Saturday, February 13, 2010

Lost In The Bermuda Triangle

If Greece is broke, can Spain be far behind? This question put by the Economist to its readers only last week, is surely one many investors and financial market participants are busily asking themselves at this very moment in time. The Economist's own ambiguous answer was hardly surprising, since as they point out while Spain is evidently not a Greece at this stage, there is no shortage of things to worry about. In fact saying you are not actually as bad as the current worst case scenario is not saying all that much, indeed it doesn't even reassure anyone that that least desired of labels might not eventually befall you one of these fine days.

Certainly, ever since Spain's Public Works Minister José Blanco came out with the claim that country is the currently victim not just to a strong speculative attack but also to an “Anglo-Saxon press” lead plot to destroy the euro the rhetorical temperature has only risen and risen, as each of the respective party desperately tries to fend off the attacks of the other. Perhaps the most striking example of this particular war of arguments is to be found in what is surely the latest-generation twist in the old dialectic of blow against blow, where a combination of internet age communication systems and sophistocated data management software furnish yet one more dimension to the current crisis debate: let's call it the birth of the "charts war". And from what we've seen so far it looks to me like the Spanish craft just got itself shot down in the nether nether land.

I think you it would be safe to say that it was Nobel Economist Paul Krugman who kicked off the latest round in the ongoing war of graphs with one simple image on his New York Times blog, one which showed Spain's rising unit labour costs as compared with those to be found in Germany.

Foul Play?

The Kindom of Spain was not amused, cried foul, and struck back during their London roadshow (courtesy of Elena Salgado and Manuel Campa) with their own version of the same topic. Spain is not so badly off we are told, since Italy's position is even worse. Adding insult to injury, they went one step further, and suggested that adding 2 million or so unskilled workers to the Spanish dole queues, and closing down a large chunk of Spain's core construction industry (driving the unemployment rate up to 19.5% in the process) has not been all bad, since in some senses it has been extremely beneficial, given that cleaning out all those low productivity, unskilled workers has meant that the productive power of what is left now looks decidedly better (since the average productivity of those still in work has notably risen). It is like saying that wartime bombing is beneficial if what it does is destroy the oldest part of your housing stock.

But this exit of so many workers from the centre of the economic stage is just where Spain's fiscal deficit problem enters, since those workers who are unfortunate enough to find themselves unemployed are still being supported by the rest of the Spanish labour force via their contributions to the Spanish social security system, and the output loss is hitting the government balance sheet hard via the drop in tax revenue. So the productivity improvement (as far as Spain as a whole is concerned) is simply an optical illusion. It looks nice on one graph (the unit labour cost one) and horrible on another (the government fiscal deficit one).

This is a point that Paul Krugman could have picked-up-on but didn't, although he did follow through with a further post full to the brim with very revealing charts, all intended to demonstrate that Spain's core problem is not essentially a fiscal one, a point which may be clearly seen from a comparison of German and Spanish fiscal deficits over the last decade. As Krugman argues, Spain had no evident fiscal problem till the housing boom went bust - it had a monetary one in that the interest rates being applied were far from the adequate ones, but the ensuing boom that these produced meant that the government's treasury accounts were generally awash with money. Then, naturally, it all went "pop".

Now the need to prop up the economy, and support all that "unproductive" labour which doesn't show up in the unit labour costs chart is producing a massive fiscal deficit. Thus the fiscal issue in Spain is a symptom, not a cause. The root of the problem lies in the structural distortions produced by the massive overheating of the economy during the boom years, an overheating which lead to excessive inflation, large-scale dependence on imports, and a complete loss of competitiveness in the non-tradeable sector - a loss of competitiveness which even the Kingdom of Spain accepts.

The problem with the Spanish government argument is that it focuses on the idea that the tradeables sector is not that uncompetitive. But this seems to neglect the rather inconvenient fact that those workers who are deployed in the tradeable sector also eat bread and go to hairdressers and ride in taxis and buy or rent homes just like everyone else. So they themselves need to pay prices set in the non-tradeable sector, and their salaries have to reflect this. Hence a problem in non-tradeables becomes a much more general one. And it shows up, naturally enough, in the tremendous hole in the current account balance.

The Kingdom of Spain, however, goes even further, and suggests that far from being subject to a continuing deterioration Spain's tradeables sector (on aggregate) has maintained its share of world trade over the last decade. But there is something intuitively wrong with this argument, and what that something is becomes evident if you consider that Spain was running a growing trade deficit over the whole period in question. Now global imports = global exports (by definition, trade is zero sum) and since Spain's trade deficit deteriorated over the period imports grew more than exports. Thus logically Spain's import share grew more than it's export share in world trade. That is Spain became a growing force in world IMPORTS. Somehow no one from the Kingdom of Spain mentioned this inconvenient little detail during their London roadshow since the country's representatives seem to be more focused on winning arguments with the perceived enemy - the Anglo Saxon press - than on finding real solutions to real problems. There is also a simple explanation as to why Spain's tradeable sector gives the appearance of being so competitive, and that is the non-competitive parts were simply driven out of business, and the demand for their products was met by imports. And this is just why Spain's current situation is so unsustainable. To get back to growth Spain has to start supplying a higher percentage of its own needs internally, and it has to find work for a large number of low skilled workers, and there is simply no way round the issue.

Smokin' Gun

Indeed, analysts at PNB Paribas recently took the competitiveness loss argument one step further and, by examining the virtual Real Effective Exchange Rates of the respective countries, showed how, far from addressing the competitiveness issues in Greece and Spain, the recent bout of fiscal spending was in fact making the situation worse.

This is a point I myself have been trying to make by using two simple charts. The ECB eased liquidity in the Spanish banking system last June with a massive injection of one year funding. This money went, via bank purchases of Spanish Treasury Bonds, to fund the government deficit, leading to a large injection of demand into the real economy. But what happened to that demand? Just look at the accompanying chart. The trade deficit started to widen again, as Spaniards availed themselves of their additional spending power to buy yet more foreign products.

So essentially the issues is this one. Spain's economy will not recover, and will not return to sustainable growth till Spanish products become much more attractive in price terms, and this only means one thing: some sort of internal devaluation, and all that talk we keep hearing about an exclusively fiscal correction is simply an attempt to remove the smoke without going to the trouble of extinguishing the fire which is producing it.

Spain Is A Serious Country

Meanwhile José Luis Rodríguez Zapatero, Spain’s prime minister continues to try to reasure his European partners and financial markets alike by telling them Spain is "a serious country and we will fulfil our promises.” In other words, despite the severity of the recession the country is currently suffering, and the major challenges facing its banking system, Spain, as the Economist would agree, is not about to become another Greece. At least, not yet!

And just to prove the point he had Labour Minister Celestino Corbacho and Economy Minister Elena Salgado announce in short order that Spanish citizens are a) going to work two more years each in the longer term, and b) will face continuing and sweeping cuts in services and increases in taxes in the short term. The trigger for this rather unexpected show of determination seems to have been the growing danger of contagion from debt crisis worries in Greece, as Spanish 10 year bond spreads briefly nudged through the psychological threshold of 100 base points above the comparable German benckmark.

Spain's banks have extensive government bond holdings, and as the spread rises the market value of these bonds falls, so - given that another important part of the banks capital base is composed of land and property assets of uncertain value - the prospect of a slide in the value of the bonds they hold leaves Spain's government with little alternative but to be seen to be taking "serious" measures, whatever the cost. What's more, despite the positive impact on unit labour costs of all that unemployment, the impact on the social security fund means there will be a longer term cost for Spain's already badly challenged pension system.

Quite how Spain's citizens will react to the news that their government's policy is now being driven by the need to "calm market fears", and that the country's leaders are actively considering asking them to retire at 67, still remains to be seen. Recent warning shots from political rivals and unions alike may leave their mark in the short term, but it is now clear that things have, in fact, changed, and Spain's politicians (and the bankers who influence them) are now likely to be much more sensitive to market sentiment than they are to public protest.

And what could be nearer to the heart of market sentiment these days than the fiscal deficit numbers. "It's a plan that is essential after our most recent deficit figures," Finance Minister Elena Salgado told journalists when she announced her last batch of measures. The main problem facing the Spanish government now is credibility, and what to do about the impression that the national airplane is flying pilotless over that perilous no-contact zone. Certainly the impression that someone is really in charge took a further unwanted hit when Spain announced an annual deficit of 11.4% for 2009 after previously (only two weeks earlier) saying the deficit was expected to come in at 9.5% of GDP. In fact it is rather surprising that as recently as last September (when the government first presented its budget plans for 2010) the deficit was still being forecast to come in as low as 5.2% of GDP (52 billion euros), while by November the forecast had already risen to 8.5% of GDP (85 billion euros) and finally (just two months later) we are told that it was 11.4% (over 110 billion euros).

A number of questions automatatically arise, like just what level of control the Spanish government actually has over its deficit, and just how convincing is the government's plan to make a three year, 50 billion euro reduction in a deficit which has just shot up in four months by more or less exactly the same amount without anyone (officially) forseeing it!

And Elena Salgado's still incomplete deficit reduction plans critically depend on economic growth forecasts – which rise to about 3 per cent a year in 2012 – that many independent economists regard as totally unrealistic. Even the IMF, with whom Ms Salgado recently took issue, are not convinced by her numbers and forecast a 0.6% (and not a 0.3%) contraction this year. The government now projects a 1.8% gain in GDP in 2011, with growth in 2012 up as high as 2.9%, from a prior 2.7%. Of course, you can pull numbers (like rabbits) out of any hat you like, but that won't bring you growth, and certainly nothing like 3% growth in 2012. So we are heading towards trouble, even as the Brussels control tower seems to be having difficulty maintaining contact with the pilot and his crew.

And time is running out. As Victor Mallet put it in the Financial Times - the recent austerity announcement does little answer the one question which is now uppermost in the minds of all those investors and economists who are busy worrying themselves about the future of Europe: can Spain control its budgets and once more become competitive within the constraints of the single European currency?

Mr Zapatero insists it can, but he and Ms Salgado have yet to prove it. I do hope they have an up to date set of charts to guide them.

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