Making Plain the Rain in Spain: A Cheat Sheet on Spain

On June 25, Spain officially requested an aid package from European finance ministers to recapitalize its ailing banking sector. More than 3 ½ years after the 2008 financial crisis, many Eurozone economies are still struggling with large public and private debt burdens and Eurozone leaders have, thus far, failed to develop policies to restore both investor confidence in sovereign debt and economic growth in the region.

Spain’s troubles indicate that the European debt crisis has moved to a more dangerous stage. A growing number of economists and investors believe time is quickly running out for European leaders to take more definitive steps to solve the immediate crisis and to better integrate the Eurozone to prevent future problems.

This paper explains the situation in Spain, and what it could mean for our economy.

What’s going on in Spain?

On June 8th, the IMF estimated that Spanish banks needed at least €40 billion (about $50 billion) in additional capital to repair their balance sheets and prepare for future losses.¹ This led the Spanish government to request an aid package of up to €100 billion ($126 billion) of fresh capital from European finance ministers. European leaders are concerned about Spain’s potential to be the next Greece; defaulting on loans, sending the continent into a deep recession, and threatening the survival of the euro. Thus, they agreed to a package over twice the size of what was deemed necessary to “shock and awe” the Spanish financial sector back to health by inspiring confidence in Spanish financial and government institutions.

Why is Spain in so much trouble?

Three words: real estate bubble. Spain’s housing boom and bust was worse than in the United States—housing prices tripled in Spain from 1997 to 2006, whereas U.S. housing prices doubled during our boom.² During this period Spain’s listed banks and small savings banks (cajas) grew rapidly, predominantly through real estate loans to developers. Most of these loans have now gone bad. In fact, on June 18th the Spanish central bank announced that 8.7% of all loans—not just real estate related loans—at Spanish banks (totaling €152.7 billion) are over 90 days delinquent.³ By comparison, loans over 90 days delinquent peaked at 5.7% for banks in the United States after the financial crisis.⁴

Spanish regulators and politicians have been slow to recognize losses in the banking system. When banks are in trouble, they don’t lend. No lending; no business expansion or job growth. This is a major reason why Spain is currently mired in a deep recession.

How bad is Spain’s debt problem?

In some ways, not as bad as much of Europe. Spain’s debt to GDP ratio was 72% in the first quarter of 2012, well below the Eurozone average of 88% (end of 2011). However, Spain’s 17 autonomous regions (roughly the equivalent of our states) have issued €145.1 billion of additional debt, equal to 13.5% of combined GDP, and these debt levels will surely increase.⁵ And due to the bursting of its housing bubble, Spain’s budget deficits have risen sharply from 3.8% of GDP in 2008 to 8.9% in 2011.⁶

The Spanish economy is now in a deep recession with limited immediate growth prospects. One-quarter of the population is unemployed, and the IMF expects economic growth to contract almost 2% in 2012.⁷ In addition, rigid labor market laws make hiring less attractive for business, and austerity policies at both the federal and regional level have impeded recovery. Economic uncertainty is a wet blanket for business expansion and uncertainty is rampant in Spain. As a result, foreign investors are wary of purchasing Spanish bonds—leaving Spanish banks as the main buyers of Spain’s sovereign debt over the last six months. This has pushed borrowing costs towards unsustainable levels and made the banking system less stable.

Is the bailout working?

Market reaction to the initial announcement has not been positive. Though Spain officially requested the aid package on June 25, a tentative agreement was announced on June 9. But the yield on 10-year Spanish bonds rose to a Eurozone record high of 7.3% on June 18—soon after the deal.⁸ The market views yield as compensation for risk. The higher the risk, the higher the yield. 7% is better than 28% for Greece, but it is a real danger zone. Greece, Portugal, and Ireland each had to seek bailouts from European finance ministers once the yields on their bonds reached 7%.

A key reason for the poor market reaction is that the terms of the bailout have not been finalized. If the deal is structured as a loan to the Spanish government—which many analysts expect to be the case—then the bailout package will significantly increase Spain’s debt to GDP ratio. Further, this new loan could be senior to previously issued Spanish debt, meaning that the loans to be extended to Spain for its banking sector would have to be paid back before other creditors get paid in the event of a Spanish default. This makes previously issued Spanish bonds more risky and less valuable.

These factors would put even more pressure on Spain’s fiscal position and hinder its ability to access the market—likely leading Spain to seek additional funds from the European Union, the International Monetary Fund, and the European Central Bank to avoid default. A Spanish default, of course, is what European leaders are expressly trying to prevent.

Why does Spain matter?

Spain’s economy is almost 5 times the size of Greece’s economy, and Greece mattered. Spain has the 4th largest economy in Europe—almost twice the size of Greece, Ireland, and Portugal combined.⁹ A Spanish default would consume most of the resources European leaders have set aside to rescue faltering economies. In addition, European banks have a lot of exposure to the Spanish economy, including Spanish government bonds. These banks would take a serious hit if Spain defaults, adding pressure to an already strained European banking sector. The fear is that economic troubles in Spain are contagious—likely to spread to other European economies.

Contagion? How contagious?

This is a matter of great debate. Is it Outbreak or the swine flu? The concern is that economic or financial problems in one country can spread to other countries in the same region or with similar economic characteristics. Since Germany is the only major European country where there is growth and where investors are comfortable that sovereign debt can be repaid over time, the concern is that a Spanish default would put pressure on the sovereign debt of other large and important struggling European economies with little prospects for short-term growth.

Italy is the most likely candidate to catch the Spanish flu next. Italy’s economy is the third largest in Europe, the 8th largest in the world, and is the size of California. While Italian banks are not the problem—they are in much better condition than their Spanish counterparts—Italy’s economy has been stagnant for five years, and its debt to GDP ratio of 120% is the highest in the Eurozone after Greece. Financial markets are already focused on Italy, with Italian 10-year bond yields hovering around 6%. And markets are unlikely to stop at Italy; France could become next in line. It is highly questionable that Europe has the resources to bail out Italy (let alone France) if it becomes necessary—at least under current political and institutional conditions. In short, a Spanish default could be the tipping point that tears the euro apart, with the whole European integration project possibly disintegrating.

Could the contagion spread here?

The U.S. is in a much better situation than Europe. Our banks are much healthier, our economy is growing, and (believe it or not) our political system functions better. But we are vulnerable in today’s interconnected global economy. The current situation in Europe is unprecedented, and a crisis in Europe would be felt on our shores.

Some vulnerabilities are easier to see than others. For example, the European Union is the largest trading partner of the United States, and accounts for 25% of global trade.¹⁰ A deep recession in Europe would be felt worldwide, slowing many economies that are important to U.S. businesses and reducing U.S. exports.

In addition, U.S. banks have over $600 billion in exposure to Europe, with almost $200 billion of that total involving European banks.¹¹ Further, because credit default swaps are not traded on an exchange, there is no way to know the full exposure of U.S. banks to massive European defaults. Still, U.S. banks are far better capitalized than three years ago. They can sustain losses and still lend, and much of their exposure to European banks is likely secured, short-term lending.

A full-blown crisis in Europe would dampen confidence worldwide. The U.S. economic recovery is still fragile. Strong headwinds from Europe would hurt confidence here, making economic growth more difficult.

Will the Euro survive?

There are a variety of opinions. But it gets really dicey if the euro collapses. There are many reasons the euro could dissolve, but one is that the Eurozone, as currently designed, is flawed. The 17-nation Eurozone has a common currency but not a common fiscal, political, and cultural union like the United States. There are vast economic differences between a member state like Greece and one like Germany. And during stressful economic times, the Eurozone acts as a straightjacket for many struggling European economies that are trying to restore growth and competitiveness. They simply do not have the authority to print money, create inflation, or do the many things countries do independently to rescue their economies.

What’s keeping the euro in place is the alternative. Economists believe the end of the euro would have a significant impact on the functioning of the global economy. The euro is the second most widely held reserve currency by central banks, and many contracts throughout the world are denominated in euros. If countries left the euro, turmoil would ripple through the commercial and financial sector as all euro-denominated contracts for the country in question will have to be revised. Courts would be called in to fix these contracts, and it is unclear what the results would be. Such uncertainty would have serious negative repercussions on confidence and business activity in Europe and throughout the world—including America.

Perhaps the single biggest reason the euro is still likely to survive is the euro is a dream of a more integrated Europe, permanently at peace, with open borders, open trade and open migration. That is a hard dream to give up.

Conclusion

European leaders are meeting this week to attempt to right the ship. Discussion will center on the need for the Eurozone to integrate further and the potential for mutualization of Eurozone debt—that is, having all of Europe share in the debts of some of Europe. Topics will include the formation of a Eurozone-wide banking union, including supervisory responsibilities and a deposit insurance scheme as well as the potential path, if one exists, toward fiscal federalism. These are not easy decisions for Europe to make. Germany has vastly different views than France, Italy, and Spain and there are differing opinions of what is needed. Whatever is decided, Spain and Europe matter to the U.S.