hay Que Bajar Los Salarios Un Diez Por ciento?

Capítulo Tres – ¿Por qué Los Bancos No Dan Crédito?

Capítulo Cuatro - ¿Qué Cobraré En Concepto De Pensión?

Capítulo Cinco ¿Puede Mariano Rajoy Bajar Impuestos En 2015?

Capítulo Seis - ¿Supone La Deflación Realmente Un Riesgo Para España?

Capítulo Siete – ¿Sociedades de Decrecimiento?

Capítulo Ocho – ¿Un País Para Viejos?

Capítulo Nueve – España, ¿La Nueva Alemania, o El Nuevo Japón?

Les ofrezco en primícia el sumario compuesto con los capítulos de mi libro ¿Adiós a la Crisis? que sera publicado por Ediciones Deusto el 4 de marzo de 2014. 

Sunday, June 24, 2012

Testing times for Spain's regions

by Antonio Garcia Pascual and Michaela Seimen

Barclays Research June 2012

In this chapter we explain why the recent constitutional changes in Spain will have a positive medium-term impact on the fiscal position of the Spanish regions. We also discuss how the regions will manage to cope with their aggregate EUR140bn of debt and how new measures, such as the Fondo para la Financiación de Pago a Proveedores (FFPP), a government sponsored syndicated loan dedicated to pay suppliers, and Hispabonos, a joint funding platform, could help the regions to cope with the challenging economic and capital market environment.

The challenge continues

Spain has become (yet again) the focus of attention of financial markets. This has been the result of a large 2011 fiscal underperformance (mainly by the regions), a poorly managed upward revision to the 2012 deficit target, confirmation that the country re-entered recession in the first quarter, and a perception that the ECB’s recent injection of liquidity may have reached the limit of its effectiveness. More recently, market stress has escalated under the market perception that the clean-up of the banking sector is incomplete (despite intervention by the state in Bankia) and may result in larger fiscal costs than currently envisaged by the sovereign. However, since the new government took office in December 2011, and despite elevated market stress, it is also fair to say that the government has taken some bold steps to regain control of the fiscal performance of the regions.

To contain fiscal deficits, including the regions’, the parliament approved a new organic law on budgetary stability and financial sustainability of public administrations in May 2012. Of particular interest is that the law lays out the mechanisms of control for the central government in the event of fiscal deviations in the regions. Furthermore, the law also implements Article 135 of the Spanish Constitution (a new constitutional amendment approved by the parliament in September 2011), which legally enables the central government to intervene in a region that does not comply with the new fiscal stability framework. Among the various challenges confronting Spain, the ability to control the central government and regional deficits is one of the top priorities. The powers endowed to the central government under the new fiscal stability law are likely to be put to the test soon, in our view. Will those be enough to effectively limit future fiscal slippages and will the central government be able to control the regions?

Constitutional amendment of Article 135 & Fiscal Stability Law

In mid-September 2011, the Socialist government (now the opposition), with the support of the main opposition party (now in government), approved a “constitutional debt brake” consistent with the European new fiscal compact rules. The amendments are already enshrined in the Spanish constitution and include: 1) the principle of a structural balanced budget for the central government and the regions; local governments will also be required to run zero headline balances; 2) a ceiling for public debt of 60% of GDP; and 3) a change in the priority of government expenditures, whereby interest payments and amortisations of public debt will have the highest priority.

Technical details on the definition of the structural budget, including the “phase-in” period for the application of the rule and the specific mechanisms of adjustment in the event of deviations, are key features defined in the new, separate organic law (recently approved by the parliament) on budgetary stability and financial sustainability of public administrations. This new law has been drafted to be consistent with the agreements reached at the euro area level on the new “fiscal compact”. The law also automatically incorporates any future amendments to the European fiscal rules.

The new organic law defines the mechanisms available to the central government to rein in any fiscal slippages in the regions. Various mechanisms of ex-ante control, which are lacking so far, are now part of the new fiscal framework. These mechanisms include preapproval of regional budgets by the central government and the possibility for the central government to recommend or even impose fiscal consolidation measures on the regions. The regions also adopted new rules for the set-up of expenditure ceilings. These new elements of “ex-ante fiscal control” are now feasible legally for the central government (and certainly desirable) following the constitutional amendment approved in September.

Please see the Appendix in this section for details of the Fiscal Stability Law as well as new preventive and corrective mechanisms for central government control of the regions.

The 2012-13 fiscal targets are unnecessarily overambitious

Following a series of fiscal data revisions, the 2011 fiscal deficit currently stands at 8.9% of GDP, compared with a target of 6% of GDP. Of the overall 2.9pp slippage, the lion’s share corresponds largely to the regional budgets (about 70% of the slippage), with the rest of the deviation split between social security and central government. The regions with the largest slippages in terms of regional GDP were Castilla la Mancha, Valencia and Murcia, regions in which the boom-bust in real estate has been the most severe. However, in absolute terms, the largest contributors to the overall 2011 fiscal slippage were Valencia, followed by Catalunya and Andalucía (three of the largest four).

On 30 March, the Spanish government presented the 2012 budget for the central government, which includes measures worth EUR27.3bn (c.2.5% of GDP). When the government took office in December 2011, it announced a first round of fiscal consolidation measures totalling EUR15bn, including changes to personal income tax, capital gains, and property tax. The central government, social security, regions, and municipalities altogether will need to achieve a fiscal swing of 4.2% of GDP by reducing the public sector deficit to 5.3% of GDP in 2012.

Is the 2012 fiscal target achievable? The short answer is not under the existing measures. But we do not believe it is necessary to achieve fiscal solvency in the medium term. In our view a more moderate fiscal consolidation path, which ensures a fiscal swing of about 8% of GDP over the next 5-6 years would be sufficient to restore solvency. Specifically, for Spain, we think it is reasonable to assume that a 1% fiscal consolidation only produces an effective deficit reduction of 0.7% (see Spain: dealing with sudden reversals, 4 May 2012).

Using the government target, to achieve 4.2% of GDP consolidation in 2012 would require fiscal measures worth nearly 6% of GDP. Our more conservative estimate of a 3% of GDP consolidation in 2012 is based on adjustment measures worth slightly over 4% of GDP. There are three main differences between the more aggressive government adjustment path and ours. First, the government is probably using fiscal multipliers of smaller size than ours. We think this is because the government is considering that a large share of the expenditure cuts can be applied to activities (such as transfers) with a low fiscal multiplier. Second, we are assuming a larger GDP contraction than the government (Barclays -2.0%; Spanish government -1.7%). Third, we are also assuming slightly less fiscal adjustment in 2012 than the government. For example, we are excluding the EUR2.5bn expected revenues from a tax amnesty, which may or may not yield such revenues.

While the slippages are likely to occur across all the components of the general government, we still think that the largest fiscal risks remain in the regional fiscal consolidation targets. We estimate that, instead of the deficit target of 1.5% of GDP, a more likely outcome is in the range of 2.0% to 2.5% of GDP. The central government will have to help the regions by redefining the size of the welfare state that the Spanish economy can afford consistent with the targets of the regions. It will ultimately fall to the regions to implement the policies. Specifically, we believe significant cuts in health, education and social spending will be required. In fact, the government has proposed cuts on health and education spending cuts worth EUR10bn.

The social security fiscal target, which aims for a balanced budget, also seems quite challenging as the economic outlook has worsened relative to 2011. In 2011, social contributions fell c.3% and pension costs rose 4%; as a result, social security was -0.1% of GDP, versus the target of +0.4%. In 2012, a deficit larger than in 2011 seems likely (ie, a balanced budget strikes us as far-fetched) as pension spending continues to rise along with unemployment benefits, while social contributions are likely to continue falling.

Are there any safeguards against these risks?

First, the central government is backed by a brand new constitutional debt brake and a new organic law that sets expenditure-ceiling rules for all the sub-central government levels and allows the central government, if needed, to potentially “intervene in a region” and take away fiscal responsibilities. Also, the new draft law of “good governance” proposes that any local authority that fails to comply with the fiscal consolidation targets (ie, that fails to comply with the new constitutional amendment or the new organic law above mentioned) can be dismissed and be banned from running for public office for a period of up to 10 years. In practice, however, these brand new mechanisms of fiscal control have not yet been put to the test. We think that politically it would be very costly for the central government to revert the process of fiscal devolution by taking responsibilities away from any region, even if temporarily.

Second, the central government controls a large share of the regional taxes. Specifically, the central government controls the tax rates of the personal and corporate income tax (PIT and CIT), as well as the VAT. The fiscal revenues from these taxes are shared between the central government and the regions (50% each). Hence, any decision by the central government to increase the PIT, CIT and VAT rates has a direct impact on the fiscal revenue of the regions. In the approved 2012 budget and in the new 2012-15 stability and convergence programme, the government has approved (or proposed) changes to the corporate and personal income tax regime as well as an increase to indirect taxes, including a hike to the VAT rate in 2013 (the standard VAT rate is currently 18%, which is 3pp below the standard rate of Italy and 5pp below Ireland, Portugal and Greece).

Third, the government is taking stock of all state-owned real estate assets and planning more active management of these assets to reduce expenditures and privatise the more marketable assets to reduce public debt. It has set up a public sector entity to coordinate the disposal of these assets. While the government does have an inventory of its real estate assets, it has not yet indicated the assets it is planning to privatise or the possible valuation.

Finally, the government will target further structural reforms, in addition to the already approved labour market reform. New reforms will be aimed at enhancing competitiveness by reducing production costs and improving market flexibility, and will cover the energy sector, market integration, housing rental market, and innovation and R&D activities. With the presentation of 2012-14 regional budget plans on 17 May 2012, the first part of the fiscal planning is finally complete. We believe the targets set for the regions are overly ambitious.

Although we appreciate that there are segments that would need more comprehensive cuts, we nevertheless believe the restructuring of public economies is a rather longer-term project and market participants could be mislead by more limited short-term achievements. In the short term, the government will also need to focus on the funding of the regions. With strong risk aversion in the market and ongoing concerns regarding peripheral economies, we believe market access for Spanish regions will be rather limited in the near and medium term. As such, the government already tried to ease the burden by establishing a support fund to finance debt the regions had accumulated with its suppliers (Fondo para la Financiacion de Pago a Proveedores, more on this below).

Furthermore, we understand that the government is working on establishing so-called ‘Hispabonos’ to support the capital market funding of the regions. While the details of the Hispabonos have not been revealed, we think it is likely that the new instruments will: 1) carry a sovereign guarantee; 2) be responsible for (most of) the funding of the regions; 3) enhance liquidity relative to each region tapping the market separately; and 4) reduce the effective funding cost for most of the regions (albeit potentially at the expense of a higher funding cost for the central government).

Fondo para la Financiación de Pago a Proveedores

In 2011, we referred in our AAA Handbook overview of the Spanish sub-sovereign market to the problem of ‘hidden debts’, particularly for suppliers receiving delayed payments. Such payments are recorded in accounts payable and by the Bank of Spain; as such, an increase of these amounts was noted in recent years. Although such a development is not unexpected, as these accounts tend to behave pro-cyclically, delays in payments were partly used to bridge periods of a more difficult funding climate. However, the economy and SMEs in particular are constrained by such delays. To address this problem, the Spanish government has set up a fund – the Fondo para la Financiacion de Pago a Proveedores – to pay the mounting debt local and regional authorities (territorial administrations) have to their suppliers. The fund – effectively an intermediary between financers and territorial administrations – has been created through a subscribed syndicated loan totalling EUR30bn at the time of writing, and can be increased to EUR35bn, which is the current estimate of excess accounts payable to suppliers according to publications by the Ministry of Finance and Public Administration (Treasury) and the Ministry of Economy and Competitiveness. Repayments are set to commence on 31 May this year for local authorities, and 30 June for regional authorities, and will be made directly from the fund to the suppliers approved for repayment.

The fund, FFPP, will grant loans to territorial administrations for up to 10 years, with a 2- year grace period; in turn, these administrations will have to come up with a sustainable long-term adjustment plan guaranteeing the repayment of future loans. This adjustment plan will be supervised by the Ministry of Finance and Public Administrations (ie, Treasury).

The fund is set up through a syndicated loan, the biggest in Spanish history, made by 26 Spanish financial institutions, and will have a 5-year tenor (with a 2-year grace period). It will be guaranteed by the Treasury, which will assume the transition of the 5-year syndicated loan to the 10-year loan to the territorial authorities. The Treasury, in turn, will have a counter-guarantee against the local and regional revenues (Participación en los Ingresos del Estado). The loan will be made at 3-month Euribor plus a premium added for market conditions, which will make the loan cost about 5.9%.

Spain hopes this operation will inject liquidity equivalent to 3% GDP into the economy, which is respectively expected to increase by 0.4% between 2012 and 2013. The operation will mainly benefit small and medium-sized enterprises, and Spain is hoping to generate a further 100,000- 130,000 new jobs.

Funding outlook – a tricky business

In their recent 2012-14 Budget planning announcements, the regions also presented an overview of the quarterly maturity structures of their debt in 2012 (see Figure 3). However, due to short-term extensions, private placements and rolling bank loans, it is rather difficult to follow an exact debt profile for each region.

Furthermore, the newly established support fund to pay suppliers, plus additional ICO liquidity lines, shifted the funding needs of the regions slightly.

In the last 2 years retail bond issuance became an interesting alternative funding tool for some regions, as to being able to place larger bonds in the market. However, funding costs for this instrument are rather uneconomical; furthermore, it is our understanding that this funding source could come to a sudden stop, as more recently some regions have been downgraded to non-investment grade by some rating agencies, which would undermine the region’s ability to use the retail market segment.

As of year-end 2011, the Bank of Spain published the following overview on the short- and longer-term funding of Spanish regions (Figure 6).

We do not believe the funding pressure for the regions will decrease substantially in the near term, despite the efforts to meet the 1.5%-deficit agreement. In our view, this target is very ambitious and could lead to misjudgements regarding the progress regions will have to make to get their budgets and deficits under control. Instead, we tend to review the progress of the regions on a more gradual and broader view. In the meantime, we will focus on the implementation of the government’s control measures and systems and the respective triggers for penalties on regions that do not follow austerity measures on an ongoing basis.

However, in the long term, the success of the penalty/intervention structure is also dependent on central government political backing in the region. As long as the PP - People’s Party - holds a majority in the regions, changes and control mechanisms and penalty structures are more likely to be enforced. However, if this situation should change In the future, approvals for interventions could become more difficult.


Hispabonos, although not in existence yet, will be bonds issued by the autonomous regions that the state intends to issue on a state-wide level to increase liquidity and lower the cost of debt. Basically, it is too costly for the autonomous regions to issue and service debt; as a result, the government might be obliged to intervene when the autonomous regions cannot pay.

The Spanish regions (some more than others) are struggling with large refinancing needs of c.EUR50bn this year. Given several Spanish regional authorities already have large amounts of debt outstanding (c.13% of GDP), it is more difficult for these to enter the market at reasonable levels. In addition, several regions have recently been downgraded to non-investment grade levels by Moody’s. For example, Catalunya alone has more then EUR41bn of debt outstanding, followed by Valencia with c.EUR20bn and Madrid with c.EUR15bn (see Figure 8). Valencia had to refinance a EUR500mn loan at a cost of 7% with a 6-month tenor in May this year, according to Bloomberg data, which is unsustainable even in the medium term.

For some regions, a recent source of funding has been larger retail bond issuance. Catalunya is one such region, issuing retail bonds, with severe additional costs attached. According to media reports, on top of paying 2.85% more in coupon than treasury securities with similar maturities, which were offering 1.94% at the time, the Generalitat of Catalunya also had to incur a further 3% in insurance costs and 2% as a commission to the individual banks selling the bonds, taking the total cost of the issue close to 10%. It is our understanding that this is not unusual as banks charge higher prices to insure and promote products that are difficult to commercialise.

Given the restrictions and risk aversion Spanish issuers face, we believe the plan to provide a joint issuance platform for the regions would be beneficial because there are several points the potential Hispabono could address:

- The issues would more likely be placed with institutional investors (and made repo-able at the ECB), which would be cheaper than trying to place them with private clients, as in the previously mentioned example of the retail bond issuance.

- Furthermore, the issues would also be larger in size, thus making them more liquid, as opposed to the individual, smaller sizes issued when needed by the regional authorities.

- According to a Reuters report, the financing costs incurred by regional authorities could be reduced more than EUR1bn per year by issuing Hispabonos. This represents an important 2% reduction in financing costs in 2012.

Nevertheless, the concept of Hispabonos also faces some opposition. Regional authorities that have smaller deficits, a comparatively small stock of outstanding debt and benefit from higher credit ratings are more reserved about pooling funding and thus facing a higher funding cost. Also, some market participants raised concerns that easier and more liquid market access could undermine current efforts to reduce spending.

The establishment of Hispabonos is being discussed at a government level, but no details regarding the format or structure of such bonds have been made public. From various media reports, we understand that different proposals are currently reviewed. In our view, an important feature would be a potential guarantee structure by the state, which is not necessarily envisaged however. Reuters, Cincodias and el Confidencial, among others reported on developments in regard to Hispabonos, with some articles mentioning that the state will guarantee the bond, while others merely say it will be backed by the state, which in our opinion is more akin to an implied guarantee as opposed to the full faith and credit of the Spanish government. In our view, since the regions have legal independence, we find it unlikely that Hispabonos would be backed by a full guarantee of the Spanish government. However, given the current sensitivity in the market, we believe correlation risk between Spain and any Spanish issuer is extremely high. As such, any failure in the sub-sovereign or agency or banking sector, for example, would have immediate implications for the state.

However, the government has passed a constitutional amendment and an organic law to have better control of the fiscal performance of the regions and repeatedly has stated in public that it will not let any region default – which is a very strong implicit guarantee in our view. For example, Treasury Minister Montoro was recently cited in el Confidencial, saying that the state would always be there when an autonomous region would require help, although we note this does not alleviate any region from its responsibility to control its budgets and reduce the deficit. The new government already proved its commitment to the regions, when it helped in December, according to Bloomberg, the region of Valencia to make a EUR123mn payment to Deutsche Bank. The Spanish treasury gave a verbal guarantee to an unidentified lender in order to advance the funds the regional government needed to make the payment.

From a timing perspective, we expect a decision on Hispabonos in the near future, as funding requirements for regions would need to be addressed at the latest in Q3 12. Bloomberg reported on 1 June 2012 that Spain is working on a mechanism to help its regions finance themselves in the financial markets and will publish details of the programme the following week. The mechanism will mean changes to Spanish law and impose stricter conditions on regions while leaving them responsible for their own debts, Budget Minister Cristobal Montoro said at a press conference in Madrid. Full implementation and legal foundation could be considerably lengthier though, as a financing mechanism must be set up and most likely reviewed by the rating agencies before any significant issuance takes place.

Either way, based on recent comments by government members cited in the media, we are confident that the establishment of Hispabonos will be addressed in the near future and that this new instrument will be implemented as an economical solution to finance the Spanish regions.

For an indication of pricing and investor acceptance in the market, we believe a comparison with other Spanish government-related debt is sensible. In the past, there has been a relatively widely diversified investor base in Spanish government guaranteed debt, such as ICO, FROB or FADE. However, with increased concerns regarding European peripheral issuers, international investor interest in these markets has become rather subdued and has been nearly completely replaced by a national investor base.

However, investors have focussed on the regions for a long time. Despite missing explicit guarantee structures, but more or less being based on the assumed large correlation risk with the Spanish sovereign, the higher spreads currently attract renewed investor interest in this segment. With the fractured market currently and a separate risk assessment necessary for each region due to complex and partially unclear data, some investors regard current spreads and the remaining insecurity about missing guarantee structures as insufficient to provide relative value in sub-sovereign investments.

In this respect, though, Hispabonos could add value by replacing a complex individual risk assessment for each region with a guarantee structure. Nevertheless, we expect investors to demand a pick up over Spanish sovereign bond issuance and given our expectation of a more implicit guarantee structure, the pick up also has to be considered to be currently slightly above government guaranteed debt.

With the introduction of a new issuance instrument, we expect maturity levels of new bonds to be skewed towards the shorter end of the maturity spectrum. As such, we expect bonds with a maturity of three years to most likely trade with an additional spread pick-up to fully guaranteed debt (eg, ICO currently is priced about 60bp over government debt). At first glance, this might appear to be an expensive option. However, with the limited liquidity and market access of Spanish regions, spreads of Spanish regional debt have been about 400bp over Spanish government debt.

Given the difference in credit quality of the regions based on the ratings and the indebtedness, we do not believe that the funds would be distributed at equal costs to the regions. As such, we would envisage a system, where funds raised via such an instrument would be distributed at a cost linked to the respective credit quality of the region.


Institutional and political background

Spain is one of the most decentralized countries in the euro area (if not the most). In the 1980s, sub-national governments were responsible for c.15% of the public expenditure; in 2010, regions accounted for c.50% of the expenditures. The 1978 Constitution grants the regions competences in many areas including education, health, public works in their territory and the environment. As a result of the fiscal devolution process, the central government currently controls less than 30% of public expenditure (excluding social security and debt service).

Politically, the Kingdom of Spain is divided into 17 autonomous communities and two autonomous cities that are located in Northern Africa: Ceuta and Melilla. Geographically, with 18.6% of the total landmass, Castilla y León is the largest autonomous community, followed by Andalusia (17.2%) and Castilla La Mancha (15.7%). In terms of population, however, with c.17.8% (8.1mn) of the total 44.1mn inhabitants, Andalusia is clearly the largest autonomous community, followed by Catalonia (16.0%), Madrid (13.6%) and Valencia (10.9%).

“No bailout rule”

The Spanish budgetary stability law (Ley de Estabilidad Presupuestaria – LEP), which was implemented in 2007, specifically states there will not be any bailout procedures for the Spanish autonomous communities.

In the Real Decreto Legislativo 2/2007 of 31 December 2007, it is explicitly stated that “the Spanish central government will neither assume nor be responsible for the commitments of autonomous communities, local entities or those related or depending on these, without affecting mutual financial guarantees for the joint realisation of specific projects”5. As a result of this specific no-bailout clause, rating agencies understand the probability for timely sovereign support is relatively low6. Still, despite limiting federal support in the case of (financial) distress, in our view, the no-bailout clause does not exclude financial help in the form of specific transfers to autonomous communities before a bankruptcy emerges. In

fact, taking into consideration the legal barriers to provide (federal) help in the case of distress, we believe there is a high probability the central government (and other autonomous communities) would make the respective funds required to turn down an event of default available before any such situation arises.

Furthermore, we believe that in case of distress, the Financial and Fiscal Policy Council (FFPC) that represents Spain’s autonomous communities could arrange for emergency funding to weather any further adverse developments. Clearly, bearing in mind the potential spill-over effects, the default of a single autonomous community cannot be in the interest of the other autonomous communities.

Regulatory issues

In Circular 5/1993 from March 1993, Banco de España (BdE) provides a classification of the respective risk weightings (RW) applicable to debt issued by Spanish autonomous communities. Among other instruments, debt issued by the autonomous communities and local entities, provided the issues are authorised by the state (“Deuda pública emitida por las Comunidades Autónomas y las Entidades locales, cuando las emisiones estén autorizadas por el Estado”), benefit from an RW of zero. In principle, all debt (loans and bonds) issued on behalf of the autonomous communities are authorised by the state with RW of zero. Yet, in the case of municipalities, authorisation is usually only sought for bonds. All other debt issued thus falls outside the scope of the above clause and becomes subject to an RW of 20% (“Grupo con ponderacion del 20%: activos, […] que representen créditos frente a las Comunidades Autónomas y frente a las Entidades locales españolas”. Bonds issued by the Spanish autonomous communities generally fall into the ECB’s liquidity class category two. Depending on the remaining term to maturity, the applicable haircut applied by the ECB ranges between 1% and 7.5%.

Key elements of the draft Fiscal Stability Law

1. A debt brake rule: Public debt cannot exceed 60% of GDP, but there will be a transition period until 2020. During this period, a path to reducing the budgetary imbalances will be devised until the public debt ceiling of 60% of GDP is achieved. In particular, public debt will be reduced as long as the national economy is experiencing real positive growth. Furthermore, when a growth rate of 2% is reached, or if net employment is generated in annual terms, the debt ratio shall be reduced annually by a minimum of 2pp of GDP (the structural deficit of the overall public sector must be reduced by an annual average of 0.8% of national GDP).

2. Balanced structural budget rule: All public administrations (including the regions) will present a balanced or surplus budget. No administration may incur a structural deficit. A structural deficit may only occur in exceptional situations (natural disasters, economic recession or extraordinary emergency situations). The EU recommendations on the stability programme will be taken into account to set the stability and public debt targets.

3. An expenditure ceiling: All public administrations must approve an expenditure ceiling in keeping with the stability target and the expenditure rule. Public sector expenditures may not rise above the GDP growth rate, in accordance with European regulations.

4. Priority of debt service rule: Servicing the public debt will take absolute priority above all other expenses, as established in the constitution.

5. Control mechanisms and sanctions: Failure to comply with these objectives by the regions will result in the requirement to present an economic/financial plan that will correct the fiscal slippage within one year. This plan must explain the reasons for the deviation and the measures that will enable the administration to get back within the limits. Fulfilment of the objectives will be taken into account for authorising debt issuance, granting subsidies and signing agreements. In the event of non-compliance with the plan, the administration responsible will have to automatically approve the non-availability of credit that will ensure the established objective is met.

Any sanctions imposed on Spain in relation to stability will be assumed by the responsible administration. The law also transposes the EU corrective mechanisms. In the event that an economic/financial plan is not fulfilled, the administration (central or regional) that has failed to fulfil the plan must make a deposit of 0.2% of its nominal GDP, which after six months may become a penalty if the failure is repeated. Moreover, after nine months, the central government may send a delegation to assess the economic and budgetary situation of the administration in question.

More importantly, the government has clearly indicated that, according with the new constitutional amendment and the new organic law, failure to comply with the fiscal stability law could trigger intervention in a region. The central government would take control of the budget of the region until fiscal stability is restored.