Sunday, April 22, 2012

Spain's Financial Crisis

"...Spain enjoyed a construction splurge in the middle of the last decade, egged on by low interest rates that were appropriate for the German economy (sluggish at the time), but not for a country where credit was growing fast. Just as the US credit bubble was helped by low rates driven by Chinese demand for US Treasury bonds, so Spain’s domestic property bubble had its roots abroad.

But why is Spain now in crisis, while the US is not? Because its banks have not yet admitted the scale of the writedowns they must take in the wake of the bubble. In terms of their book value (the value of assets minus liabilities on balance sheets), Spain’s banks have multiplied eightfold since 1998, according to an analysis of MSCI data by David Morris of Global Wealth Allocation in London. That is twice the growth for the rest of Europe, and 80 per cent more than in the US.

Meanwhile, Spanish banks’ earnings are at about half their peak levels, much as in the UK and the US. The difference is that in those countries earnings are recovering after taking huge writedowns to take account of the burst credit bubble. Spanish banks have yet to do this, and the market plainly expects more writedowns before they
are done.

The news of the past few weeks shows that this is ever harder to postpone. House prices are falling. Spain’s banking regulator also announced that non-performing loans had risen to 8.16 per cent of banks’ portfolios, the worst figure in 18 years. Entering the crisis, less than 1 per cent of loans were non-performing.

Meanwhile, implementing the kind of austerity demanded by markets and by other European countries will be tough. With unemployment anchored at more than 20 per cent, Spaniards are feeling the pain already. Other countries making cuts, such as Portugal and Ireland, benefit from a strong sense of cohesion. This is not true of Spain, which devolves power to regions that feel strongly independent of each other and often speak different languages. (Just watch this weekend’s match between Real Madrid and Barcelona, which pits Catalonia against Castile.)

All of this explains why attention is back on Spain. There is plainly good reason to be concerned about the country. But has the market adequately priced this?

The stock market is certainly pricing very bad things for Spain, even as the recovery in asset prices elsewhere continues with only a mild pause. At its worst this week, the Ibex 35 index was barely
3 per cent above its low for the crisis, set in March 2009. (The S&P 500 in the US is about double its crisis low.) The Ibex is no further forward than it was in early 1998.

So the market is plainly alive to the risks for Spain. Given that this crisis has not been accompanied by a wider sell-off (unlike the global sell-offs that accompanied crises in the far smaller economy of Greece), there is obviously a conscious bet that there will be no broader Spanish contagion. Alternatively, traders believe that their bets against Spain are enough to hedge against the risks to the eurozone as a whole.

Is that a good bet? It certainly shows faith in the ECB and its ability to nurse Spain’s banks through their problems. It also shows confidence in Europe’s politicians outside Spain.

It is hard to see how Spain could be rescued with the funds the EU has available for the task. That is why the International Monetary Fund is drumming up more. It is a decent bet that one way or another the rest of Europe will find a way to stop a Spanish banking crisis from turning into a broader meltdown; but there is ample scope for markets to get nervous about that judgment, and push down prices, in the months ahead."

- FT
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