Spain's reforms create path to economic stability

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Spain has been among the hardest-hit countries in the European Union in the wake of the global economic crisis. An era of high borrowing and housing euphoria has given way to economic contraction and a banking crisis, with unemployment above 25%—the highest ever in the country—and its recession likely to continue into 2013i. Yet Spain’s stock and bond markets, after two years of decline, staged a powerful rally in the second half of 2012. Investors seem to be betting that the worst is over for Spain, the world’s 13th largest economy.

In this interview, Anupam Damani, TIAA-CREF Managing Director, Eurozone Portfolio Manager, and Jessica Zarzycki, Associate, Developed-Markets Sovereign Analyst, talk about what led to the recent market rally, the Spanish government’s recent efforts at reform, the outlook for global investors, and the real story behind Spain’s high unemployment numbers.

Article Highlights

  • Spain’s economy has been among the hardest hit in the EU, and its jobless rate moved above 25%, an all-time high.
  • Despite tough times, Spain’s stock and bond markets rallied impressively last year.
  • Several key developments, including banking reform, broad ECB support and improved economic competitiveness, have been encouraging signs.
  • Investors are likely to allocate away from low-yielding assets and into riskier ones, such as Spanish equities and debt.
  • To continue attracting investors’ interest, the country needs to continue on the path to stability.

Spain’s leadership has spent the last few years trying to get a handle on the country’s economic problems. Do the recent rallies in its stock and bond markets suggest it is succeeding?

The market is responding to progress within Spain on fiscal and structural issues, to political commitment within the EU toward a banking union, and to some timely steps by the European Central Bank (ECB) that have made the debt of EU’s “peripheral” countries, including Spain, less risky. In terms of the numbers, the improvement has certainly been dramatic. Spain’s equity-market rally in the last half of 2012 erased all of the market’s losses for the year: The MSCI index for Spain shows a net return of 21.78% for July 1 through December 31, more than offsetting its –15.42% return in the first half of the year.

Meanwhile, Spanish bonds—both short-term and long-term—also rallied in the second half of the year, with bond prices rising and yields falling as investors began to perceive less risk in Spain’s government-issued debt. The 10-year yield, for example, declined by 229 basis points (2.29 percentage points), from a peak of 7.60% on July 24 to a year-end close of 5.31%.

What are the biggest positives?
The Spanish government has made considerable progress in the area of banking reform. Banks are now required to hold much more capital and have significantly increased the provisions required against non-performing assets. In addition, the small savings banks, called cajas, have seen significant consolidation. Their number has been reduced from 45 to 11, and they have been able to transfer bad loans off of their balance sheets (albeit at a loss). The bigger, more geographically diverse Spanish banks, such as the Santander Group and BBVA, are well capitalized and are not expected to need assistance from the government.

The stress tests completed by independent auditors have indicated that the recapitalization needs of the banking sector are around 60 billion euros. But even if recapitalization required 100 billion euros—the amount that European finance ministers have earmarked for this purpose—the Spanish government can manage to keep that amount on its balance sheet for the time being without having an explosive debt trajectory. The injection of an additional 100 billion euros of debt into the banking system would add approximately 10% to GDP, which would put Spain’s debt-to-GDP ratio around the euro zone average.

Last year, Spain’s leaders also passed a law requiring that the country’s budget be balanced and that its debt-to-GDP level (now at about 85%ii) not exceed 60%.

Finally, the ECB pledged in the summer of 2012, “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.” The ECB reinforced this philosophy with the creation of the “outright monetary transactions,” or OMT. OMT is a mechanism for supporting the bonds of European governments, including Spain, if the government requests support with conditionality attached. In essence, the OMT allows the ECB to be more like the Federal Reserve in that it acts as the lender of last resort. These steps reassured investors in Spanish debt, allowing Spain to benefit from the OMT before it has even been tested.

Besides its banking sector, where else has Spain made strides?
Exports are another bright spot. Although imports have been decreasing, exports have increased at a faster pace, leading to a current account surplus in the past two months. This is a positive sign for a future economic recovery. Spain is a big exporter of industrial technologies, chemicals, materials, and, of course, tourism. The tourism industry in Spain, in fact, has benefitted tremendously from turmoil in the Middle East and North Africa, as tourists have avoided destinations such as Egypt.

Labor productivity has also improved. Between 2000 and 2008, Spain had one of the fastest-growing unit labor costs (ULC) in Europe, creating a headwind for its economy. The ULC has dropped meaningfully over the last two-and-a-half to three years, making Spain significantly more competitive. Indeed, this is one of the reasons why Spain’s export numbers are better.

That’s not to say that Spain has completely resolved its problems. We are looking at a long-term adjustment. The country still needs more time for growth to pick up, as well as continued effort in terms of structural and fiscal reforms.

Spanish Prime Minister Mariano Rajoy won his position with a very strong mandate in late 2011 and came into office pledging to address the country’s debt crisis. How has he done?

Spain has some complicated political and economic issues—and they have recently been exacerbated by the issues in the country’s banking structure as well as its autonomous regional structure. Rajoy waited to implement reforms until after the Andalusia election in March 2012, and early elections in Galacia and Catalonia also caused a slowdown in reforms. But part of the issue was also due to Rajoy’s personality and his tendency to take a provincial perspective rather than looking at things from a pan-European point of view. As a result, it has taken financial-market pressure to get him to embrace reforms. But that’s true of other European politicians as well—many moved slowly until the market forced their hands.

There has been a lot in the news about the desire for independence on the part of Catalonia, the largest of Spain’s 17 regional governments. How serious is this talk and—given that Catalonia accounts for about one-fifth of the nation’s GDP—what economic ramifications does it have?

A lot of it is brinksmanship—a negotiating tactic by Catalonia to keep a higher share of its income, rather than have to transfer it to the central government. But Catalonia would lose a lot if it seceded. First, Catalonia requested regional liquidity funds from the central government, which provides the region with guaranteed funding support, in 2012 and 2013. Second, Catalonia’s economy is heavily dependent on the Spanish market. Finally, there is no guarantee that Catalonia would be admitted to the European Union as an independent entity. We’re likely to keep hearing noise out of the region, but in our view it’s unlikely to amount to its leaving the country. However, it may be able to negotiate a better fiscal transfer deal in 2013.

Spain is not the only European country that is struggling with debt and facing fiscal problems. How have some of the other countries responded?

Italy’s Prime Minister Mario Monti enacted an ambitious pension-reform plan early in his term that took a number of bold measures, including raising the retirement age. Ireland and Portugal under the “Troika” programiii have been required to enact bold labor and market reforms. Spain could learn from these policies.

What impact has Spain’s crisis had on the rest of the European Union?

Spain is the fourth-largest economy in the euro zone, after Germany, France and Italy. If Spain’s economy were to deteriorate further, there could be contagion risk. But the recent history offers hope that policymakers would have an effective response if that were to happen.

The ECB, in particular, has been very vigilant about providing liquidity with the Long-Term Refinancing Operation (LTRO), and as a lender of last resort with the OMT. This provides time for the larger vision of creating a more integrated euro zone and with a sounder political and fiscal union. Both the core countries with large, sound economies (such as Germany and France) and the peripheral countries with shakier economies (such as Greece, Portugal and Ireland) have shown with recent elections and polls that they think they have a better future within the euro zone than outside.

How should investors approach Spain, in the near term and long term? With its recent gains, are the best opportunities gone?

Markets tend to oscillate between fear and greed. Prices may not appreciate as quickly as they did in the second half of 2012, given the gains that have already occurred, but there is potentially more upside. There is a significant pool of money—well over $1 trillion—that has been earning zero or negative yields as investors waited and gauged the likelihood of a euro zone breakup. Now that that risk has abated, investors are more likely to move those funds into riskier assets in Spain and Italy. However, that initial enthusiasm could wane if Spain does not continue on its course toward improvement. Over the next six months to two years, Spain needs to continue stabilizing growth and implementing fiscal and structural reforms in order to attract investment.

What does Spain’s 25%-plus unemployment level say about economic improvement in Spain?

Unemployment at that level is not good for any economy; it drags down growth and can lead to social unrest. But the numbers in Spain are a little misleading, for two reasons. One is that Spain has a large “gray” economy, with employees paid off the books so that they are not included in official employment numbers. The other is that it has a lot of family support, with grown children receiving assistance from parents and grandparents. Those things do help absorb the shock in times of crisis.

For many Spaniards, another positive development is that the core creditor nations, including Germany, are focusing more on structural reforms now than on austerity measures. These countries are allowing some fiscal slippage, as long as it’s related to the economy and not government mismanagement. They realize that austerity, if it becomes an obsession, can do more harm than good. The fact that these nations are giving Spain some breathing room creates less drag on growth and ultimately benefits employment growth. By the second quarter of 2013, Spain’s GDP should stabilize and stop falling. That will be an important turning point.

For a lot of people in Spain, it’s too early to celebrate. Unemployment, debt-to-GDP and some other negative statistics will continue to rise into 2014. But markets are forward-looking. If investors see the better policies being implemented, they will continue to reward the country.

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