The key to Spain’s turning the corner as 2013 begins is the housing market. This takes on increasing importance given the reprieve in crisis interest rates. House prices are still falling and the economy is contracting despite the improvement, making a return to crisis possible.
The positive narrative for Spain would be that the Spanish are finally doing what the Irish have done and recognizing the bad debt in the financial sector. Having done so, Spain is now experiencing a tailwind courtesy of the ECB’s support. Despite the contraction in the economy, the crisis will fade away as the writedowns from bad debts diminish and the banks are recapitalised.
That’s the narrative supporting purchases of Spanish debt right now. And while I think much of this narrative makes sense, it doesn’t fit together because some of the facts on the ground do not support it. Just today, the Spanish papers were saying that bad debt in Spanish banks have now risen to a record 11.38% of loans outstanding as of November 2012, the latest month’s data available. Combine this fact with the continuing drop in Spanish house prices and you have the makings of more writedowns and increasingly impaired bank balance sheets.
Here’s the logical flow of how Spain escapes the sovereign debt crisis:
Because Spain is a part of the euro system, the government is beholden to bond market vigilantes in the capital markets for funding. Spain’s central bank cannot monetise the government’s deficits because the Spanish government does not issue currency. Spain effectively borrows in a foreign currency. And so the issue of credit quality and defaulting in that currency could create a downward spiral that leads to a Greek death spiral.
To be sure, unlike other currency users, governments have the ability to increase revenue coercively via taxation, making their debt less risky than other debt. However, there are only so many taxes a government can impose before those taxes overwhelm the ability of the taxed to both pay the tax and make other consumption expenditures. In Spain’s case, the genesis of crisis came via high fixed debts that are no longer supported by asset prices incurred during a housing bubble. Private balance sheets are underwater, causing many to default and yet more to restrict consumption in order to bring their liabilities and assets into line. And so, increasing tax or decreasing government spending too drastically in this situation creates a negative feedback loop with the private sector that causes the economy to contract violently. The so-called government spending multiplier is high in Spain now, as it is in many other post-financial crisis countries. So, default is still a concern, despite the government’s coercive taxation power.
Any debtor’s debt profile is enhanced by its ability to generate cash at a rate that is higher than the interest rate of its debt. If I owe $100 and pay 8% interest on that debt, I need to generate $8 in cash to keep my debt level constant, ceteris paribus. Looking at this from a government’s perspective, Spain needs to increase its tax revenue at a rate higher than the yield on its bonds in order to have what its creditors consider a sustainable growth path without making asset sales. The constraints here for Spain then are tax revenue as a percent of GDP, GDP growth and interest rates.
As I wrote regarding the negative feedback of higher tax and GDP during a private sector debt crisis, tax revenue as a percentage of GDP and GDP growth are not purely independent variables. Tax and GDP growth have a reflexive relationship that makes this situation trickier. Moreover, interest rates inherently depend on creditor’s assessment of those two variables, and are thus also reflexively dependent on tax rates and GDP growth. The bottom line here is that there is no stable equilibrium to the Spanish situation. Anything can destabilise the three variables, tax revenue, economic growth and interest rates, upon which Spain’s future depends.
In that context, two events stand out as potential catalysts for renewed crisis.
First are the municipal governments. These governments are largely dependent on the sovereign for funding because they have been locked out of debt markets. They also have the same variables at play that Spain does regarding tax, economic growth and interest rates. In a benign environment characterised by rising tax revenue and lower deficits, they can maintain debt profiles that seem sustainable enough to creditors to push down their borrowing rates and lessen their dependence on the central government for funding. What they need is a combination of a stabilising housing market and private spending to lessen GDP contraction.
But then there is the housing market itself, which plays into consumer spending via private sector balance sheets and into government debt via the need for additional bank capital. In the last year, Spanish house price declines were still accelerating. The year-over-year decrease in Spanish house prices was 15% when we last saw data in December. The last bit of data on the balance sheet effect on banks was equally poor. A new record 11.38% of bank loans in Spain are bad. That puts the bad credit at 191.6 billion euros, up 43% from 134.2 billion in the last year. And since house prices are continuing to fall in Spain – and right now at an accelerated rate – we should assume more bad debt and more writedowns are coming. That means more support for Spain’s banks by the central government.
My view is that the combination of house prices declines and austerity will be too much for the Spanish private sector to bear. I believe the contraction in consumption and GDP to support balance sheets will be larger than is commonly assumed. And this will mean Spain misses its fiscal targets. Moreover, I also believe that the still accelerating house price declines will mean that Spain’s government will have to contribute more to recapitalise its banks than is now assumed. And so this combination will make Spain vulnerable to a spike in interest rates, causing the country to seek protection under the OMT umbrella by formally requesting a bailout from the Troika with ECB monetisation support.
Right now, Spain’s bonds are benefitting from a dearth for safe assets in the eurozone, with only a few countries rated AAA. The OMT threat has increased the willingness of investors to take on default risk in the sovereign space. But, if the combination of house price declines, bad debt, writedowns, and missed fiscal targets materialises, the huge amount of debt Spain needs to roll over this year makes me believe that investors will reassess Spain’s debt sustainability at some point during 2013.