Friday, June 27, 2008

Italy's Economy On The Ropes (Again)

"Italy’s per-capita GDP growth was 5.4% in the 1950s, 5.1% in the 1960s, 3.1% in the 1970s, 2.2% in the 1980s and 1.4% in the 1990s. A rough-and-ready extrapolation of this decade-long continued slowdown would lead to expect no more than 0.5% in the 2000s."

Altogether, the long-run data suggest that the bad performance of the Italian economy is not the figment of the currently unfortunate business cycle contingency. This is why speaking of decline may not be totally unwarranted. With one caveat to add, though: given that the rest of Europe has been and is still growing at a positive pace, Italy’s alleged decline is of a relative, not an absolute type. Italy’s per-capita GDP has simply grown not as fast as Europe’s GDP, but has not diminished over time (yet)"

Francesco Daveri and C. Jona-Lasinio,
Italy's Economic Decline, Getting the Facts Right

The Swiss writer Frederich Dürrenmatt tells a joke somewhere. It relates to the tragically flawed expedition that Scott lead to the Antartic in the early years of of the last century. There are various possible approaches to the fictional treatment of this topic. Shakespeare might perhaps have Scott fail due to problems which are deeply rooted in his character. Brecht on the other hand would probably have explained the failure as being rooted in some kind of turmoil produced by the class struggle. Samuel Beckett would more than likely have reduced the whole thing to some sort of "endgame", with Scott being frozen in a block of ice surrounded by his crew members equally trapped in other blocks of ice to which Scott speaks without ever receiving any kind of response or answer. Then there is Dürenmatt's own version: Scott's expedition simply failed due to one stupid mistake made right at the outset - Scott accidentally locks himself inside a refrigeration chamber whilst purchasing provisions for the expedition.

Very amusing you might say, but what has this exactly got to do with Italy? Well Italy's economic expedition, like Scott's naval one, is, it seems, essentially flawed. And we have various explanations going the rounds to help us to understand why this is. The Shakesperian version would have it that the whole thing is down to character, you know, all that excessive interest in under the table money and things like that. Then, of course, you have the Brechtian account. Italy's longstanding love/hate relationship with the latter day heirs of former fascist and communist movements, and the veto power vested in the extremes when you have a badly fragmented political system. Then you have the more intellectualised Brussels/Brechtian account, which would put the whole problem down to Italy's failure to really enter into the spirit of the Lisbon Reform and Dialogue Process. Then of course there would be the accidental spanner in the historical works account ,whereby Italy simply got locked out of modernity before it even got started. I think the smart name for this would be "path dependence", with Italy, say, being forced out of ERM in 1992 by one very smart decision by one very well known investor, and the rest, as they say, now being history.

Curiously, with or without the plethora of would-be explanations we have on offer, there is a least consensus on one thing: something is wrong with the Italian economy, badly wrong. But before getting into my own "scripting" of what is actually going on Italy, lets start from the ground floor and take a look at some of the basic facts of the case.

Italy's Growth Decline

The first thing to notice about Italy's economy is its more or less endemic weakness. If we look at the chart for quarter on quarter growth since 2000 (see below), what is evident - and regardless of whether or not Italy is actually (technically speaking) in recession right now - is the fact that Italy has already been in recession three times so far this century (and sometime this year it will almost certainly be in for a fourth, and in 2009 a fifth?) - in Q2/Q3 2001, Q1/Q2 2004 and in Q4 2004/Q1 2005. It is the fragility of this situation which is so noteworthy I beg to suggest.

If we look at the long term GDP growth chart the position becomes even clearer, since after pretty strong - if rather volatile - growth in the (1950s, 1960s - see Davieri and Jona-Losinio, and) 1970s, Italian headline GDP growth has been more like a flame which is steadily going out - the proverbial candle in the wind. Just one hefty puff and it is gone, it seems to me. And the current combination of the ongoing credit crunch (tighter lending conditions) and the global food and energy "shock" may well constitute just the strong puff that was needed. (Although I'm not sure that "shock" is quite the right term here, since normally shocks are considered to be exogenous, while looked at from the perspective of the global economic system rather from that of individual national economies, what is happening might well be though to be endogenous. I think this argument will have to await another occasion, although I do have a shot at putting an initial case here).

Basically if we look at the trend here, and in particular if we think about how frequently the Italian economy has been dipping in and out of recession over the last seven years, we ought at least be prepared to ask ourselves the question whether a point might not arrive when Italy enters what appears to be a recession and then never comes out, in the sense that we don't get to see sustained positive headline growth again, and the economy simply contracts and contracts. Of course, if this were to be the case we would need to revise our historic vocabulary, since what we would be facing would certainly be far more than a mere recession, while at the same time it is quite unlikely that what we will have could be described as a slump, in the sense that after a slump we normally get a rebound). Rather, and in similar fashion to the emblematic Venice itself, the Italian economy may slowly but surely be simply sinking into the sea.

Certainly the theoretical possibility of such an eventuality does exist, and the far from hypothetical possibility of such a state of affairs actually coming to pass in reality should not be simply discounted, since with the coming decline in the labour force as the Italian population ages and shrinks, and the decline in things like retail sales which may accompany an ever reducing number of consumers, it isn't hard to see how this might happen. If we simply take the issue from the supply side for the moment it is plain tha, barring immigration, raising productivity is just about the only way Italy can hope to sustain growth momentum in the future, and productivity growth is precisely what Italy hasn't been delivering in recent years. As we can see in the chart below, output per hour worked in Italy has been steadily losing ground vis-a-vis the other members of the EU 15 since the mid 1990s.

And if we look at the annual rates of change in GDP per hour we get a chart (see below) which looks remarkably similar to the one we saw above for long term GDP growth.

Viewed From The Supply Side

Now this comparative performance vis-a-vis the EU 15 is the exact opposite of the one we should be seeing, given the fact that Italy is in the short term the most challenged of the EU economies in terms of potentially labour supply (see chart below). Between 2010 and 2020 the working age population is set to decline by around 1.5 million. So, given the supply side constraints on labour, if Italy is to avoid slipping into long term economic contraction then the whole productivity trend has to be reversed, and this is no easy matter and something, frankly, which it is hard to see actually happening after so many years of talking so much and doing so little. (In this regard it is far from clear whether eurozone membership has provided Italy with sufficient incentive for change, or whether - by guaranteeing cheap liquidity - membership has simply allowed Italy's problems to continue and the underlying stituation to deteriorate as argued by OECD economists Romain Duval and Jørgen Elmeskov in their well known paper " The Effects of EMU on Structural Reforms in Labour and Product Markets" presented at the ECB Conference "What effects is EMU having on the euro area and its member countries?" held in June 2005).

Obviously this labour supply constraint can be circumvented in the short term by raising participation rates and immigration (although in the longer run sustainability implies that something serious needs to be done about the underlying low fertility issue). However it needs to be said that progress so far in this direction has certainly been far from satisfactory. As can be seen from the next chart, Italy has had quite a dramatic surge in immigration in recent years.

Employment in Italy has risen from 20.617 million in Q1 2000 to 23.170 million in Q1 2008. That is there has been an increase of about 2.5 million (or 12.4%) in the number of those employed, so Italy has been creating jobs, but this has largely been in labour-intensive, low-value activities, and hence the productivity result. More to the point, since Q1 2005 Italy has generated 800,000 extra jobs, and 500,000 of these positions have been filled by immigrants. That is, the Italian labour force itself is nearly stationary at this point.

And Then From The Demand Side

What little economic growth Italy gets these days largely comes from two things: exports and government spending. Since the prowess of the former continually shows evidence of ongoing weakness (see here), while the latter is already responsible for the second largest debt to GDP ratio on the planet (or the third, depending on whose version of the Greek accounts you accept), it is plain that demand side elements in the Italian case are inherently weak. If we take Q1 2008 as an example, GDP was up by a seasonally adjusted 0.5% on Q4 2007, which seems to be a relatively positive result. But when we come to examine the details things don't seem to be so rosy at all. Imports were down 0.5% on the quarter (due to weak internal demand), while exports were up 1.4% (this was the positive part). As a result the balance between imports and exports changed substantially, and this is undoubtedly one of the main factors in the "bounce back" in the first quarter from the 0.4% q-o-q contraction registered in Q4 2007.

Total consumption was up q-o-q 0.2% (all data seasonally adjusted), but it is the composition of the consumption that matters here, since private household consumption was only up 0.1% (after falling 0.4% q-o-q in Q4 2007) while government consumption and transfers were up 0.4% (that's a 1.6% annual rate in an economy that is hardly growing). It is hard to see how this rate of increase in government consumption can be maintained and the deficit be reduced at one and the same time.

Investment is basically a second order factor here, since this will rise and fall as either exports or domestic demand generate the impetus to justify the invesment. Gross Fixed Capital Formation was down q-o-q by 0.2% in the first quarter, of which equipment was stationary, transport equipment down 3.4% and construction up 0.3%. However when we come to look at year on year machinery and equipment (ie investment and renewal) spending, we find it was down 0.9% following an annual 2.5% drop in the previous quarter. That's why all those business confidence readings are so important, since in many ways the bottom has all but fallen out of Italian investment in machinery and equipment over the last nine months, and to get this item moving again we are going to need to see a revival in confidence, something which is unlikely to appear over any immediate horizon. Italian business confidence dropped to its lowest level in almost three years in June under the impact of slowing economic growth, rising energy costs and a stronger euro. The Isae Institute's business confidence index dropped to 87.1 from a revised 89.4 in May. That is the lowest reading since July 2005.

On the export side Italy is no Germany or Japan, and struggles to sustain a trade balance, there is often a goods trade surplus, but a significant deficit on services (especially in transport and business services) means that Italy normally runs a trade deficit these days.However the fortunate combination of reduced imports and increased exports sometimes means that the trade impact on headline GDP is positive, and we see economic growth. The dynamic can be seen to some extent in the chart below - which shows movements in GDP, investment in machinery and equipment and exports. The uptick starts with a movement in investment, which is presumeably a response to changes in the order books, then exports surge, and in their wake headline GDP moves up. Then the rate of increase in exports starts to weaken, investment hits a downward path, and some quarters later GDP folds. Now investment in capital and equipment, while still falling year on year, did bottom in Q1, but here comes the rub, with the external environment worsening, and the storm clouds gathering this may well not have been sustained into an uptick. And viewed in this light the fact that the June business confidence reading fell back again might be thought to be rather ominous.

Returning now to consumption we can see in the chart (below) that the dynamic behind Italian household consumption has steadily faded in recent years (in a way which reproduces the pattern seen in the long term GDP growth and productivity charts). This is why I say the only real possible first order drivers of growth for the Italian economy are exports and government spending, since both investment and consumer spending tend to be derivitives of these.

As far as retail sales go, these were down by 5.9% in real terms in April (the latest month for which we have ISTAT data), while the retail PMI has now been registering contraction for 16 consecutive months. The June figure suggests another strong contraction (36.3) but not as rapid as the April one (31.4). Again, we could ask ourselves whether Italian retail sales will ever grow again, especially since they were mainly contracting in real terms though most of 2006/07 which was one of Italy's best growth spurts in the century so far.

As far as housing booms go Italy has not had a real boom since the one which took place between 1985 and 1992. The housing market does however continue to limp along, and construction activity is a GDP positive. Nationally, prices in 2007 rose by around 4% in nominal terms, much the same as the previous year, while the number of sales dipped by 4% falling to roughly 16% below their 2004 peak.

Prices in the major cities have been growing somewhat faster than the national estimates in recent years but are considered by both Nomura and Scenari to have grown by at less than 5% in 2007. Over the past decade, house prices have not risen at anything like the rate seen in many other EU countries, and only grew by about 30 to 40% in real terms between 1996 and 2006.

Pensions Retirement and Debt

So to tie all this up (neatly if possible) where does my analysis leave us? Well Italy badly needs to turn the productivity problem around, and there are, naturally, as many suggestions around about how to do this as there are explanations for her plight. Unfortunately most of the suggestions have been on the table for rather a long time now, and nothing noticeable has happened. So what confidence can we have that things will be any different this time round? Very little I would say.

In Chapter Two of its Italy country note "Economic Policy Reforms: Going for Growth 2008" the OECD did outline a long list of priorities for Italy. In order increase productivity, the OECD recommend that: divesture programmes be accelerated in public utilities, transportation and media; golden shares be replaced with arm’s length regulation; and regulators be strengthened further: planned liberalisation of market and local government services be fully implemented, and statutory and official authorisations giving anti-competitive powers to professional associations be removed. The OECD also advocate a decisive push to boost tertiary education graduation rates and improve university teaching and research quality. All such measures are doubtless very worthy, and will produce some results if implemented. But it is not at all clear that, even with decisive government action (which is not at guaranteed at this point, indeed interest seems rather to be focused on "Robin Hood" taxes and other such like) they will go deep enough and take effect rapidly enough to stave off what is likely to become the number one issue of the day: the sustainability of Italy's fiscal debt.

In order to appreciate the depth of the problem here, we might just take one area: pensions reform. As we have seen, after many years of very low fertility, fewer and fewer young Italians are now joining the workforce to replace the older Italians who are retiring. Instead their places are now being taken by a steady stream of newly arrived immigrants. In fact two-thirds of the annual increase of 308,000 new workers in the fourth quarter of 2007 were immigrants, with the other third being effectively accounted for by an increase in employment rates in the 55 to 64 age group. At the same time Italy has the highest proportion of over 65 year olds in the European Union and the second highest in the OECD (after Japan).

Italian civil society is effectively in denial, however, about the importance of this problem, and the best illustration of this is the ongoing failure to reach agreement on substantial increases in the retirement age - indeed despite all the recent "anti-immigrant" rhetoric we have been hearing coming out of Italy the fact of the matter is that a very large share of the new employment has gone to immigrants, and these immigrants are effectively working to pay a significant chunk of the pensions bill being run up by all those Italians who are still taking their retirement at 58 (only to live and claim their pensions a lot longer than most other Europeans to boot). Yet one more time Italy is more or less at the head of the list (see chart below) in terms of early exit from the labour force.

In fact one of the big problems for the Italian political system in its attempts to do something to address the downward drift in the economy is all the political horse trading that is needed to move even the smallest change forward. Last November Prodi only finally managed to get the support of Italy's labour unions for the 2008 budget (which was of course an attempt to keep the fiscal deficit under control) by accepting that there would be a much more gradual pace of increase in Italy's pension and retirement age as a trade off. The agreement he reached involved a staggered increase in the minimum retirement age, which at that point was set at 57. The change in fact involved supplanting (or going back on) a previously agreed reform law - one which would have boosted the retirement age to 60 from as early as January 2008 - and an effective slowing down of the reform process. The law which was put aside was agreed to in 2004, by one of Silvio Berlusconi's governments, and the decision taken then had been to raise the minimum retirement age— from 57 to 60 - as of January 2008. Under the new Prodi plan the retirement age was raised by one year, to 58, in 2008. In July 2009 the retirement age will again go up, this time to 60 for those with 35 years of contributions, or remain the same for those workers who can muster 36 years of pension payments. From 2011, the retirement age for everyone will rise to 60, and then to the astronomic age of 61 by 2013.

This decision, apart from being an astonishing one for outside observers, raises a number of important issues, especially since the ageing population problem is one which affects Italy in a very important way. Male life expectancy in Italy is now fast approaching 80, and is among the highest in the EU. At the same time Italy currently has the third-lowest birth rate in the EU (TFR around 1.3). Without raising the retirement age, contributions simply won't keep pace with pension payments (which are already running at approximately 15% of GDP see chart below) over the coming years, even assuming there is no ageing impact on the overall economic growth rate, which as we are seeing is far from clear.

Of course doing things in this way is not only ridiculous, it is also totally unsustainable. Italy undoubtedly needs migrant labour, but as a complement to, and not a replacement for, a very substantial and swift increase in the retirement age and in employment participation rates among the over 60s. The consequence of not addressing the retirement question is obvious: Italy's debt - which did fall back slightly in 2007 (to 104 percent of GDP from 106.5 percent in 2006) will start to rise again.

Interest payments alone on the national debt currently run at some 70 billion euros a year, or about 1,200 euros for each Italian, and any serious slippage in fiscal "clean up" is going to be closely watch by the financial markets, where, it will be remembered, the difference in yield between Italian 10-year bonds and the benchmark German bunds tends to increase notably at the first sign of risk aversion in the global financial markets. The spread between German and Italian bonds widened to 52 basis points in mid March, the most since October 1998, when it was as by much as 61 basis points. Any repetitions of this incident will surely cost the Italian government dear, since spending programmes - like the pension system that already eats up a full 15 percent of GDP - will almost certainly become more expensive to fund, leading to cuts in other - less protected and less structural - areas.

Any mention of rising Italian government debt only piles on the risk to Italy's credit rating. Both Standard & Poor's and Fitch Ratings reduced Italy's creditworthiness in October 2006. Fitch now rates Italy's long-term debt AA-, while S&P gives it A+. Italy's debt is rated 'Aa2' with a stable outlook by Moody's. Italy's issue with the ratings agencies is liable to prove no mean one, as the ECB made clear back in November 2005, when it took the decision not to accept government paper (bonds) in the future from any country which has not maintained at least an A- rating from one or more of the principal debt assesment agencies.

Only this week the Italian employers association, Confindustria, cut their forecast on the Italian economy for 2008, suggesting it will effectively grind to a halt this year economy and grow by the miniscule 0.1 percent this year, the slowest pace since 2003. Even more importantly they suggested that the slowdown in growth will simply add to the strain on Italy's public finances. They forecast Italy's budget deficit in 2008 will rise to 2.5 percent of gross domestic product compared with its previous forecast in December of 2.2 percent. This is really the number of all numbers to watch, since Italy desperately needs to avoid a deficit of over 3% if it wants to stay out of trouble with the debt ratings agencies. Confindustria predicts that Italy's deficit will increase to 2.6 percent in 2009, in the process casting doubt on the government's ability to balance the budget by 2011 as required by EU agreements. So I guess this is our "risk barometer" on Italy. Each tenth of a percentage point the Italian deficit climbs over that 2.5% forecast will represent one more nail in the coffin of S&P's A+ rating, and will put Italy one small step nearer having the doors of the vaults over at the ECB slammed firmly shut in the face of Italian government paper.

Friday, June 20, 2008

Has Spain Contracted The Artemio Cruz Syndrome?

The Mexican writer Carlos Fuentes once wrote a novel entitled "The Death of Artemio Cruz". The novel begins with an elderly Artemio who suddenly finds himself awake and lying on his deathbed, gripped by repeated spasms of excruciating pain, and terrified even to open his eyes for fear of what it is he might get to see if he does. After years of debauchery and loose living (shade's of Oscar Wilde's Dorian Gray here) the thing which seems to frighten him the most is the possibility he might get to take a look at himself in a mirror.

Of course, there are comparisons and comparisons here. Spain's economy is far from moribund, nor is it in its death throes. But Spaniards are suffering, and the process of adjustment is painful, and the attitude of the country's leader - José Luis Rodriguez Zapatero - does somewhat resemble the case of Artemio Cruz in that he appears, at least from the outside, to be totally obsessed with looking at anything that isn't an actual reflection of the actual state of the Spanish economy.

And of course it's easy to criticise here, since the problems Zapatero is reluctant to look too closely at are serious ones, and worse still, it isn't at all clear that anyone really knows what to do about them at this point.

So what is the problem?

Well to get straight to the point, in good old basic Econ 101 direct fashion, at this moment in time everything about the Spanish economy is either going dramatically up, or coming dramatically down.

On the upside we have consumer price inflation, producer prices, unemployment, unpaid bills of exchange, and the current account deficit.

Going down fast we have retail sales, industrial output, services activity, bank lending, and of course mortgage lending and construction activity.

Of course this is now a complete horror story, and in macro economic terms the problem is grim. But this unfortunately isn't the worst of it. It is all too apparent from the above graphs that the slowdown in the contruction sector has now spread, and extended across the "real economy" as a whole. Maybe the worst of part of all this is the state of the services sector, which has long been the mainstay of the Spanish economic expansion, and which is now, at least according to the purchasing managers index, contracting very sharply, and has been doing so since January.

But how did the problem start up in the construction sector? This is the real isue, since what sets the property slowdown in Spain (and of course in Ireland and the UK) apart from the normal, run of the mill, garden variety of property slowdown, is that it didn't start with an interest rate tightening process from the central bank (this was taking place, and a more or less orderly correction did seem to be underway) but rather it was given a huge kick from the credit crunch shock which effectively followed the outbreak of the US sub prime crisis in mid August 2007. In particular the Spanish banks found themselves in a major quandry when they discovered that the wholesale money markets had become effectively closed to their leading financial product (the cedula hipotecaria) after September.

So this is a tale of two structural problems, one a bank financing one, and the other an external deficit one. Let's look at them one at a time.

The Liquidity Straps Are On

Evidence of the difficulties that Spain's banks are having is everywhere. Take bank lending for example. According to the most recent data we have from the Bank of Spain, lending to Spanish households was up by 4.245 billion euros in March when compared with February, and year on year lending to households was up by only 10.6%. I say "only" here since this rate of increase in lending is only about half what it was at the start of 2007, and as such it is only about half the rate of new mortgage generation that the extensive Spanish construction industry needs simply to keep turning over.

The reason for this decline in the rate of new lending creation is obvious: the liquidity crunch, which is now the principal reason why Spanish banks are steadily lending less and less extra money in new mortgages each month, although as seen above we are now steadily moving from a construction crisis fuelled by a lack of availability of funds for mortgages to one which will be increasingly driven by absence of demand for them as the "affordability" issue steadily locks-in on those who would like to buy their own home.

The fundamental problem is not that hard to understand, even for the non specialist: since the Spanish banks are now short of cash they are simply able to lend less, and it is this, and not the 4% repo rate set by the ECB (or the sudden rise in 1 year Euribor following the sub prime shock), which is the principal reason the value of mortgages created on urban buildings in Spain (at approximately 16,575 million euros) was down in March 2008 by 36.7% over March 2007. In housing, the capital loaned exceeded 9,975 million euros, 41.9% less than in March 2007. 105,608 properties were mortgaged in March 2008, a decrease of 37.77% over March 2007.

The Spanish banks are, of course, able to raise money, but much of this is on a short term basis, and not appropriate for long term lending on products such as mortgages. Moody's recently suggested that Spanish savings banks are trying to attract foreign investors (especially German pension and investment funds) with private placements of tailor-made securities. But such issues are typically in the 30 to 300 million euro range - a long way from the earlier jumbo cedulas. In addition maturity on these securities is much shorter, typically three years.

Another strategy the banks have been using has been to issue short term (typically three month) paper, and there was roughly 90 billion euros worth of it outstanding at the end of March. Banks are also trying frantically to attract more deposits, and since the end of last year some 20 billion euros have been transferred out of investment funds into long term deposits. The however do not come cheap, and the price the banks are paying for this money is prohibitively expensive - some of it even pays 7% - for it to be used as a basis for mortgage finance, for mortgage finance since mortagages are still widely on offer for around 0.5% over 1 year euribor (or 5.25% or so).

Thus the problem for the banks is really how to find a stable long term source of finance for their mortgage business given the fact that the wholesale money markets have been virtually closed in their faces. Since we have no idea at the present time at what level Spanish property prices will finally settle (and thus what the true market value of the mortgages pools which effectively back the cedulas actually is) then it would seem that the day the doors will once more open again (at least at prices the Spanish banks would be interested in) is far from being at hand.

The Madrid based consultancy Analystas Financeros Internacionales (AFI) estimate that during 2007 Spanish banks were raising approximately 40% of their funding requirements outside Spain, as compared with only 15% in 2000-2001.

According to AFI the Spanish banks and savings banks did continue to issue residential mortgage backed securities (cedulas) in the second half of 2007 (to the tune of an estimated 50 billion euros, although this number seems rather high to me), but none of these were placed with external investors (since there were effectively no takers). Rather they were kept on the books for later use in repo facilities with the ECB as and when required.

Data from the Bank of Spain show that Spanish banks have doubled their share of the ECB's weekly funding auctions since August 2007 - up to 10% of the total from a previous 5% - and that in February Spanish banks borrowed 44 billion euro out of a total of 442 billion euro borrowed by European banks. Which means the Spanish banks may have "parked" an additional 22 billion euros or so of cedulas with the ECB over this period, not an enormous quantity given the scale of the problem, and this suggests that at the present time they are resolving most of their immediate needs via other channels.

One of the curious issues that arise from a little careful thought about this data is, if the Spanish banks - who are undoubtedly the worst affected in the eurozone - are in fact using such a small part of the ECB facility, what is all the rest of the money being used for? In otherwords it may well not be the Spanish banks who are "abusing" ECB facilities at all, but other banks who are "piggy-backing" on the facilities provided to help the Spanish banks to obtain money for their own purposes. The Economist last week had a useful article about the way some banks have been "dumping" (they call the ECB a litter bin) ABS's on the ECB. Perhaps the most revealing data point they offer in the article is this one:

"Of €208 billion ($320 billion) of eligible securities created, only about €5.8 billion have been placed with investors, according to calculations by JPMorgan."

So some European banks have been increasingly creating paper for explicit use with the ECB. My feeling is that following all the publicity this issue has now been receiving the rate of new paper creation may well have diplomatically slowed, since if there is one thing Spanish banks don't like to do it is draw attention to themselves (unless of course the news is positive, which in this case it most decidedly isn't). Of course, if bad moves on to worse we may well see the need for more "containment" activity from the ECB. Which makes it rather unfortunate that so much liquidity has already been soaked up, before the show has truly gotten under way as it were.

The big issue is of course that there is now no private market for the earlier jumbo bond offerings. Worse, many of the original jumbos were offered with maturities of between five and eight years. So these cedulas will effectively soon be coming up for rollover.

I would say that the greatest risk points for the Spanish economy from the banking sector at this stage come from:

1/ the potential liquidity crisis which may be provoked by the need to refinance the cedulas.

2/ the potential increase in the quantity of bad debt provision which the Spanish banks may need to set aside as and when the builders themselves start going bankrupt in serious style. With anything up to an estimated 1 million unsold properties on the books in Spain at the moment, and with the banks being de facto owners of these properties through their financing of the builders, this avenue is the most important short term threat of debt delinquency, and not unpaid mortgages (IMHO). And the sums involved are by no means chickenfeed, and could well be very similar in magnitude to the quantities owing on the cedulas. ie the whole problem is very large indeed.

Of course later, as the financial problem ripples its way through the real economy, the ability of individual households to meet their mortgage obligations may well become a problem, but we are a long way from that at this point, and sufficient unto the day is the evil thereof is very much the case here I think.

AFI estimate that around 40 billion euros in cedulas and other bank debt come up for refinancing in the second half of 2008, that in 2009 this number will rise to around 80 billion euros, and that the number will remain high through 2010 and 2011. That is to say my rule of thumb guess that we may be facing around 300 billion euros in rollover issues (or somewhere in the region of 25% - 30% of Spanish annual GDP) in the coming years does not seem to be too far off the mark. And as I say, we may need to make similar provision for equivalent exposure to bankrupt builders etc.

The following chart which is simply for the Spanish bank BBVA should give some rough and ready indication of the rollover issues which are coming up, and their temporal distribution.

The Current Account

Spain had a current account deficit in March of 12,049.5 million euros, which was well up on the 7.3114 billion euros registered in March 2007. According to the Bank of Spain this deterioration in the current account is due to two factors, the increasing trade deficit, and a growing deficit in the income account. If we look at the trend in the current account deficit we will find that in the January to March period (Q1) the total deficit was 32.552 billion euros, while in Q1 2007 the total was 26.637 billion euros. This is a year on year increase of 26.3%. If we now consider the fact that last year's "whole year" deficit was an estimated 105.8 billion euros (or 10.1% of GDP) then if this first quarter trend continues Spain could well be facing a whole year deficit of something in the region of 130.8 billion euros. (The current IMF WEO guesstimate is 171 billion dollars, or at todays prices roughly 110 billion euros).

Now, given that Spain also has a major economic (credit crunch driven) slowdown underway and that it is quite possible that GDP will be nearly stationary this year (let's say a maximum and very optimistic 1% whole year growth), the value of the the deficit as a % of GDP is set to rise, and possibly very substantially, by between 1 and 2 percentage points. In fact given that Spanish GDP at current prices in Q1 was some 268.496 billion euros, the CA deficit was already running at a rate of 12.12% of GDP. And to give us some idea that this way of doing things isn't entirely without foundation, we could note that the CA deficit during Q1 2007 was 24.89% of the whole year deficit. So where we go from here, it seems to me, depends on two things, the price of oil, and the rate of growth of the Spanish economy.

The Trade Deficit

To get some idea where we are here, it is perhaps worth mentioning that the goods trade deficit was up 4.5 billion euros in the January to March period over the same period in 2007 (or an increase of around 25% year on year), and since exports grew 2.4 billion euros while imports were up by 6.9 billion, then we can see that this story is virtually all about one thing: energy imports (since the rising income deficit - up 0.5 billion euros in Q1, or around 7.5% - while important for what it suggests about the future since Spain is having to borrow so much externally to keep afloat, is not determining over a short term horizon).

In fact exports were down in March, but since March was such an untypical month due to the calendar effect of Easter I think we are better staying with the Q1 data for the time being.

The Financial Account

This large deficit in the Spanish current account - which resulted (after taking into account a small positive balance of 223 million euros in Spain's favour on the capital account) in a net financing requirement of 11.8 billion euros (up from 7.6 billion in March 2007) was basically covered by some very large movements on the financial account.

Spain's net external financial balance with the rest of the world was running to the tune of 17.87 billion euros in March (up from 5.7 billion euros in March 2007). This increase in the inflow of external funds is very large indeed (and we will look in detail at some of the ingredients shortly), but the end result was that net assets of the Bank of Spain vis-a-vis the rest of the world were up by 6.86 billion euros on the month (a very large change from the negative balance of 773.9 million euros in March 2007). Now since things are going so stupendously badly as far as Spain's economy goes, we may well ask why things appear to be going so incredibly well on the flow of funds front. So let's take a look, since the answer we find may well be interesting.

The large increase in the net flow of funds, was mainly the result of a significant increase in the category of "other investments" (which is basically made up by loans, deposits and repos) while there were net outflows on all the other instruments in the account.

Direct investments saw an outflow of 2.3 billion euros, which was down on the net outflows of 6.27 billion euros in March 2007. There were net outlows to the tune of 14.34 billion euros in portfolio investments (largely bonds and equities) which contrasted with the large inflow under this concept 18.14 billion euros in March 2007. If we look at the appetite of foreign investors for Spainish bonds and equities the situation gets even worse, since in March there was disinvestment in Spain to the tune of 12.662 billion euros which compares with an inbound investment of 23.829 billion euros in March 2007.

If we now come to repos, loans and deposits there were net inflows in March of 34.831 billion euros - while in March 2007 there were net outflows of 6.404billon euros. Now we don't have a monthly breakdown of this data, since the Bank of Spain gives this on a quarterly basis, and the last quarter we have is Q4 2007, but as a rough rule of thumb we could say that flows in and out of deposits at banks and other financial instutions are far and away the most important item here (about two thirds of the total, while repos are pretty insignificant at this level).

The bottom line is that in March there was a massive disinvestment by Spanish financial institutions in deposits outside Spain - to the tune of 37.911 billone euros (bringing the money home?) which contrasts with net outflows in March 2007 of 18.846 billion euros. On the other hand foreign investors disinvested in Spanish loans and deposits by 3.080 billion euros which compares with inflows of 12.442 billlion euros in March 2007.

Something happened in March, but I'm not really sure yet what, and we need to see more data. The above chart contrasts the respective flows by the two agents - internal and external - since essentially the balance doesn't tell you anything more than that it needs to be more or less maintained while it is who is moving what where which is really interesting (remember negative readings from Spanish agents mean positive inflows since they are disinvesting abroad). Looking at the chart we can see that lending and deposit transfers into Spain by external agents suddenly turned negative in March after two months of quite strong positive flows, and as a result Spanish financial institutions had themselves to transfer money into Spain, otherwise it seems to me the whole domestic liquidity situation would have been like it was in December (when something similar happened, but the banks didn't move sufficient resources in and bank lending growth came to a virtual dead stop).

Essentially as I say we need to see what happens under this heading in the coming months, but the volatility that has crept into these flows, and which is evident at the right hand end of the chart, is fascinating, and obviously indicative of things we are yet to learn about. What is becoming most clear is just how rapidly Spanish financial agents need to react when external the appetite for lending to Spain slows. I think this may well be one of the clearest indicators we have of the impact of the current account deficit induced money drought.

In Brief Conclusion

In this post I have focused on two aspects of Spain's current economic crisis, the growing current account funding problem and the structural financing problem in the banking sector. Of course, at the end of the day these problems both boil down to one: Spaniards need to start saving more and borrowing less for consumption. This is very easy to say, but will mean an enormous wrench and change in previous behavioural patterns. What I want to stress is that these factors are structural and not cyclical, and it would be fools gold to be playing around at this point in time with the idea that some sort of cyclical uptick will miraculously put things right. Since domestic demand is no longer going to drive the Spanish economy the undelying issue now is basically Spain's lack of competitiveness in exports, and its very strong external energy dependence at a time when oil prices are rising substantially, and when the high price effect looks like it could be long term.

For some time the existence of this problem was hidden by the impact of the housing boom, and by the fact that this boom was increasingly financed by the issue of asset backed securities (ABS, cedulas hipotecarias). Thus during the boom Spain had no difficulty financing its deficit. But times have changed.

My general impression is that even the funding that the Spanish banks are currently getting from the ECB is far from being sufficient since it covers only a small part of their needs and hence bank lending is rising at around 5% per annum instead of the 20% year on year rises we were seeing a year ago. So the Spanish banks are really getting starved of cash (or cash at a price which is interesting to them for mortgage lending), and hence all the frantic tooing and frowing we are seeing on the financial account.

Nowhere is this situation more clearly illustrated than in the case of the portfolio investment flows into Spain from foreign investors (basically bonds and equities), and as can be seen in the chart below these underwent a sea change following August last year. This is what explains all the frantic moving around looking for funds we are seeing, since without the under other concepts Spain could soon become seriously short of money. At the end of the day, if you are sending money out every month to pay for your oil, where are you going to get the funds from for new lending? Desperate situations require desparate acts.

In my opinion the most serious property related issues here in Europe are to be found in Spain, Ireland and the UK. And Spain may well be in the worst state of the three of them due to the dependence on cedulas, and due to the fact that the term-mismatch issue means these need to be rolled-over in an none too distant future - starting with maybe 40 billion euros as early as this autumn. So the Spanish banks have to both refinance old lending and find the new money for future mortgages at one and the same time. Not funny.

But, as we have seen here, on top of the credit-crunch property issues Spain also has a huge CA deficit one, and the problem is only likely to get bigger if oil prices keep rising. Spain shares this CA problem with Greece (deficit 2007 13.9% GDP) and Portugal (deficit 2007 9.4% GDP) within the eurozone and these deficits have largely been masked by serving up "all eurozone" data where the large German surplus (surplus 2007 7.6% GDP) covers a multitude of sins. But German citizens are obviously NOT going to pay for Spanish oil (they may lend the money, but how long can this can continue to go up and up is anyones guess, it looks like an extermely exaggerated version of the US funding depence on Japan and China in some strange sort of way).

So the bottom line is that Spain is headed straight towards a crash on the two biggest global issues of the moment, the credit crunch and oil. The proverbial double whammy. Not pretty, which perhaps explains why the average Spanish citizen, just like Artemio Cruz, prefers to keep his or her eyes closed rather than gaze on what might be there to behold with the eyes wide open and a mirror held up to their face.

Wednesday, June 4, 2008

Artemio Cruz in Spanish

Economía El síndrome de Artemio Cruz


La novela de Carlos Fuentes, «La muerte de Artemio Cruz» comienza con un anciano Artemio tendido en la cama, sacudido por espasmos, al borde de la muerte y con pavor a abrir los ojos porque no sabe lo que verá si lo hace. Algo parecido sucede con el Informe Económico del Presidente del Gobierno. Se empeña en mirar hacia otro lado, en apartar su vista de la desagradable realidad de la crisis. Por eso, el Sr. Zapatero se empeña en diagnosticar una gripe a un enfermo de cáncer y en administrar aspirinas a quien necesita quimioterapia. Ninguna de las iniciativas planteadas por el Líder Máximo sirve para amortiguar los efectos de la desaceleración ni mucho menos para volver a tasas de crecimiento elevadas. Por ceguera, ignorancia o falta de voluntad política el gabinete socialista renuncia a afrontar la situación. Su comportamiento recuerda al de los gobiernos del tardofranquismo, empeñados en no aceptar que el ciclo expansivo de las décadas anteriores había saltado en pedazos. No tomaron medida alguna para combatir el shock petrolífero de 1973 y la crisis duró diez años, hasta que Miguel Boyer puso en marcha su plan de estabilización en 1983.
La banca ha anunciado que la morosidad se duplicará en nueve meses. Aunque este hecho no tiene por qué plantear problemas de solvencia al conjunto del sistema, sí acentuará la restricción del crédito en la economía española si se tienen en cuenta dos factores adicionales: la potencial crisis de liquidez provocada por la necesidad y dificultad de refinanciar las cédulas hipotecarias; y el inevitable incremento de las provisiones que deberán realizar cajas y bancos para protegerse frente a las bancarrotas que se producirán en el sector de la construcción y frente a los impagos de hipotecas y créditos al consumo provocados por el aumento del paro. Con un millón de viviendas sin vender, las entidades financieras se van a convertir en los propietarios de esos activos y esa va a ser una vía explosiva de aumento de la morosidad. AFI estima que las instituciones de crédito deberán refinanciar alrededor de 40.000 millones de euros en cédulas y otras deudas en la segunda mitad de 2008 y unos 80.000 millones más en 2009. Si bien la solidad del sistema financiero es considerable, será complicado que escape a un escenario de restricción de liquidez que dure más de un año. Ningún desplome inmobiliario conocido ha terminado sin una crisis bancaria y sin una recesión.
Como señaló Edward Hugh en su análisis para el RGE Monitor, el problema para bancos y cajas es encontrar una fuente de financiación estable en el largo plazo para su negocio hipotecario en un contexto en el que los mercados monetarios se les han cerrado. Como nadie tiene idea de cuánto pueden caer los precios inmobiliarios, los incentivos para suministrar recursos a las instituciones financieras son mínimos. Por eso los títulos ligados a las hipotecas, emitidos por las cajas, no son adquiridos por los inversores internacionales a pesar de los elevados tipos de interés ofertados. De ahí los intentos de colocarlos en la red, lo que además de ser una estrategia cortoplacista y de impacto limitado acentúa todavía más la contracción crediticia interna. El famoso «credit crunch» quizá se modere en otros países, extremo dudoso, pero se acentuará en España a lo largo de los próximos trimestres.
Esa situación estructural se agravará cuando el BCE de Jean-Claude Trichet suba los tipos de interés en julio o en septiembre. Así lo descuenta el mercado. El Euribor ha escalado hasta el 5,36 por 100. El crédito será cada vez más escaso y caro. Este hecho impulsará caídas adicionales de los precios de la vivienda, así como del consumo y de la inversión privada que acentuarán las fuerzas recesivas en curso. Si además se suma a ese cuadro clínico las presiones recesivas e inflacionarias de un petróleo muy caro, el panorama es estremecedor. El resultado inevitable es un fuerte incremento del paro, de las quiebras y de las suspensiones de pagos en una espiral recesiva que se autoalimenta sin remisión. Ahora bien, siempre está para calmar los nervios y transmitir confianza la calma tranquila del presidente del Gobierno.n