The ‘pain in Spain’ will surely bring us more pain, too

Vivek Kaul

The BSE Sensex, India’s premier stock market index, has given a return of 5% over the last one month. This rally has come on the back of the decision of the finance ministers of euro zone (countries that use the euro as their currency) deciding to give a loan of €100billion to weak Spanish banks on June 10. But the euphoria generated by the rescue now seems to be fading.
Rising bond yields
The bond yield on 10 year Spanish government bonds on June 8,2012, a couple of days before the rescue was announced, was at 6.22%. Since then the yield has risen to 6.95%. Bond yield is essentially the return an investor can hope to earn from a bond every year, if he holds onto the bond until its maturity. A rising bond yield means that the investors perceive the bonds to be risky and hence demand a higher return from them.
But what has changed in the last one month for Spain? The euro zone plan was to give loans to Spanish banks which are reeling under property loan losses. But this loan being given to banks needs to be guaranteed by the Spanish government. The Spanish government’s debt to GDP ratio is already at 68.5%, which is on the higher side. And this guarantee would further add to the increasing debt of the Spanish government and thus push up its debt even further. Hence, the demand for increased returns on Spanish government bonds by investors.
Low tax collections
As the government debt rises the government needs to raise the amount of taxes it collects, in order to repay the debt. But given the difficult economic environment that prevails any attempts by the government to raise taxes has a negative impact on overall spending. As people pay more tax and the cost of public services go up, it leads to them cutting down on their spending. Lower spending means lower taxes for the government.
The tax collected by the Spanish government during the first five months of the year has fallen by 1.5%. This even after it increased taxes on income, electricity and tobacco could not make up for a 10% drop in the collection of value added tax. What also brings down the ability of the government to collect taxes is the high unemployment prevailing in Spain. The unemployment rate touched 24.6% in May. The rate is higher than 50% among the Spanish youth. If the government is unable to collect enough taxes its ability to pay interest as well as repay its past debt goes down, increasing the overall riskiness, leading to a higher rate of return demanded by investors. This also means that the government will have to pay a higher rate of interest on any fresh debt that it issues in the days to come.
The basic problem
The Spanish government ran very small fiscal deficits or surpluses for most of the period between 2001 and 2008. But the external borrowing of the country went by 88% to €2.54trillion between 2005 and 2009. Most of this money was borrowed by Spanish banks to finance construction and buying of real estate.
The gross domestic product (GDP) of Spain grew at the rate of 8 percent every year from 1999 to 2008. This primarily happened because Spain went all out and promoted the Mediterranean lifestyle, leading to many people buying homes along its sun-drenched shores. As the demand for homes increased construction became the industry to be in and housing prices tripled over a decade.
Spain ended up building many more homes than it could sell. Estimates suggest that even though Spain forms only 12 percent of the GDP of the European Union (EU) it has built nearly 30 percent of all the homes in the EU since 2000. The country currently has as many unsold homes as the United States of America which is many times bigger than Spain. Loans to developers and construction companies stand at nearly $700billon, which is around half of its current GDP of $1.4trillion. With homes lying unsold developers are in no position to repay and this has put Spanish banks into trouble. Spain’s biggest three banks have assets worth $2.7trillion, which is two times Spain’s GDP. This is a problem that will not go away overnight.
What makes the situation more precarious is the fact that house prices are still falling. Experts feel that prices still need to fall by 35 percent from their current levels if they are to reach normality. This will mean more home loan defaults and more trouble for Spain in the days to come.
The reasoning for the rescue
The European Union and the European Central Bank have decided to come to the rescue of the Spanish banks and come up with what the media is calling a “bold” plan to pump money into its troubled banks. The logic for this rescue was the same as was in the earlier cases of bailout. If Spain is not rescued the crisis will spread to other countries. Not that rescuing countries with bailout plans helped in the past. Greece was the first country to be bailed out. Then came Ireland’s turn. And then Portugal. Now it is the turn of Portugal’s Iberian neigbour Spain. Who will be next?
To conclude
It is difficult to predict what exactly will happen in the days to come, but one thing that one can say with absolute confidence is that the European Central Bank and the euro zone will have to come up with more bailout plans. This will have the entire world markets including India on the tenterhooks. Every time a European country will get into trouble, the markets will fall. Money will go out from countries like India and will flow into the US dollar and American government bonds. This will lead to a depreciating rupee, which as we have seen in the past can have a huge negative impact on the Indian economy. But as the ECB and the euro zone will come to the rescue, markets around the world including in India, will rally again.
This cat and mouse game will continue for a while but will only postpone the inevitable. The fact that one day European countries won’t be able to repay their debt. As economist Bill Bonner wrote in a column “Let’s…put our hands together and welcome catastrophe. It’s coming…we like it or not. So why not like it?”
(The article originally appeared on on July 9,2012.
(Vivek Kaul is a writer and can be reached at [email protected])