My co-blogger on Global Economy Matters Manuel Alvarez in his post on last weekend’s Spanish election called it “Zapatero’s election to lose”, meaning by this that the opposition scarcely seemed credibly poised to win, and their best chance of victory rested on the possibility that Spain’s Prime Minister Jose Luis Rodriguez Zapatero might somehow or other manage to clutch defeat straight out of the jaws of victory (aka throw the election away). In the event he didn’t, and the Partido Popular now face another 4 years sitting it out on the opposition benches.
But there is another sense in which one might think that this was Zapatero’s election to lose, and that is connected with the scale and importance of the economic problems which are steadily arriving on the Spanish centre stage, since given the scale of what now seems to be happening in Spain I find it hard to understand how anyone would actually be able to relish having won this one. There are, surely, occasions when discretion is most certainly the better part of valour. Wolfgang Munchau effectively made a similar point in a recent Financial Times Op-ed where he suggested the the winner, whoever he should be was destined to ” spend the next four years cleaning up an economic mess on a scale not witnessed in Spain in modern times”.
I thoroughly agree. I also agree that Munchau more or less hits the proverbial nail directly on the head when he goes on to suggests in his article that “the twin engines of the coming Spanish economic crisis are a collapsing housing market and a current account deficit, now at 10 per cent of gross domestic product”. As he also points out, these two are related since it has been the inflow of investment to fund the mortgage lending needed to fuel the property boom which has enabled Spain to finance its current account deficit. But now that this flow of funds has all but come to a halt, as has the lending which went with it.
But before I let myself get into too many more details I think I should point out that I owe the inspiration for my title here to this self proclaimed piece of “wonkery” from Paul Krugman on his NYT blog. While the “pawnbroker” part of the title in and of itself is far from original, its use in the Eurozone context perhaps is rather more so. What I seek to achieve in using it is to draw attention to the similarity between what the Federal Reserve is currently doing in the context of the United States banking system and what the ECB is doing in the Spanish one. While it is obviously true that the ECB is currently and very publicly meticulously refraining from carrying out a loosening of monetary policy by traditional means (ie lowering interest rates) it is nevertheless the case that the ECB is engaging quite extensively in what James Hamilton most appropriately calls monetary policy from the asset side of the balance sheet, by trading cash for paper with the Spanish Banks on a regular and systematic basis. (For a good summary of what all this balance sheet side lingo actually means, see this post from Randy Waldman).
And why pawnbroker? Well basically the Spanish banks today face a rather peculiar problem. They have relatively little cash (the Spanish have not been big savers in recent years, and as a result current deposits are not the be all and end all of their balance sheets), but they do have quite a lot of reasonably valuable assets in the form of (pretty illiquid) mortgages (we are NOT talking sub prime here, at least not yet we aren’t, but normal and well serviced garden variety mortgages, often with a lot of owner equity in the property lying behind them). In order to transform some of their assets into the cash they very much need to carry out their normal daily lending business the Spanish banksare having to convert their still reasonably valuable (because quite highly collateralised) mortgages into bonds (which are in effect rather less valuable, since at the present time virtually none wants them, see this post), and then take these bonds over to the ECB for discounting so they can finally get their hands on some of that ever so sought after cash. Just like you might do when you fall on hard times by taking your mothers wedding ring down to that nice little shop on the high street with the three large balls jangling outside.
And how do we know that the Spanish banks are having a difficult time finding the cash they need? Well their willingness to go to the ECB to borrow would be one indicator (drawings at the weekly ECB auctions were up by 24 billion euros – or 100% – last autumn) and their willingness to lend would be another. During the years between 2004 and 2006 Spanish households were able to increase their borrowing at a rate of about 10 billion euros a month. In 2007, and in particular after August 2007, this situation began to change, the lending still continued, but the flow became more volatile, almost as if there was a twist in the water hose. Even as late as November 2007 Spanish household were still able to increase their borrowing by as much as 12.5 billion euros (possibly one last frantic gasp of activity), but then came December, and in December 2007 something very strange happened, since household borrowing in Spain only went up by a measly 500 million euros (to see in more detail what happened to new bank credit last December see this chart, or the “raw data” in this pdf, its the second column from the left that matters). Now it is still early days to reach any strong conclusions about where all this is leading, but the virtual evaporation of new credit in December is clearly worrying, and shows all the signs of constituting what is known in the economics trade as a “sudden stop” in bank lending, with the abrupt nature of the stop undoubtedly being a by-product of the acute funding crisis from which the Spanish banking system is currently suffering (see below for the explanation, but basically if you have no new money then you can’t make new loans). As I say, the Spanish banks have plenty of mortgages on their books, but what they don’t have (in sufficient quantities) is cash in hand, which is why they now need to queue up at the weekly ECB auctions to trade pieces of mortgage backed paper (otherwise known as cedulas) for cash. However, as many of the more observant banking analysts are already noting, this kind of situation was never anticipated when the banking structure known as the “eurosystem” (and which lies behind the paper money we have in our hands) was first devised and created. Yet without a longer term solution to the problem it is by no means clear where the Spanish banks are going to get the money they need to lend to their customers (or indeed, now that the housing boom is well and truly over, what the large volume of money which was previously lent would now be borrowed for). Even more to the point, if the Spanish banking system doesn’t succeed in finding a stable and sustainable way to attract the external funding it so badly need to square the books, how is Spain’s extraordinarily large external deficit going to continue to be financed?
Financial AND Economic Crisis
Perhaps the first thing to get absolutely clear in our minds right from the outset here is that the economic correction which is currently taking place in Spain is a very unusual one in terms of what we have become accustomed to in developed economies in modern times, since the transmission mechanism for Spain’s current difficulties does not run in simple one-way-street fashion from problems which have their source in the real economy (a correction in house prices for example, or a downsizeing of the construction industry, although both of these undoubtedly form part of the picture), nor does it run from an attempt by a central bank to “burst” some sort of perceived asset bubble or other (Trichet and the ECB’s tightening of interest rates), rather the mechanism operates via a direct blow-out in the cylinder-head-gasket of the global financial system, a blow-out which has produced an immediate and direct change in global credit and lending conditions, and in the level of risk appetite which prevails in the securitised mortgages/covered bonds sector of the wholesale money markets (leading to a situation where these markets are now effectively closed to Spanish banks) , and it is this change in financial and credit conditions which is now making its impact felt on the real economy in Spain, with the actual and present danger that these negative consequences for the real economy may then in their turn feed back into the financial sector, in the process creating some kind of ongoing lose-lose dynamic.
As I say, such a phenomenon is certainly unusual in a modern European context, although some may wish to point to parallels with what happened in Japan in the early 1990s, and the subsequent “lost decade”. I wouldn’t go so far at this point as to suggest that Spain is facing a lost decade, although the situation is very very serious (as I hope to show in the data and arguments that follow), and at the very least Spain now faces several “lost years” and a massive macroeconomic structural adjustment.
A Slowing Real Economy
So first of all let’s take a brief look at some of the macro indicators which may us get an idea of just what has been happening to the Spanish “real economy” in recent months. In the first place unemployment is up, and substantially so. Unemployment in Spain has now risen from something over 1.9 million in June 2007 to something over 2.5 million in February 2008. The figures were up year on year by some 9.9% in February.
Regional differences area also important, with the year on year rises being very strong in some costal areas, like Valencia (20%) and Murcia (30%). Basically the Spanish labour market was moving in a positive direction from January 2006 to May 2007, but then it turned in June 2007 (ie it was already on the turn when the “sub prime turmoil” started), and since June what we have effectively had has been a one way street of pretty bad news.
Strangely, while the economy has been slowing somewhat (in fact we have still really to see the slowdown reflected in the headline GDP numbers, since the economy apparently grew by 0.8% – or at an annual rate of 3.2% – in the last quarter of 2007) and unemployment has been on its way up, prices have continued to rise, and inflation has accelerated with the harmonised CPI for February coming in at 4.4% for the second consecutive month.
In this context of rising prices and rising unemployment it is hardly surprising that consumer confidence is taking a big hit, and if we look at the confidence index, we will find that despite registering some very slight improvement in February for the first time since April the general index, which stood at 76.8 was still very near to plumming all time historic lows (see chart here)
The European Commission has also reported a continuing decline in its eurozone â€œeconomic sentimentâ€ indicator for February, with the composite number for the whole zone reaching its lowest level since December 2005. The indicator, which gauges optimism across all economic sectors and is regarded as a reasonable guide to likely future trends, fell to 100.1 points in February from 101.7 in January.
While the picture across the eurozone shows considerable variation at this point with France holding up better than most, and Germany (as explained here) hanging on in better than I personally expected, Southern Europe seems to be having a much harder time of it. Italy is very much in the doldrums already, while Spain (along with that other “construction driven” eurozone economy, Ireland) is – as can be seen in the chart here – now registering a strong downward retreat.
But it is when we come to the real data that things start to get decidedly hairy. Eurostat have, for example, recently published the January retail sales data, and the Spanish numbers do not look good at all. Basically Spanish retail sales have now contracted in 5 of the last six months. In January they were down 1.1% on December (seasonally adjusted of course) and 2.4% on January 2007. If you look at the chart there is now a very strong clear downward trend (which resembles more what we have been seeing in Latvia or Hungary in recent months than the kind of data performance we are accustomed to getting from Western Europe), and the only real question is where this will now stop. The slide is evident. Basically this is a reflection of construction and banking sector issues gradually arriving and making their presence felt on the real economy.
Spanish manufacturing activity contracted again in February, posting its weakest performance in over six years, according to the most recent survey for the NTC Purchasing Managers Index (PMI). All five sub-component of the Index pointed to worsening conditions as both production and new orders fell in February following modest growth reported in January. The headline PMI, which measures the general health of Spanish manufacturing, fell to 46.7 — its lowest since December 2001 — from 49.8 in January, pushing it further below the 50.0 mark separating growth from contraction. The data from the manufacturing PMI is also pretty consistent with the latest industrial production data released by the Spanish Statistics OFfice (INE). Accoring to the release the Spanish Industrial Production Index – when adjusted for working day effects increased by 0.7% in January when compared with January 2007. Uncorrected the Index was down 0.2% year on year.
Activity in Spain’s service sector also fell to a record low in February as costs surged while business gave few signs of any kind of bounce back, according to the NTC Purchasing Managers Services Index. Though the headline PMI figure recovered to 46.1 from January’s 44.2, the figure was still well below the 50 mark which divides growth from contraction and was the second weakest reading in the survey’s eight year history.
And Then There Is Construction
I take it that it goes without saying that one important part of the problem which currently besets Spain is deeply ingrained in the contstruction sector, and even if in this post I want to concentrate attention on two of the more neglected areas of Spain’s current embarrassment – the real economy and the financial sector – I obviously can’t pretend to offer a complete analysis without some mention of what is happening in construction. One small data point here really says it all, and that is the estimate from the IPE business school that in March there some 500,000 unsold new homes in Spain – more or less the equivalent of one year’s residential construction output at the old pace. And of course the old pace is now history. Spain’s economy is not going to be able to get the old uplift by producing anything like 500,000 new housing units a year anytime in the foreseeable future.
We could also look at the December mortgages data, which, as was to be expected, saw a decline in both the value and the number of new mortgages (and it should be remembered that mortgages and construction were still being driven to some extent by the completion of old orders, ie those that predated the advent of the credit crunch in August 2007). The average value of the new mortgages created in December was 161,142 euros – down 1.9% on December 2006, although this number was in fact up 1.4% on November 2007. Perhaps more significantly the number of new mortgages (102,976) was down in December by 26.87% on November and 14.6% on December 2006. As a result of the reduced numbers of properties being newly mortgaged the total value of mortgage loans (16.59 billion euros) was down in December by 25.88% on November and 16.24% on December 2006.
We could also try looking at what Wolfgang Munchau calls his favourite current chart (although why anyone would call such an appaulingly depressing picture a favourite is beyond me) – the one originating with Bank of Spain data which shows how building approvals and permits have (and I quote Munchau) “fallen off the edge of a cliff since the end of 2006”.
As Munchau points out, at their peak in March 2007, house building permits were rising at an annual growth rate of 25 per cent. In the autumn of 2007, their annual change had dropped into the region of minus 20 per cent. The situation in terms of approved starts is even more dramatic, since these rose at an annual growth rate of close to 28 per cent in March 2007. By September the annual rate of change had fallen to minus 66 per cent. As Munchau adds, house prices have not fallen significantly in Spain yet, but this is surely only a matter of time, and especially when we come think about the large stock of unsold new homes (estimated as I say at 500,000, currently waiting on the books, and the drop in the number of mortgage loans mentioned earlier in this post.
Systemic Financial Crisis?
But now let’s get back to that cherry which is currently ever so smartly perched right on the top of our Spanish election Sunday pudding: the problem of how to provide sufficient liquidity to the banking system to square off the monthly balance of payments deficit. Now Wolfgang Munchau quite correctly ties-in the capital inflows which have been needed to finance the Spanish housing boom with the huge balance of payments surplus Spain currently runs (Spain needs in the region of 9 billion euros in external finance a month to keep this one afloat), but I’m not sure he has yet fully appreciated just what a problem for the Spanish banking sector – and indeed for the whole eurosystem – this financing problem can become, since while he quite reasonably draws our attention to the fact that in the Spanish case “there can be no currency crisis….since Spain does not have its own currency”, he omits to ask himself the equally pertinent question as to whether or not there could be a (euro-) systemic banking crisis instead? As I try to argue in some depth in this post the answer to that question is that there most certainly can.
Perhaps another data point would be useful here. The Spanish banks currently attend the weekly liquidity auctions at the ECB to raise something in the region of 48 billion euros of funding (a figure which is double the 24 billion euro number they needed before the summer). However, as Jean Claude Trichet insistently points out, “there is no question that the Spanish – or any other – banks are being bailed out” at this point. This, like so many of Trichet’s statements is entirely true. But it is not the whole truth. That is, there is a bigger picture. And herein lies the problem.
It is, for example, also true that the ECB has not changed its rules to accept mortgage backed securities (like the US Fed had to under pressure last August), but this apparent constancy in rules also stands alongside the fact that a banking system which didn’t need much recourse to the facility in question has now doubled its use of it, and in a very short space of time.
It is also true that Spanish banks were not allowed by the Bank of Spain to set up special purpose vehicles to finance their lending, but again, they created the cedulas hipotecarias system to find another way to do something which, at the end of the day, is not that disimmilar. The strong argument against SIVs is that engaging in off balance sheet lending is likely to lead banks to take on lending which is inherently more risky (as we are seeing with the US sub-primes), but in a certain sense (and as I try to argue and explain in my post here on the cedulas system) the cajas regionales have played a sort of off-balance-sheet-entity role for Spains leading and better known banks, and since we still don’t know how far down the value of the entire Spanish mortgage pool is going to fall, we have no way at this point of making a valid assessment of the level of risk that has been actually taken on board by these cajas. What we do know is that their lending has largely been financed by the generation of mortgage backed securities (cedulas) rather than from generating deposits, and in the aftermath of the Northern Rock fiasco this little detail alone should be enough to make people nervous.
On the other hand, it is also the case that the level of mortgage defaults in Spain is at this point comparatively small, but then again the whole process of deterioration in the real economy is only just starting, so it is far to early to say at this point whether or not cover will prove adequate in the longer term, but then again, the problem for the Spanish banking system may not originate in defaults in the first place, but rather from a perceived rise in their risk rating if the value of the entire pool of mortgages on their books starts to decline significantly.
So Where Is The Problem?
Well if we want to get a first measure of what kinds of problem are looming in the Spanish banking system we could think about the level of incoming bond purchasing Spain has benefited from in recent years (and we can get reasonably accurate information on all of this thanks to the monthly balance of payments data made available by the Bank of Spain). The Spanish bonds boom really took off sometime in 2002, and it came to a sharp and rather unfortunate end in the middle of 2007 (I would say on or around the 9 August to be precise). In any event the height of the boom was in 2005, 2006 and the first half of 2007.
This take off date for the Spanish bonds boom is hardly accidental, since it more or less coincides with the arrival over a sustained period of negative interest rates in Spain (since with the ECB refi rate at 2% and Spanish inflation in the 4% range, real interest rates were running around the minus 2% level, a rate at which it would almost seem foolish not to borrow money and invest in a house or flat whose price it seemed would never stop rising). So this one simple fact explains to a considerable extent the intensity of the Spanish housing boom.
However since the “financial turmoil” started in August last year, demand for Spanish mortgage-backed bonds (the so called cedulas) has all but dried up. The weak performance in recent months has not been the first time that capital inflows to Spain have “wobbled”, but this time the wobble is much more sustained and, since the wholesale money markets are at this point effectively closed to the Spanish banks, there are good reasons for imagining that this time round the change will be a much more lasting and even permanent one.
Now, why, apart from the implications for the banking system, is all this so important for Spain? Well let’s think about another part of the problem, the current account deficit one. The fact of the matter is that the sustained consumer boom which developed in association with the construction one had a long term and pretty disastrous impact on Spain’s external trade balance (and in particular on its energy component, all those extra houses use energy remember). And this deterioration in the external trade position has remained, and arguably gotten slightly worse, even as the economy has started to slow down.
In the past, as I have been saying, this deficit has been offset by the sum total balance of funds coming in as part of the financial account, but this is precisely what has dropped off since August last year.
The consequence of this is that Spain’s banks are increasingly having to find the money they need to make the books balance via the eurosystem, and this is basically the significance of that increase in borrowing that the Spanish banks have had to undertake at the weekly ECB auctions (referred to in this post ). The evolution of the net asset and liability position of the Spanish banks vis-a-vis the eurosystem has been totally transformed in recent months, and the underlying position has moved from one where the fluctuations in Spanish bank liabilities towards the system showed no particular trend to one where there is now a large and constant increase in the amount of money borrowed every week by the Spanish banks from the eurosystem (presumeably largely or exclusively at the ECB auctions), and this money is essentially needed to settle the monthly deficit in the balance of payments account.
As I say, prior to August 2007 the movements in asssets and liabilities showed no particular trend, but since August, and for every month for which we currently have data, the Spanish banks have needed to raise additional money at the ECB. This is really a direct result of the fact that the banks have been unable to sell their cedulas for cash in the global markets. What the Spanish banking system lacks right now is a way to generate cash on a stable basis to meet the needs of the current account deficit.
Now as I have been regularly pointing out, another of the very specific features defining the way in which the property boom was financed in Spain lay in the ability of the Spanish banking system to provide very low interest (variable) rate mortgages. Curiously, many commentators imagined that this (variable) component constituted the greatest risk element in Spain. That is, they imagined that it was Spain’s mortgage borrowers (or homeowners) who were assuming the greater part of the risk, and that the risk lay in the danger of ECB base rate increases of the kind we had been seeing before last August. As it turns out they were wrong. Risk at present has almost all been inadvertently assumed by Spain’s banking system, and this decidedly odd situation has arisen (I’m sure this was never the intention) due to the widespreade recourse of Spain’s banks to the use of securitised (or covered) bonds – the so called cedulas – to finance lending and to the offering of variable rate mortgages to clients at very narrow margins (lets say around 0.75% or 1% over 1 year euribor). Now the banking system considered it was onto a sound bet here, since the banks in their turn could borrow (thanks to the investment AAA grade often assigned to these bonds, which made them virtually equivalent to government paper) at very favourable rates themselves (normally three month euribor). This they felt meant they were treading on very solid ground. Again they were wrong, since it is just this very global repricing of risk appetite I mentioned earlier, and the reassessment of the AAA rating which was previously assigned to their mortgage bonds which goes with it, which has produced the problem.
Oh, yes, and there’s a third little detail which makes all of this just that little bit worse. The different term structures of the lending and the borrowing. Basically the Spanish banks, and especially in the current context the regional cajas (since these cajas have undoubtedly been landed with the lions share of the problem), borrowed short and lent long. The majority of the mortgages issued between 2000 and 2007 had a duration of between 20 and 30 years. Indeed during the last two years of the boom it even became fashionable to offer mortgages over 50 years, so sure did the banks feel of themselves.
But as I say they borrowed short. Not of course the very-very-short-liquidity type borrowing that we are increasingly seeing Spanish banks having to resort to as they stand in line at the ECBs weekly money auctions, but rather a five to ten year horizon which was used to generate the lions share of their funding, and which was done via the creation of cedulas. That is to say, while the vast majority of the mortgages issued will still be outstanding come 2025, almost all of the bonds which go with them will need to be refinanced long before, and in particular during the years between 2012 and 2017. And here is where we hit the snag, since the money markets which the Spanish banks need to do the refinancing are currently closed to them. These money markets can of course be reopened, but they can only be reopened at a price (ie the price of paying a risk premium), and that is really the bigger half of the snag, since while the debtors are on supposedly “variable” mortgages , these are effectively fixed to a barometer over which the Spanish banks have no influence (normally they are at 1 year euribor plus something, euribor can of course go up, but it can also come down, as I think we are about to see in the next moves at the ECB). So the borrowers, it turns out, really do have a yardstick that lets them know what they are into. This is not the case with the lenders (the banks) however, since while we do not know what eventual risk premium will be built into the funding of Spanish banks (this in part depends on how far and how fast property prices fall, and how much difficulty the banks have in maintaining their mortgage pools), we do know that the days when they could fund them at a simple euribor 3 month rate (y punto) are now well and truly over, and we could even contemplate the possibility that if bad goes to worse, and even worse, and then worse again, then they could be asked to pay out even more than they are receiving in income from their mortgage paying clients!
And the amounts of money are not small. One good recent estimate put the total quantity the banks will need to “roll over” in the space of about 5-7 years at some 300 thousand million euros.
A country with a large and sustained current account deficit – as we can see in the case of the United States – can do one of two things. It can tighten money and credit conditions in order to try and use an indirect method to slow internal demand, or it can allow the value of the currency to slide (as we have seen and continue to see in the case of the dollar) in a direct attempt to reduce the deficit. But, as Munchau pointed out, Spain has no autoctonous currency of its own to let slide, so the only real alternative is to squeeze internal lending to try and reduce the deficit, and in the meantime lean on the ECB for money. The contraction in lending needed to reduce a deficit of this magnitude is most probably going to be very large indeed, and the consequences for the real economy may well be substantial, so it is to be anticipated that in the short term some other makeshift alternatives will be sought. What these alternatives might be are currently a complete mystery, since for reasonably obvious reasons little of the discussion which must currently be taking place behind the curtains has found a public airing at this point, even though we in Spain have been living though what was otherwise a heated electoral debate. All we can do is watch, stupefied, and wait, as the organisers of the concert prepare to emerge from their cabal to let the public in general know what gets to happen next.
So as Spaniards survey the outcome of last weekends polls they might like to reflect on this thought. Given what we have seen in the course of this post, Spain would appear to be currently running the risk of being the first modern developed economy to suffer the twin issue of a sudden-stop in the credit system and a dramatic slowdown in the real economy at one and the same time, yet in the seemingly interminable election debates which have taken place over the last month or so this singular and intriguing little detail has scarcely been mentioned. Of course there has been plenty of talk of the “construction slowdown”, and plenty of finger pointing about who exactly is responsible for it, but the full measure and extent of the problem has been scarcely aluded to, even in the faintest whisper. Yet one of these days in the not too distant future someone is going to have to emerge from behind the curtains to let the rest of us all know just what the plan actually is.