AN ATTAINABLE GOAL
By Antonio Guerrero
Spain's economy is still under pressure, but signs of
renewed confidence are slowly emerging.
When Spain beat the Netherlands in July to win the country's
first-ever soccer World Cup, Spaniards took to the streets to
celebrate the historic victory. Immersed in a two-year recession
and one of the country's worst-ever economic crises, they seemed to
find respite from their daily concerns in the tournament. Yet, with
the IMF still expressing doubts over the country's economic outlook
and with another ratings downgrade on the horizon (see box), the
festivities ended in little more than a bad hangover.
While the recession technically ended with a meager 0.1% GDP
expansion during the first quarter of this year, the government
predicts the economy will still post a 0.3% contraction for
full-year 2010. The IMF expects the economy to shrink by 0.4%. Next
year promises to be better, but the finance ministry has cut its
2011 growth forecast from 1.8% to 1.3%, with the IMF remaining
significantly more bearish, predicting just 0.6% expansion. In a
report released in July, the IMF pointed to unstable financial
markets and ongoing weak demand as factors likely to curb growth.
The multilateral warns, somewhat euphemistically, that Spain's
economic outlook remains uncertain.
Lean times ahead: Spain's economic future depends on the success
of its current austerity measures
Spain's unemployment rate has more than doubled over the past
three years, to reach a record 20% in the second quarter of
2010-the highest joblessness rate in the eurozone. The country also
has the region's third-largest budget deficit, at 11.2%, although
the government hopes to cut the gap to 6% next year. Socialist
prime minister José Luis Rodríguez Zapatero is cutting public
wages, has frozen pensions and reduced public sector spending,
among other austerity measures required as part of an agreement to
participate in a €750 billion ($962 billion) EU financial support
program for distressed countries.
Government Focuses on Banks
Spain's economic woes began when its housing and construction
sector bubble burst two years ago. Construction loans by Spanish
banks had soared to nearly 45% of GDP, while the construction
sector contributed some 18% of GDP at the height of the bubble.
"Bubbles of this sort are in significant part fueled by spreads
between borrowing costs, on the one hand, and capital gains on
appreciating property, on the other," says Robert Hockett,
professor at Cornell Law School. Banks can take some comfort,
however, from the fact that they avoided the subprime mortgage
debacle experienced in other markets, including the US.
The government is focusing much of its effort on protecting the
nation's financial system, which was put through extensive stress
tests this year. Twenty-seven Spanish financial institutions (9
full-service banks and 18 savings banks) were tested and only five
failed. Under the test, banks were evaluated according to their
probable solvency levels under several key variables: GDP and
unemployment levels in both 2010 and 2011, as well as short-term
interest rates.
Under the stress scenario, GDP would drop sharply, unemployment
would soar and spark defaults, real estate prices would fall by 28%
and the price of public debt would decline. Financial institutions,
under the test's guidelines, had to have a tier 1 ratio (capital,
reserves and preferential shares) of 6%, though the legal
requirement is only 4%. The best result was for Banca March, with a
19% tier 1 ratio for 2011, followed closely by Banco Santander,
BBVA and La Caixa, which together account for nearly two-thirds of
the banking sector.
The fact that only five banks failed the test is being viewed
positively by the Spanish government, which hopes the results will
help reestablish the country's standing in the international
financial community. While the number of failures was higher than
for Germany and Greece, which had one failure each, Spanish
authorities note that this was the result of having had 95% of
Spanish banks tested, compared with an EU average of just 65%. The
IMF says Spanish banks will need €17 billion in capital and another
€5 billion under a stressed scenario.
The five failures involved smaller regional savings banks, known as
cajas. "One estimate suggests the cajas need up to €35 billion of
additional capital," says Joe Portera, executive vice president and
senior portfolio manager at Hartford Investment Management Company
(HIMCO), a subsidiary of the Hartford Financial Services Group. "In
response, Spain has changed its banking laws to allow cajas to sell
up to 50% ownership to outside investors in order to raise capital.
The revised legislation also targets a reduction in local and
government influence on the cajas and their operations." Several
weaker cajas have recently announced mergers, which Portera
predicts will slash the total number of cajas by more than 50%.
Under the new savings bank law, regional administrations and public
entities saw their voting rights in savings banks' management
boards cut to 40%, from a previous 50%, while elected officials can
no longer serve on a bank's board. Regional governments had gone on
a spending spree in recent years, accumulating some $200 billion in
debt. Regional authorities are vowing to cut public sector salaries
by 5% and replace only 10% of retiring civil servants. They also
plan to go to debt markets this year to raise $57 billion, despite
the fact that a dozen Spanish regional governments have been
downgraded.
"Overall, we believe the Spanish government has demonstrated clear
support for its banks and a workable mechanism to provide capital
funding," says Portera. "We believe the €99 billion Fund for
Orderly Bank Restructuring [created in June 2009] is of sufficient
size. If the market gets comfortable that the stress test process
has defined the outer limit of the Kingdom's contingent liability
to its banks, we believe Spain has the tools to oversee an orderly
consolidation of its financial system."
Investors Remain Skeptical
Meanwhile, some market players are sitting on the sidelines. "At
this juncture investors are taking a wait-and-see attitude toward
Spain, and for good reason," says Joe Quinlan, managing director
and chief market strategist in the Investment Strategies Group at
Bank of America. "Despite belated efforts at fiscal consolidation,
there remains a great deal of uncertainty around Spain's fiscal
health and economic outlook."
Quinlan, a former senior global economist and strategist for Morgan
Stanley, feels there is still more downside to Spanish equities. "A
buying opportunity is emerging, but not yet," he says. "There are
better places to put money to work in Europe, namely the more
robust markets of Germany and the Nordic nations. The overall
general mood toward most asset classes in Spain remains bearish; no
sectors stand out, although a few large-cap banks may recover
before other equities."
Quinlan feels it will be another six to nine months before we see a
recovery in Spain, with the government needing to issue more debt
and heightening investor concerns during that period. "On a
relative basis, Spanish assets are not cheap enough and the
financial picture is not clear enough for investors to take the
plunge," he adds.
F. John Mathis, director of the Global Financial Services Center at
the Thunderbird School of Global Management, still sees some
opportunities. "With risk levels high and rising (high CDS
premiums), there are many assets that are selling at a discount,
such as real estate and government and corporate bonds." Equities,
especially those related to residential construction companies and
construction-related industries, and stocks for banks and other
financial services-related industries are also selling at low
valuations says Mathis, a former senior financial analyst with the
World Bank. "Companies that receive more of their revenue from
outside of the euro area should recover more rapidly and do better
than those solely dependent on domestic sales."
Zapatero: Popularity is suffering as he tightens Spain's
belt
Portera feels that developments in Spain are causing investors
to avoid the country at the moment, but agrees that some buying
opportunities exist. "We do see value in names, such as Banco
Santander, which attain a large percentage of their revenue outside
the Iberian Peninsula," he says. Portera says the potential for a
debt-restructuring event sparking further risk aversion remains a
possible pitfall. "This is still a low-probability event, but given
current yields in Spanish government bonds at less than 200 bps
over German bonds, we do not think you are being adequately
compensated for the volatility. Certain bank names in US dollars
are attractive as they are being punished for the neighborhood they
operate in and not necessarily for their operating
performance."
Treasuries Sale Prompts Optimism
In July the Spanish government sold €3.4 billion of three-month
treasury bills in the first such sale since completing the EU
banking sector stress tests. Its borrowing costs fell during the
sale, with July's bills placed at an average rate of 0.672%, down
from 0.913% at June's auction. It also sold six-month debt at an
average of 1.144% in July, compared with a higher 1.577% in June.
Authorities hope the auction's results indicate that investor
confidence is increasing, albeit gradually. "There needs to be a
commitment to work together to overcome the crisis, recognizing
that viable long-term solutions will likely involve near-term
challenges, sacrifices and difficult decisions," says Robin
Lumsdaine, professor of international finance at American
University's Kogod School of Business. "It's also important to try
to have a clear communication strategy that keeps people informed,
instills confidence and alleviates panic. I realize that's easier
said than done, but insufficient buy-in can derail even the best
ideas."
The situation is not boding well for Zapatero, who is charged with
introducing the difficult austerity measures that are pushing his
popularity rating downward. Several key labor unions are calling
for strikes. As a result, social unrest is becoming a concern for
the administration. "The long period of recovery in Spain for the
economy and the financial system will likely result in some civil
unrest, which may have some political consequences for the current
government," says Mathis. "This will make it more difficult for the
government to implement the appropriate policies."
At least the soccer celebration was fun while it lasted.
Not Another Greece
Moody's has put Spain's Aaa rating on review for downgrade,
which would make it the last of the major ratings agencies to cut
Spain's rating amid the country's economic downturn. Standard &
Poor's downgraded Spain's rating one notch to AA in April, with a
negative outlook. The move was followed by a downgrade by Fitch to
AA+ in May, with a stable outlook. "In our opinion, Spain is likely
to have an extended period of subdued economic growth, which
weakens its budgetary position," said S&P in its downgrade
rationale. S&P projects Spain will post average annual GDP
growth of 0.7% between 2010 and 2016, down from its previous
forecast of more than 1% over the same period.
Comparisons to Greece, Europe's other troubled market that sent
shock waves through the eurozone's financial markets, seem
inevitable. Moody's downgraded Greece by four notches this year and
S&P cut it by three notches. Spain's rating is likely to be cut
by no more than two notches by Moody's, which cites Spain's
deteriorating economic outlook and potential difficulties in
meeting its fiscal targets as reasons for the expected
downgrade.
"I don't think Spain is the next Greece, not by a long shot,"
says Robert Hockett, a professor at Cornell Law School. "Its public
finances have until recently been much stronger than Greece's. It
was, for example, seriously paying down debt during its boom years,
in conspicuous contrast not only to Greece but also to the US."
Spain's debt-to-GDP ratio has been favorable compared with that of
its neighbors. In 2009 its debt ratio was equal to 53% of GDP, well
below the 79% average for the eurozone. "The credit fundamentals of
Spain continue to be very strong," notes Moody's. Yet, speculation
over a possible debt default continues to plague the country.
July's banking sector stress tests also suggested Spain's
banking sector is in better shape than many had feared. S&P
maintains its AA and A-1+ long- and short-term counterparty ratings
for Santander and BBVA, Spain's two largest banks, though with
negative outlooks. The ratings agency gave the two banks kudos for
their resilience during the global downturn. "As we have seen,
difficulty in any individual country presents challenges for many
others, particularly in Europe," says Robin Lumsdaine, professor of
international finance at American University's Kogod School of
Business. "But with each challenge we learn a bit more, and those
lessons can improve both the response and recovery times."