- Written by John Mauldin
- Monday, 22 February 2010
The Pain in Spain
That of course brings us to the elephant in the room – Spain. While the eurozone can survive a Greek default or a serious Greek depression, Spain is another story. Spain is a very large country whose deficits, if not brought under control, could in fact tank the euro.
Spanish leaders have been all over Europe, loudly proclaiming that they are not Greece. However, their current fiscal deficit is in the same league (9%), and they have other problems. And just as Dennis and David disagree, this week I had two reports on Spain hit my inbox the same day, from two of the groups I respect the most. And they do not agree abut the future of Spanish debt.
The first was from the European team of the Bank Credit Analyst. I have been reading BCA for decades, and they have a real knack for being right. I pay attention when they write something. They are a serious research firm, and consult with the biggest firms in the world. It is not an exaggeration to say the central bankers pay attention to them.
And they think Spain is going to work out. Let's look at a few paragraphs from their latest report:
"Listen to the current market commentary and you might be forgiven for thinking that history is repeating itself. We don't want to minimize the country's woes. Unemployment has after all just breached the psychologically brutal level of 4 million.
"But much of the analysis is backward looking. What the markets fear has already happened. A rerun of the Greek debt crisis is not inevitable, Spanish bonds are cheap relative to Bunds and many of the cyclical imbalances are on the mend. Spain has already undergone 18 months of painful economic adjustment. The current account deficit in relation to GDP has more than halved to 4.6% from its peak in 2008, when in absolute terms it was the second highest in the world after the US.
"The budget shortfall is beginning to roll over, a reduction plan is in place and the public debt-to-GDP ratio is 60%, barely more than half the Greek ratio. Most importantly, the inflation rate has converged with the euro zone average, one of many indicators confirming the decade-long adjustment to membership of the currency club is complete.
"Spain does not fit well into the caricature of a two speed Europe, with the south on a slow, unsustainable growth path. Its demographic profile is far more propitious to economic growth than Germany or France, never mind Greece and Portugal, and its policy makers are in many instances more vehement about the need for financial discipline. After all, it was Spain which recently attempted to get the EC to agree to penalties for countries that did not hit their economic targets, only to be blocked by Germany. If there is to be a euro crisis, it is not going to be Spain that causes it.
"... The shakeout in the labor market will bring a sharp short term jump in productivity, with policy changes providing additional help thereafter. Immigration creates the potential for Spain to grow its way back."
It was just a few months ago that I published a report from Variant Perception on the serious problems of Spanish banks. Spain has almost 20% unemployment and the government deficit is almost 9%. They have a trade deficit of 4%. Real GDP is down by 5%. Getting back to growth and a less severe government deficit is going to take some serious willpower from a socialist government. So I was glad to read that someone I respect as much as BCA thinks things will work out.
Then I read a short report by Ray Dalio and the team at Bridgewater. It is hard to get their work, but every now and then someone gets me a copy. I don't know Ray, but I have serious respect for his work. I am a huge fan. He is one of those men about whom the word brilliant can be used without risk of exaggeration. Bridgewater manages $80 billion or so for some of the largest institutions in the world. ( www.bwater.com)
So what do they write about Spain? They are not as optimistic.
"[because of the recession] ... the Spanish government decided to run big budget deficits that have been funded with big borrowings, but the more the debt increases, the closer this approach is to coming to an end. As of now, conditions are tenuous but acceptable because most investors a) are used to thinking of Spain as being safe and not having wide credit spreads and b) have been inclined to pick up yield by holding debt that was generally considered safe, so they funded these deficits with narrow credit spreads.
"We do a lot of work estimating what a country's credit spreads should be in light of its cash flows and asset values and have made more than a few bucks doing this. Based on these criteria, we judge Spain's actual credit spread to be just about the narrowest relative to what it should be on the basis of its fundamentals -- i.e., the spread is 1.4%, and we would assess the fundamentals to warrant it to be 6.5%, on the basis of fundamentals alone.
"We judge Spanish sovereign credit to be much riskier than is discounted because it seems to us that there is a high risk that Spain won't be able to sell the debt that it needs to fund its deficits, and there is virtually no chance that the government can cut spending (nor does it want to). That is because a lot of debt is coming due; the Zapatero government is weak, very socialist and supported by a collection of factions (e.g., those in states seeking independence); and the Spanish people are now politically fragmented and only care about what money the government is going to give them. Also, the private sector debt problems have largely been kept under the rug rather than dealt with via restructurings.
"In other words, 1) Spain has big debt/deficit problems; 2) it is not dealing with these problems by doing the tough, forthright things to alleviate them; 3) it doesn't have the printing press to avoid the risk of default (unless the ECB helps them); and 4) it has a narrow credit spread. Situations like this, in the past, have been associated with both debt rollover and capital flight problems.
"... Spain's external debts, have exploded without a significant offset of external assets. On net, Spain owes the world about 80% of GDP more than it has external assets. As a frame of reference, the degree of net external debt Spain has piled up in a currency it cannot print has few historical precedents among significant countries and is akin to the level of reparations imposed on Germany after World War I. We don't know of precedents for these types of external imbalances being paid back in real terms.
"On top of the debt that needs to be rolled, Spain's cash flows (current account and budget deficit) are extremely bad. Spain's current living standards are reliant not just on the roll of old debt, but also on significant further external lending.
"For these reasons, we don't want to hold Spanish debt at these spreads."
And this, gentle reader, brings us to the heart of the problem. These are two very smart research houses with opposite conclusions. Having disagreements is not all that unusual. Disagreements are what makes for horse races and markets.
But the difference is in essence the same disagreement that David and Dennis have. It is one of political nuance. BCA thinks Spain will get its act together, and Bridgewater does not, or at least not until its hand is forced by the markets (my assumption, not theirs).
The amount of pain that Spain must endure to get it fiscal house in order should not be underestimated. Wages are going to have to fall relative to northern Europe for them to be competitive. The dependence on government is going to have to be reduced. This is not going to be easy for a socialist government with a very thin coalition.
And that brings us back to Greece. While Greece can be readily bailed out (assuming they accept large budget cuts) because it is small, Spain is too big to save. The European Union cannot set the precedent that countries that do not set their fiscal houses in order will be bailed out by countries that do.
This is the nature of the End Game I have been writing about. The decisions are now political. How do we unwind the debts and the leverage? How much pain do we postpone and how much do we take on today? It is the same question for much of Europe, Great Britain (serious problems there), Japan (which is a bug in search of a windshield), and the US. We now have a limited number of path-dependent options. By that I mean the political paths chosen by the various governments will dictate the economic path we go down.
How Much Is Too Much?
And to close, I want to show a chart from today's Wall Street Journal, from a column by Daniel Henninger.
This is the definition of an unsustainable path. Spending has grown 7 times as much in real (inflation-adjusted) terms as median household income over the last 40 years. Like Greece and Spain and much of the rest of the developed world, we will be forced to make hard choices. We cannot afford to do everything that even conservatives would like, let alone liberals. We cannot fight two wars, increase spending on health care, stimulate a faltering economy, and fun a 20% explosion in federal employees in just one year, etc., etc.
Pay attention to Greece and Spain and especially Japan over the next few years. Unless the US gets its fiscal house in order, we will be next. It will not be any easier for us in five years than it is for Greece today.John Mauldin, Best-Selling author and recognized financial expert, is also editor of the free Thoughts From the Frontline that goes to over 1 million readers each week. For more information on John or his FREE weekly economic letter go to: http://www.frontlinethoughts.com/learnmore