Spain will get worse without reform and European help
.
Mohamed El-Erian
April 30, 2012
Standard and Poor’s' multi-notch downgrade of Spain’s sovereign credit rating was
largely shrugged off by markets. That is the good news. The bad news is that
S&P’s reasoning speaks to dynamics on the ground that are likely to worsen
if a more balanced Spanish policy mix is not accompanied by targeted external
support.
.
In slashing Spain’s credit rating to BBB+ and retaining a negative outlook, S&P cited its forecast that the Spanish economy would contract by 1.5 per cent in 2012 (rather than expand as previously anticipated), the budget deficit would exceed 6 per cent of gross domestic product (compared to a government deficit target of 5.3 per cent), and the country’s debt-to GDP would rise steadily to almost 90 per cent by 2015. And all this in the context of recent government data that show that one in every four Spaniards is unemployed (with the youth unemployment rate alarmingly exceeding 50 per cent).
.
This difficult reality explains why Spain is experiencing the worrisome combination of high borrowing costs, a slowly shrinking bank deposit base, capital outflows, and an increasingly binding internal credit crunch. This is a scary combination. It systematically withdraws oxygen from a real economy that is already struggling mightily; and it worsens in to a vicious cycle unless pronounced progress is made in three critical areas.
.
First, Spanish policy needs to do a better job in convincing citizens that medium-term economic stability is both feasible and probable. To do so, it must act through both the numerator and denominator of debt sustainability; and, in particular, by striking a better balance between deficit containment (numerator) and growth (denominator).
.
Too much of the burden is being placed on budget austerity and not enough on structural reforms that enhance Spain’s growth and job creation in a sustainable manner. As such, there are doubts about the durability and effectiveness of Spain’s adjustment efforts.
.
Second, Spain needs to reduce worries about the potential impact on government finances of contingent liabilities that reside in its banks and on account of its real estate bubble. At a minimum, this requires further progress in consolidating the banking system, in allocating loan losses, and in convincing institutions to be much more aggressive in raising new capital from the private sector.
.
The greater the timidity of these actions, the larger the concerns that Spain’s funding needs will overwhelm the markets’ appetite to provide voluntary financing at reasonable terms. It is thus paramount for Spain to do more to reassure the world that its budgetary financing gap will not be crushed by the assumption of liabilities from other sectors of the economy.
.
Third, Europe needs to be more willing and able to support Spanish adjustment efforts. As currently set up, European mechanisms for exceptional financing assistance are overly binary – either way too little assistance or, at the other end, a full blown rescue package that brings with it the risks of collateral damage and unintended consequences.
.
Existing procedures make it difficult for Spain, if not impossible, to receive targeted official financing without also signaling that it is becoming a ward of the European state. As such, rather than complement a market-financed adjustment program, recourse to European emergency funding could result in Spain foregoing virtually all access to private financing (as is the case today for Greece, Ireland and Portugal).
What is at stake here goes well beyond the wellbeing of 46m Spanish citizens. The country’s health is also central to the proper functioning of a vital European unity project that is already under pressure due to economic and financial dislocations elsewhere, as well as political uncertainties that are sure to continue increasing.
.
Spain does not have the public debt problems of Greece, nor its administrative dysfunction. Moreover, its government has not followed Ireland in assuming on its balance sheet the liabilities of an irresponsible segment of the private sector. But all this could prove irrelevant in avoiding a full-blown crisis if the country’s mounting difficulties are not tackled in a more balanced fashion by the government and, at the same time, supported by European partners in a more targeted fashion.
.
In slashing Spain’s credit rating to BBB+ and retaining a negative outlook, S&P cited its forecast that the Spanish economy would contract by 1.5 per cent in 2012 (rather than expand as previously anticipated), the budget deficit would exceed 6 per cent of gross domestic product (compared to a government deficit target of 5.3 per cent), and the country’s debt-to GDP would rise steadily to almost 90 per cent by 2015. And all this in the context of recent government data that show that one in every four Spaniards is unemployed (with the youth unemployment rate alarmingly exceeding 50 per cent).
.
This difficult reality explains why Spain is experiencing the worrisome combination of high borrowing costs, a slowly shrinking bank deposit base, capital outflows, and an increasingly binding internal credit crunch. This is a scary combination. It systematically withdraws oxygen from a real economy that is already struggling mightily; and it worsens in to a vicious cycle unless pronounced progress is made in three critical areas.
.
First, Spanish policy needs to do a better job in convincing citizens that medium-term economic stability is both feasible and probable. To do so, it must act through both the numerator and denominator of debt sustainability; and, in particular, by striking a better balance between deficit containment (numerator) and growth (denominator).
.
Too much of the burden is being placed on budget austerity and not enough on structural reforms that enhance Spain’s growth and job creation in a sustainable manner. As such, there are doubts about the durability and effectiveness of Spain’s adjustment efforts.
.
Second, Spain needs to reduce worries about the potential impact on government finances of contingent liabilities that reside in its banks and on account of its real estate bubble. At a minimum, this requires further progress in consolidating the banking system, in allocating loan losses, and in convincing institutions to be much more aggressive in raising new capital from the private sector.
.
The greater the timidity of these actions, the larger the concerns that Spain’s funding needs will overwhelm the markets’ appetite to provide voluntary financing at reasonable terms. It is thus paramount for Spain to do more to reassure the world that its budgetary financing gap will not be crushed by the assumption of liabilities from other sectors of the economy.
.
Third, Europe needs to be more willing and able to support Spanish adjustment efforts. As currently set up, European mechanisms for exceptional financing assistance are overly binary – either way too little assistance or, at the other end, a full blown rescue package that brings with it the risks of collateral damage and unintended consequences.
.
Existing procedures make it difficult for Spain, if not impossible, to receive targeted official financing without also signaling that it is becoming a ward of the European state. As such, rather than complement a market-financed adjustment program, recourse to European emergency funding could result in Spain foregoing virtually all access to private financing (as is the case today for Greece, Ireland and Portugal).
What is at stake here goes well beyond the wellbeing of 46m Spanish citizens. The country’s health is also central to the proper functioning of a vital European unity project that is already under pressure due to economic and financial dislocations elsewhere, as well as political uncertainties that are sure to continue increasing.
.
Spain does not have the public debt problems of Greece, nor its administrative dysfunction. Moreover, its government has not followed Ireland in assuming on its balance sheet the liabilities of an irresponsible segment of the private sector. But all this could prove irrelevant in avoiding a full-blown crisis if the country’s mounting difficulties are not tackled in a more balanced fashion by the government and, at the same time, supported by European partners in a more targeted fashion.
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