The gain of Spain goes mainly down the drain

OK, you got me: I know I am by my own rules supposed  to start these posts with a (supposedly) funny cartoon, but it so happens that drawing takes a lot of time. Sometimes it cannot be found and, worse, there are real-life graphics incomparably more hilarious than any cartoon I can draw. Just check out these prices!

Spain is a medium-to-small country with a tendency to punch above its weight. Its footprint in History is absurdly large in proportion to the extent of its technical, military or financial capacity. This has left a permanent yearning for a bigger weight in the world’s affairs in the the subconscious mind of its citizenry. Time might have come again for this, if not in the sense that it’s probably hoped for.

Just as in the mid thirties Spain became the stage of a bloody rehearsal for WWII  while the world didn’t really care, these days the economy of a seemingly unconcerned Europe teeters at the edge of an abyss, depending on what will happen in that picturesque and remote corner of its geography . Small as it is, the weight of Spain will once again decide the day.

As it has been widely debated in the press, the European rescue facility (EFSF) is not big enough to bail out Spain, even if it was conceived with precisely that goal in mind. Since it has already had to shoulder part of Ireland’s rescue and Portugal’s on the line, given that it’s actual lending capacity in order to maintain its AAA status is limited to 250 of its 440 bn € and considering that any Spanish rescue would be considerably larger than those made in Europe so far, Spain is in fact without a safety net as of now. But if Spain falls, there will be effects on the Euro, on core European countries’ banks and industries, on countries like Belgium and Italy, depending on foreign finance, with deteriorated fiscal positions but doing well so far.

With a view to profit from the temporary lull in market panic, then (and in order to be able to say “I told you!” if something goes wrong) we start a three-part series on Spain. The first one will look at the situation of its economy, the second will muse on the financial sector, by the third we we’ll go from external financing to implications of a likely debt crisis for other countries. To avoid being dubbed unhelpful, we will even try to play God here and say what’s to be done.

Let’s start with a look at the Spanish bank sector balance sheet:

At 3.449 bn Euro, Spanish banks’ assets are roughly 3,5 times the conveniently sized Spanish GDP (let’s face it: a 1.000 billion GDP is the dream of any market analyst with a dislike for complicated divisions!) This is considerable leverage for a country that is not expected to grow much in the following years and whose banking sector is oversized. The origin of much of this credit, owed to foreign creditors, makes it doubly problematic.

The composition of the outstanding credit is already very revealing of the preferences of the citizenry and the limitations of the economy: A disproportionately large portion of credit to the financial sector (10% against an international average of 8%) leaves 77% to be shared among productive sectors (54%  of this part, 6% below international standards) and unproductive credit to families. Out of this last portion, the amount used for real estate investment is 77%, substantially higher than the usual 60%. Construction companies take up a huge proportion of credit to companies and are very leveraged, especially when one takes into account the decrease of real estate assets value of the last two years.

Financial activity and real estate are, thus, crunching growth of the other productive sectors in Spain. This is a situation that has been sustained over time, telling of a weak industrial and technological base as well as of a limited financial culture, which leads individuals to invest mainly in houses.

The distribution of employment confirm these hypotheses. Although all sectors experienced employment reductions from 2008 on, the fall of employment in construction was much steeper. All in all, unemployment went from 8,3 in 2006 (it’s hard to believe, but this was a historical low!) to just over 20% now.

Adoption of the Euro fuelled this bubble, since cheap credit flowed into the country (mostly through the banks) and was used to build and buy houses. This housing boom inflated artificially activity, the balance sheet of families, companies and banks, it absorbed resources that should have been used to foster productivity in the industry and was the origin of the huge debt of the private sector.

The graphic below shows a ballistic evolution of credit. it is a little difficult to see in this graphic but, proportionally, credit for consumption remained stable, while the share of credit for home acquisition grew at the expense of that for productive uses until June 2006, when it started a very gentle relative decline.

If we consider then that construction takes up 12% of the “productive” credit and real estate developers hold a whooping 32%, we can already conclude what’s the main cause of Spanish’s banks troubles (no, not Ballmer, you fool: developers!!!- but groovy video, huh?).

All in all, credit with real estate guarantee or given to companies with revenue dependent on the evolution of the real estate sector represent 72% of outstanding credit of the country in September 2010. About two thirds of this, roughly half of total credit, is owned by individuals, who for a number of reasons tend to be much more resilient and present much lower rates of delinquency. 24% of total credit corresponds, however, to developers, developers, developers… (damn, this is catchy!)

Developers have unloaded billions of assets on the balance sheet of the banks, either in payment of debts or through execution of debts. The greater part of these are undeveloped land plots and, given the situation, their value is paltry to none.

In the long run, the enormous leverage that the Spanish economy took to blow a bubble in the real estate sector means that the balance sheets of banks have to be drastically trimmed. The following factors ensure that there will be no easy way to grow out of this hole:

  1. Lack of technological ability in the private sector…
  2. …due to a deficient education system and lack of competence in the economy…
  3. … which leads to low productivity…
  4. … and a chronic current account deficit
  5. Massive presence of saving banks, a public-controlled, ownerless kind of financial institution that takes up half of the market. They are power brokers at regional and national level not easy to strip of their privileges.
  6. Heavy dependence on wholesale external financing of the financial sector.

So far, the approach has been to extend and pretend. Banks have been taking up real estate assets in payment of debts or else acquired them through liquidations. These assets are kept on the balance sheets at high valuations, waiting for the time to dump them without great losses. As the situation drags on, new credit can’t be created and the country is increasingly exposed to a sudden dry-up of international funding.

Liquidating these assets will prove tricky, considering that banks are now by far the main owners of real estate in Spain (in the next post we will estimate their foreclosured assets at 88 bn € and their total real estate related risk at 1.100 bn. or 100% of GDP, of which 140 bn already defaulted and 430 bn at high risk) Hence the hilarious part of the first graph: how do these prices reflect the kind of excess supply built in the system?

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About Outis

Nobody is cooler than you
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