Spain: The Regional Maginot Line?

Julian Pendock|Partner, Senhouse Capital
Thursday, 14 Apr 2011 | 5:17 AM ET

Back in 1997, Thailand commenced its own banking crisis. The conventional wisdom was that the Thai economy was too small to affect other countries in the region. Nevertheless, the Asian crisis was soon in full swing, bringing down governments and moving from South East Asia to the whole of the region.

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Talk of cultural differences that were utilized to explain the “Asian miracle” were put aside, echoing the de-rating of the “Japanese miracle”.

In other words, we have been here before.

Talk of the “Spanish miracle” came to an abrupt end as once again, history may have not repeated itself, but it certainly rhymed.

The key linking all three “miracles” was excessive leverage (debt). Typically these ultra boom-and-bust cycles are brought about by a combination of loose fiscal policy, often accompanied by negative real interest rates.

The creation of the euro zone was always conceptually flawed as the euro was a political, rather than economic, construct. The interest rates were set at an appropriately low rate for Germany, which led to negative real interest rates in European periphery countries (the PIIGS or Portugal, Italy, Ireland, Greece and Spain).

In the absence of any federal balancing legislation, the euro did not conform to generally accepted criteria of being an “Optimal Currency Area”.

The housing boom in many PIIGS was rational given the highly negative real interest rates. The tax receipts from the construction, and buying and selling of houses, led naturally to profligate government spending , as no government would want to “take the punch bowl away”.

As typically happens during bubbles, misallocation of capital takes place on a substantial scale. The TMT bubble implosion was worked through quickly as the froth came rapidly out of the equity market, and replacement demand meant that TMT products were again ordered quite rapidly, although the sector was permanently de-rated (and many European telco shares offer very high dividend yields, and low valuations).

The key in whether the European debt crisis will spread to systemic contagion, depends on confidence. The words of politicians and bankers extolling confidence about the solvency and liquidity of the banking systems and /or government’s debt position achieves little, because expressing any doubts about the health of the system spreads self-fulfilling panic.

In the UK, one Northern Rock depositor memorably said: “I only started to panic when the government said that there was nothing to be alarmed about”.

Reasons have been trotted out by a wide variety of commentators as to why each “bailed out” nation has been bailed out.

The first point to make is that the various mechanisms to solve the problem of excessive debt, by loading countries with yet more debt, threatens to exacerbate the problem, not solve it.

The economic rule of thumb is that in order to pay off debt, once a crushing level of debt is taken on board, nominal GDP has to grow at a faster rate the rate of interest paid on that debt; otherwise, the debt: GDP ratio will continue to climb. The “solution” also confuses a liquidity problem with one of insolvency, and unfortunately the periphery countries are plagued by the latter issue.

The second point is that the more a nation can rely on internal demand for debt, the greater the amount of debt it can service. Japan is a classic case of this, but must start to seek foreign buyers of its government debt from 2014. So far, the periphery nations that have been “bailed out” have stagnated at best, or contracted further.

Euro coin in front of the giant symbol of the Euro outside the headquarters of the European Central Bank.
Thomas Lohnes | AFP | Getty Images
Euro coin in front of the giant symbol of the Euro outside the headquarters of the European Central Bank.

The history of manias and crashes tells us that economics is not an exact science; the world can be explained by various equations only within certain parameters.

Outside of these parameters, the world becomes infinitely more difficult to predict. Investors should, however, bear in mind that unsustainable debt levels and absurd house price increases were in plain view for years before the bubble burst.

In terms of the future, France and German will try to muddle through because French banks had $493 million exposure to the periphery nations in 2010 and Germany had $465 billion. The “core” EU will do everything they can to protect their assets in Southern Europe.

Banks have also shifted most of their holdings of sovereign debt into their “banking book” from their “trading book” (by some estimates, 92 percent of Spanish sovereign debt has been moved onto the “banking books”).

The “banking book” does not have to be marked to market and therefore is not included in the EU’s delusional banking “stress test”. Expect bankers and politicians to keep on making very positive noises about the health of periphery economies and their banks, because they are plainly linked via sovereign debt.

There is little point on dwelling on the differences between Portugal, Ireland and Greece. The point is, has the problem been contained at the borders of Spain?

Spanish total non-financial debt stands at 354 percent of GDP which compares unfavorably with Portugal at 415 percent but favorably with Greece at 275 percent. However, Spain has youth unemployment at a staggering level of 40 percent and many of those surveyed wish to leave Spain; this would be a disaster for a country already stagnating.

Rather than pile on more debt, and suffer “internal devaluation” i.e. more wage deflation, more government spending cuts and lower GDP, surely the answer is for an orderly “haircut” (i.e. forgiveness of at least some debt) in the near future. This would give those countries’ economies room to breathe and grow once more, in a similar way that in the US, companies that file for bankruptcy under Chapter 11 get time to put their house in order once again.

Otherwise, in any one of these countries, it takes only one politician to point out that the country is spending more on debt owed to foreigners, say, than on education, which is of course a valuable investment in the next generation.

Ireland is already coming close to this; in 2007 the country paid 6.1 percent of its GDP on health and in 2012 the country will pay 5.7 percent of GDP on health.

A populist movement as “austerity fatigue” sets in, could lead to default and rapidly spread to other countries, leading to systemic default and another banking crisis. Recent events in Northern Africa and the Middle East have shown the potential for contagion.

Each periphery country that has been “bailed out” was viewed by the market as being OK until the market suddenly decided otherwise. The Spanish government’s optimistic assessment of regional Cajas’ (the local savings banks) capital requirements allied to surprisingly low levels of reported impaired assets by Spain’s banks does not engender great confidence; on a per capita basis, Spain has three times as many unsold residences as the US, and Spain’s banking reliance on the opaque ECB has been estimated at 80 billion euro.

If the EU script is played out in a similar fashion to the past, there could be an event that spooks the bond markets, and once again any panic-selling of government debt will be blamed on hedge fund “vultures”.

The author is Julian Pendock, partner at Senhouse Capital