Thursday, 7 June 2012

Bracing for Impact!

The ongoing sagas in Europe can seem at times like a multi-car pile-up.  It begins with just a car or two spinning in circles after having been swiped but soon escalates as drivers are surprised by what they encounter.  Onlookers try to warn the oncoming traffic but the drivers are distracted and everything seems to happen in slow motion.  Just as people wince as they wait for what seems to be a major collision (fresh elections in Greece on July 17th), eyes are averted to the potential for even more carnage – a banking crisis in Spain.

The turmoil in Greece and Spain appear similar but stem from different causes.  The government in Greece had too much debt before the global financial crisis came crashing into our living rooms.  The Greek government had borrowings of more than 100% of GDP in 2007 and this quickly rose to over 160% of GDP in the four years as tax revenues plummeted and government spending proved difficult to trim.  The government in Spain, on the other hand, was comparatively a model of virtue with debt of than less 40% of GDP in 2007.  Even as worries mounted, the level of government debt in Spain was still less than 70% in 2011. 

Yet Spain has been shunned by investors due to concerns over its banking sector.  Spain has fallen victim to a property bubble and it is typically in banks where the first symptoms show.  People or companies take out a mortgage using their new real estate purchase as collateral, and when prices are rising, everyone is happy.  However, when the market turns sour, property prices drop and prospective sales are not enough for the banks to recover the value of the debt. 

Dealing with a banking crisis like this is tough enough as it is.  The government needs to shovel money into the banks to stop them from collapsing under the weight of all the bad debts.  Write-offs are required for money that won’t be recovered and considerable time and effort is necessary before banks can get back to operating as per normal.  Typically, the government would just step in and put up the money to bolster the banks.  Bankia, Spain’s four largest bank, was recently bailed out by the government at a cost of 19 billion euros with the rest of the banking section expected to need around another 45 billion euros.  Compared to the level of government debt in 2011 of over 700 billion euros, putting up the cash is manageable and the debt to GDP ratio would still be less than 100%. 

Yet, Spain has more obstacles in the road in front of it than just a banking crisis.  The high interest rates on Spanish government debt (around 7%) means that the government doesn’t have the access to the funds it would normally have.  And the government is short on cash as it cuts spending to lower the government deficit.  To add to this, the economy is in recession with real GDP expected to fall by 1.5% in 2012 and 0.1% in 2013 with the austerity measures and banking crisis likely to make things worse.  The deteriorating economy also hits property prices, exacerbating the problems at the banks.  And on top of all this, the possibility of Greece dumping the euro means that Spaniards are taking their savings out of the banks and putting it under their mattresses due to worries about a return to the peseta.

As well as being short on funds, the Spanish government has lacked the creditability in dealing with its banks after having underestimated that cash that would be needed to bolster Bankia.  Help is on offer via a bailout for its banks from Europe and the IMF but Spain is wary.  While the money would be welcome, the conditions would not be and the saga in Greece are a reminder of this.  There have been some positive moves such as deliberation over whether Spain should be given an extra year to reduce its deficit to 3% which would help (as suggested previously – Spain and the Long Hard Slog).  But with both Spain and Greece now playing chicken with the leaders of Europe to try and ease their share of the burden, expect the carnage to mount.