Spain: The Euro-Zone’s Pearl Harbour?

December 1st 2010

On the morning of December 7, 1941, Imperial Japan launched an aerial attack on the
U.S. Pacific fleet stationed at Hawaii’s Pearl Harbour. The aggression was precipitated
by the United States’ decision to embargo all exports of oil to Japan, following the
aggressor’s invasion of French Indochina.
The embargo threatened to derail the energy-dependent nation’s military ambitions, and
in response, the Japanese not only attacked Pearl Harbour, but simultaneously launched
offensives against the Philippines, British Malaya, Java, and Sumatra. The region’s
territories conceded defeat to Imperial Japan one-by-one, as its colonial expansion
gathered momentum, and within a year, the Japanese ruled over one of the largest
maritime empires in history.
Fast forward to today and bond market vigilantes have launched an offensive upon the
euro-zone’s weakest links. The Greeks cried for help earlier in the year, and in the latest
round of turbulence, the Irish – whose government will present an austerity budget to
parliament, somewhat ironically, on the anniversary of Pearl Harbour – became the
second nation to surrender to the vigilantes and call for rescue. The Portuguese are
unlikely to resist the onslaught much beyond the New Year, and the vigilantes have
already set their sights on a bigger target – the Kingdom of Spain.
The Spanish economy is the fourth largest in the euro-zone and is almost twice the size of
the Greek, Irish and Portuguese economies combined. The Mediterranean country is
faced with a number of daunting challenges including mass unemployment, excessive
private sector debt burdens, a disturbing loss of competitiveness, an ailing banking sector
and a large fiscal deficit. Could the Kingdom of Spain become the euro-zone’s Pearl
Harbour?
Spain benefited considerably from EMU membership and economic growth outpaced the
OECD average in nine of the ten years pre-crisis. Investors became convinced in the
mid-1990s that adoption of the euro was virtually assured, and the more than three
percentage point premium attached to government bond yields relative to their German
counterparts disappeared.
The sharp drop in borrowing costs provided considerable stimulus to the housing market,
which was compounded by the removal of currency risk and the subsequent increase in
the number of foreign buyers. The resulting construction boom contributed to serious
macroeconomic imbalances, as both investment and labour were pulled away from the
tradable sectors – construction value-added contributed 17 per cent of GDP at its peak, at
which time the sector employed 13 per cent of the workforce. The economy thus,
became heavily dependent upon the fortunes of one sector and vulnerable to a potential
deflation of a property bubble that saw house prices increase by more than 140 per cent in
real terms in just ten years.
Strong labour demand in concert with low interest rates triggered a boom in domestic
demand as both households and non-financial businesses leveraged their balance sheets.
Indeed, household debt as a percentage of gross disposable income soared from less than
80 per cent earlier in the decade to more than 120 per cent at the peak, while non-
financial corporate sector debt jumped from less than 50 per cent of GDP in the mid-
1990s to more than 130 per cent in 2007. The debt-fuelled demand boom contributed not
only to inflation rates that far exceeded those of its trading partners, but also a surge in
the current account deficit to some ten per cent of GDP at its peak.
Amid the boom in domestic demand, the Spanish government pursued a pro-cyclical fiscal
policy that added to the expansionary conditions. The fiscal position remained in surplus and
public debt-to-GDP was maintained well below the euro-zone average, even though
government expenditures increased rapidly. The fragility of the underlying fiscal position
however, was simply masked by the housing-fuelled bubble.
The Spanish economy’s structural imbalances were exposed once crisis struck. The
continuing deflation of the property bubble has seen the unemployment rate soar to more
than 20 per cent, leaving households with little option but to deleverage their balance
sheets, while the decline in domestic demand has forced businesses to do likewise.
Meanwhile, the drop in windfall tax receipts saw the fiscal position swing from a surplus
of almost two per cent of GDP in 2007 to a deficit of more than 11 per cent in 2009.
The government has responded with an austerity programme and looks set to achieve this
year’s deficit target of some nine per cent of GDP. Both next year’s and intermediate
objectives look far too ambitious and are predicated on growth assumptions that seem
overly-optimistic. Economic growth is likely to be sluggish for several years, as the
private sector continues to deleverage and the economy shifts to a more sustainable
growth model.
Spain’s fiscal position is not all that troubles investors however; the health of the banking
sector is also of genuine concern even though the savings banks have already been
provided with capital injections of €15 billion. Total exposure to property development
and construction loans amount to almost €450 billion, and the resulting losses combined
with write-downs across the rest of the aggregate loan book could lead to further
recapitalisation needs of as much as €120 billion or roughly 12 per cent of GDP.
Both the investment and political elite believe that the country’s fiscal position is
manageable, even after allowance is made for worst-case losses arising from the ailing
banking sector. Indeed, Prime Minister Zapatero has warned, “those investors who are
short selling Spain that they are going to be wrong and will go against their own
interests.” The bond vigilantes beg to differ and are currently pricing a default
probability of more than 40 per cent.
The Kingdom of Spain is certainly too-big-to-fail, but it may also be too-big-to-rescue.
The euro-zone’s moment of truth looks set to arrive in 2011.

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