Complacent Europe must realise Spain will be next
By Wolfgang Münchau
European politicians have every incentive to postpone crisis resolution indefinitely, as I argued last week. In the meantime, the debt of several peripheral eurozone countries continues to build up. On Wednesday, Portugal finally accepted the inevitable and applied for a financial rescue. European officials quickly pronounced that this would be the last rescue ever. Everyone in Brussels fell over themselves to argue Spain would be safe.
On Thursday, the European Central Bank raised its main refinance rate by a quarter point to 1.25 per cent.
This was a well-flagged move, but more are likely to follow. I expect the ECB’s main policy interest rate to rise to 2 per cent by the end of this year and to 3 per cent in 2013. This trajectory, while consistent with the ECB’s inflation
target, will have negative consequences for Spain in particular. Apart from the direct impact on economic growth, higher interest rates will hit the Spanish real estate market. Almost all Spanish mortgages are based on the oneyear
Euribor money market rate, which is now close to 2 per cent, and rising.
Spain had an extreme property bubble before the crisis, and unlike in the US and Ireland, prices have so far fallen only moderately. According to data from Bank of International Settlements, real house prices in Spain –price per square metre adjusted by the personal consumption deflators – rose by 106 per cent from the beginning of monetary union and to the peak in June 2007. They have since come off by 18 per cent as of end-2010.
Calculations such as these are sensitive to the starting date, but Spanish real prices were relatively flat throughout the 1990s, so this is a relatively safe starting point.
Where will it stop? I would expect all of that increase to be reversed. The total peak-to-trough fall would be more than 50 per cent, and prices would have to fall by another 40 per cent fall from today’s level. Is that a reasonable
assumption? In the US, real house prices stagnated for most of the 20th century. Increased demand, through immigration for example, should not affect the price level, as long as supply can adjust.
The situation is different in countries with natural or artificial supply constraints, like the UK. But in terms of supply conditions Spain is more similar to the US. I have yet to hear an intelligent reason why Spanish real house prices
should be any higher today that they were 10 years ago, and indeed why they should keep on rising.
The most important housing market statistic in Spain is the number of vacant properties, about 1m, which means that the market will suffer from oversupply for several years. This will be the driver of further price declines. Given
the stress in the system – recession, high unemployment, a weak financial sector, higher oil prices and rising interest rates – one might even expect house prices to overshoot below the horizontal trend line.
Falling house prices and rising mortgage payments are bound to push up the still moderate delinquency rates and the number of foreclosures. This will affect the balance sheet of the cajas, the Spanish savings banks. The balance sheets carry all property loans and mortgages at cost. As default rates rise, the savings bank system will need to be recapitalised to cover the losses. The Spanish government implausibly estimates the recapitalisation need to be below !20bn, while other estimates put the number at between !50bn and !100bn. The assets most
at risk are loans to the construction and real estate sector – !439bn as of end-2010. Spanish banks also have about !100bn in exposures to Portugal, a further source of risk.
The good news is that even under a worst-case scenario, Spain would still be solvent. The Spanish public sector debt-to-GDP ratio was 62 per cent as of end-2010. Ernst & Young, in its latest eurozone forecast, projects the
debt-to-GDP ratio to increase to 72 per cent by 2015 – still below the levels of both Germany and France.
But the Spanish private sector debt-to-GDP ratio is 170 per cent. The current account deficit peaked at 10 per cent of GDP in 2008, but remains unsustainably high, with projected rates of more than 3 per cent until 2015. This
means that Spain will continue to accumulate net foreign debt. The country’s net international investment position– the difference between external financial assets and external liabilities – was minus !926bn at the end of 2010,
according to the Bank of Spain, or almost 90 per cent of GDP.
If my hunch on the Spanish property market proves correct, I would expect the Spanish banking sector to need more capital than is currently estimated. It is hard to say how much because we are well outside the scope of
forecasting models. When prices drop so fast, there will be much endogenous pressure that no stress test could ever capture.
The mix of high external indebtedness, the fragility of the financial sector and the probability of further declines in asset prices increase the probability of a funding squeeze at some point. And that means that Spain will be the
next country to seek financial assistance from the EU and the International Monetary Fund. As for the large number of official statements that Spain is safe, I think they are merely a metric of the complacency that has characterised the European crisis from the start.
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