As Spanish Unemployment Rises Sharply Again, Just When Did Spain Enter Recession?

The number of people presenting jobless claims in Spain soared to nearly 3 million in November, following a 6 percent rise in registrations over October, providing us with yet further evidence, if we needed it, of the gravity of the situation which is now unfolding before our eyes.




The Spanish Labor Ministry stated that an additional 171,243 people signed on for unemployment benefits last month, bringing the total to 2.99 million. Year on year the increase was of 42.7%. Obviously it is hard to make exact forecasts for how the situation will evolve, but on a rough and ready (back of the envelope calculation) basis - which is as good as any here, since the degree of undertainty is so large - if the contraction continues at the same pace over the next twelve months, then by December we could have an increase of around 50% - or a total of about 4.5 million (15% of the labour force) unemployed, and rising, of course, assuming we won't hit bottom in 2009.



Basically, since I assume the contraction continues at the current rate (ie no further acceleration in the contraction on average, and no significant deceleration) then this is what you might call the median forecast, where upside risks and downside risks more or less balance. Clearly the situation could be worse than this, but then again it could be better. My instincts tell me that the rate of unemployment creation will accelerate over the next six months, as industry takes a terrific beating, but then may slow down in the second half. But then these are only that - instincts, or guesses. Nevertheless I have little doubt that unemployment will still be rising when we reach December 2009, since the earliest this can hit bottom will be in 2010, and even horizon this isn't a sure thing at this point, given the downside risks which are floating around.


Consumer Confidence Slides

Spanish consumer morale also fell back again in November, reaching 48.7 from the 50.1 registered in October - according to the latest data from Spain's Official Credit Institute (ICO). The result is hardly surprising given the way layoffs have been soaring and the economic contraction deepening. Consumer confidence, which was at 76.1 in November last year, hit a record low of 46.3 in July just as European Central Bank rates interest rates to a cycle high of 4.25 percent and oil prices hit a record $147 a barrel, since which time they have bounced back slightly.



Confidence was down in most of the main index components, although we might like to note that it is the sub-component referring to expectations for the economy going forward which is the main factor keeping the index up above the July level. In particular the outlook for the economic situation of the country is well up above July, which is surprising since during this time the economic outlook has evidently deteriorated. Could this be a case of a "we didn't get an earthquake today, so maybe one tomorrow is now more likely" type rule application, with the idea being that things have gotten so bad, that surely they now have to get better, especially with oil prices coming down. Self perpetuating wishful thinking would be another way to describe this thought process, since nothing could be farther removed from reality, unfortunately. Still, we should bear in mind that any reading of less than 100 on this index (which was only started in September 2004) indicates pessimism dominating over optimism, and whichever way you look at it we are certainly well below 100 at this point.




Just When Did Spain's Recession Actually Start?

Now all of this raises another very interesting question: just when did Spain's recession begin? This is a very timely question since the NBER Business Cycle dating committee have just decided that the US recession started in December 2007. They arrived at this conclusion since the apply a rather different methodology to the simple "two consecutive quarters - seasonally adjusted - of contraction". Their explanation can be found here, but the gist of the reasoning is based on this idea:

"A recession is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in production, employment, real income, and other indicators. A recession begins when the economy reaches a peak of activity and ends when the economy reaches its trough. Between trough and peak, the economy is in an expansion."

So leaving aside all the politically embarrasing awkard little issues of just how you decide on how to call a recession in terms the general public can understand, what really interests economists is the business cycle process itself, and identifying the peak (the moment when one cycle draws to a close) and the trough (the moment the next cycle begins). And again leaving aside the evident asymmetry in the popular discourse on the topic (namely that people are clearly far more prone to overanticipate when it comes to determining the trough than they are when it comes to the peak), identifying both peak and troughs is important since it should enable us to make more appropriate, targetted and effective decisions in both the monetary and fiscal policy areas. So the economic nitty gritty here is, OK, two consecutive quarters of contraction does constitute a nice "rule of thumb" guide, but far too often, the devil is in the details, and this kind of simple rule of thumb simply does not get to the heart of the matter. And to validate this argument even further, let's take a look in the Spanish case which is indeed a very interesting one.

In reaching their decision the NBER dating committee relied on two key indicators, domestic production and employment:

"Because a recession is a broad contraction of the economy, not confined to one sector, the committee emphasizes economy-wide measures of economic activity. The committee believes that domestic production and employment are the primary conceptual measures of economic activity."

That is, they use these two indicators because they feel that they offer (in what is evidently an imperfect world) the best available measure of where an economy actually is at at any given moment in time. Employment I would have thought was an obvious indicator, but domestic output is also important since it strips out all kinds of misleading data-skews which derive from movements on the external trade side.

Now if we look at the Spanish labour market in terms of the trend in unemployment, then it is easy to see in the chart presented above that the annual change in unemployment altered trend around June 2007. Up to that point unemployment had been falling, while subsequently it started to rise.

Now if we turn to the seasonally adjusted employment data prepared by the INE for the national accounts we find, well surprise-surprise, that the number of people employed in the Spanish economy reached it peak between July and September 2007 (the third quarter). So the Spanish labour market definitely turned in the summer of 2007.



The NBER offer a number of measures of domestic output, among them:

The last monthly measure of production is the Federal Reserve Board’s index of industrial production. This measure has quite restricted coverage—it includes manufacturing, mining, and utilities but excludes all services and government. Industrial production peaked in January 2008, fell through May 2008, rose slightly in June and July, and then fell substantially from July to September. It rose somewhat in October with the resumption of oil production disturbed by hurricanes in the previous month. The October value of the industrial production index remained a substantial 4.7 percent below its value in January 2008.

Well here we could simply consult the INE's seasonally adjusted quarterly industrial output data. And guess what we find, well yes, you guessed, the series peaks in the third quarter of 2007.



Now obviously industry is only one part of domestic output, although it is remarkable to note how this sector, and not only construction, started to decline after the summer of 2007. This seems to suggest that Spain, right from the start, was having something more than a "housing slowdown". On the other hand, the services sector, as I argue in this post, did hold out somewhat longer, and as a result the cycle peaked somewhat later in this sector, possibly during the first quarter of 2008, although aggregate services do seem to have continued to expand - even if at a very slow rate - right up to the third quarter (which just shows how difficult it is to get a really precise measure on a process like this), and this may explain why so many "Spaniards in the street" have been going round saying "crisis, what crisis, I see no crisis, the bars and restaurants are full..."




Since services account for over 60% of the Spanish economy, this is, of course, more than just a detail. Then again, if we look at the entire path of the Spanish services sector since Q1995 (which is when the INE time series begins) we can begin to get an idea of just how significant this "peak" is, and how it is obvious we are now in for a major correction (since the upside has been so large and extended, or you could say "distorted"), and how talk of a short term setback is completely off the mark. Basically Spain's current "business cycle" has run from the last quarter of 1993 till the summer of 2007, which is, well, "one hell of a business cycle", and the question we will now have to get down to is just why it has been like this, especially if the correction is, as seems likely, a lengthy and painful affair. Let us hope that at least we will be able to say in the future "once bitten, twice shy".





Retail Sales Peak In November 2007

If we move from the production over to the demand side, then of course one very useful measure of domestic demand is provided by the volume of retail sales. In Spain the relevant index, in fact, peaked in November 2007.



And since the year-on-year measure turned negative around the same time, it is not unreasonable to suggest that domestic demand was entering contraction at around this point. It is important to remember here that Spain had been experiencing a mild "housing slowdown" for some months before the financial turmoil of the summer started to bring things to a grinding halt (see more on this below), and the effect of this slowdown can be clearly seen in the year on year retail sales chart in the months prior to the summer of 2007. Retail sales momentum had clearly passed its expansionary peak in late 2006.


Spain's Recession Started A Lot Earlier Than Q3 2008 On Any Reasonable Measure


So, what am I doing and what am I not doing here? Basically there is no doubt that for historical record purposes the 1 July 2008 will go down as the date the Spanish economy entered the current recession (or whatever it is we finally decide to call what is happening at the present time). But for economic analysis purposes we should be aware that the last business cycle very clearly turned, and went past its peak (thus "entering" recession in another sense of the term) not in the summer of 2008, but rather in the late summer of 2007 (on my best estimate, but then I am not a committee, and I have no authority whatsoever here), and thus, if we had all been a little less worried about defending our rears, and a little more concerned to actually get something done, they obviously the large structural problems which now lie out there before us could have been gotten to work on much earlier. In particular both fiscal and monetary policy could have been made more appropriate from a much earlier point.

If we look at the evolution of headline GDP itself, we can clearly see two "breaks" in the data, the first in the middle of 2006, representingwhat we could call the "housing slowdown". This was evidently provoked by the interest rate raising cycle at the ECB together with the rising cost of mortgages and the impact of both of these on growth. The second break is alos clear enough even for the untrained eye, and comes in the second half of 2007 (following the closing of the wholesale money markets to Spanish financial products), and this is when, in any meaningful sense, the long boom in the Spanish economy really and decisively reached its peak and the downturn - or recession as defined by being "a broad contraction of the economy, not confined to one sector" - really got underway. Remember, a car travelling at 120 Km per hour on the motorway which runs out of petrol can still roll on for another couple of kilometres before coming to a complete stop.

Lastly it is worth pointing out that one of the principal reasons the internal demand contraction didn't show up so clearly in headline GDP data was the simultaneous evolution of the external trade balance, which, while remaining very negative, lessened as we moved through the quarters. This was becuase exports have continued to increase while imports - despite a very large increase in oil prices - have remained almost stationary (see chart above). Thus the net impact of external trade on recent q-o-q GDP has been - ironically - positive, even though the substantive impact over time is hugely negative. I mean, going back to the car, try putting the handbrake on hard, shoving the thing in first gear, accelerating like mad, and then easing of the handbrake slightly. The handbrake is still breaking, but off you go shooting forward. This is what reducing a negative influence can mean. Be careful you don't have a wall in front of you when you try this.

Another thing we need to think about here is that as the external environment deteriorates further (global recession in 2009 etc) this positive boost from exports may well not last too long (at least in the short term - although in the longer run this increase in exports is precisely what will be needed, although, again as is clear in the chart, getting exports to catch up with, and ultimately overtake, imports is going to be quite a long haul process for the Spanish economy). So basically, depending on how much further imports fall, the "positive external trade effect" may well be a very short lived one.




Returning, in conclusion, to the main topic of this brief review, Spain's long boom, just how long the run up has been is very clear indeed from the final chart I present. The point is here, I think, we now know where the peak was, but we don't know how long it will be before we see that employment chart turn up again, and even more to the point, how long it will be before Spanish employment gets back to the levels which were being enjoyed in the Summer of 2007.

Are Baltic Devaluations Now In The Works?

Now this is a very interesting question, isn't it? The only honest answer I can give is that I don't know, and indeed I haven't the faintest idea. The government of Latvia (the Baltic state which is currently most rife with "rumours" about imminent devaluations) works in its own wondrous ways, and neither we (nor Latvia's citizens) have any idea at all how they plan to lift their country out of the deepest depression they have experienced in many a long year.



What I do know is that, economically speaking,the present situation is simply unsustainable, and something is going to have to be done. Indeed the country's government is in talks with both the IMF and the EU Commission about this very topic as I write. My own opinion is that domestic consumption is now dead (as a growth driver) for as far ahead as the eye can see (and maybe even further), that the country's citizens now need to start to save rather than borrow more, and that the only way Latvia can turn itself around is by exporting more than it imports. But for a country which ran a 23% current account deficit in 2007 this is going to be very difficult objective to achieve, since after two years of very strong inflation Latvia's relative prices with the rest of the world are completely uncompetitive.

Historical experience has taught us that it is not an easy thing to tell people "we are going to cut your wages by between 5 and 10% this year, next year, and then possibly the year after". Apart from the fact that voters don't like to hear this kind of talk, you can also enter into a deflation dynamic which then comes to be very hard to break out of. Hence, according to conventional economic wisdom, devaluation tends to be the preferred option. And it is my opinion that, despite all the attendant difficulties, devaluation is the best option among the unappetising list of unpleasant options presently available to Latvia (and the other Baltic states, and Bulgaria). Unfortunately, having reached this point there are simply no "pleasant" options available.

The curious thing is that for voicing this opinion I could go to prison in Latvia.

According to the Baltic Course online newspaper Ventspils University College lecturer Dmitrijs Smirnovs was detained for two days recently on suspicion of spreading rumors about the devaluation of the Latvian currency. He was detained in connection with an opinion that he had expressed during a debate about the development of the Latvian economy and the future of the Latvian banking and credit system. His arrest followed the publication of his opinion in Ventspils' local newspaper Ventas Balss. According to the newspaper report he said the following:

"The U.S. problems are trifling, compared to what awaits us. They have now reached the bottom and will start to recover. Problems in the European Union have only just begun and we may be hit by a crisis that is ten or maybe twenty times worse than that in the United States. The Swedish banks will no longer be able to offer inexpensive loans through their subsidiary banks in Latvia. They will tell us to pay back the debts! How will we pay them – with the real estate? We have no assets to pay back the debts! [..] The pyramid has been built and now we have to wait until it collapses. [..] The only thing I can suggest now: first of all, do not keep your money in banks, second: do not save money in lats, as it is very dangerous at the moment."

Dmitrijs Smirnovs appears to have been detained by members of the Latvian Security Police, who seem to have been charged with the special mission of protecting the integrity of the Lat at this very delicate point in Latvian history. And while some of the advice Smirnovs offered to his audience may have been ill-advised (given the delicate nature of the problems involved), they are opinions, and in a free and democratic society he should be at complete liberty to express them.

In fact Smirnovs is not the only such case to have arisen in recent days, and Baltic Course report that two more people are "under investigation" by the State Security Police. According to Latvian newspaper the Telegraf Latvian police previously detained a journalist under suspicion of spreading rumors about the Baltic nation's financial system during the global market crisis (also see this report and debate in comments about the same issue in Baltic Business News, while the same source reports that in the Finish newspaper Kauppalehti - which is evidently not controlled by the Latvian Security Police - they are simply discussing whether the Lat will be devalued before Xmas or in two to three months time).

The police held a journalist working for a Latvian newspaper yesterday evening in an investigation that started on Oct. 6 due to ``rumors about the Baltic country's financial system,'' police spokeswoman Kristine Apse-Krumina said, according to the Russian- language newspaper. She gave no details on what rumors the journalist is accused of spreading. Another investigation has been started following a run on currency exchange booths in the capital Riga last weekend that was caused by rumors about a devaluation of the lats, she added.

One of the other cases under investigation by the State Security police appears to be a member of the Latvian pop group "Putnu balle" based on statements made during a pop concert in Jelgava on November 9. Kristine Apse-Krumina, aide to the Security Police chief, stated that the cases was opened following a complaint from a bank, which alleged that lead singer Valters Fridenbergs had urged the people to withdraw their money from Parex banka and Latvijas Krajbanka during the warm up to the concert. According to band manager Anete Kalnina what actually happened was:

"As it often happens at concerts, the band members communicated with the public, telling jokes about themselves as well as many other things. The band had performed two songs when the guitarist Karlis Bumeistars had to tune his guitar, which is when Valters Fridenbergs started talking to the public," Kalnina said. Commenting the current situation in Latvia, Fridenbergs said that the audience had better hear the concert to the end, and only then rush to ATMs. "The people at the culture center got the joke, and laughed. It was not an encouragement" to withdraw money from banks, said Kalnina.

Evidently State Security Police charged with the investigation of seditious devaluation rumours have no such sense of humour, although maybe having to attend a few more pop concerts wouldn't be a bad therapy for them.

I myself received what could be termed a "mild threat" on my Latvian blog, following my publication of an opinion by Bank of America analyst, David Hauner, about the need to devalue:

``They will keep the pegs at the current exchange rates well into 2009, but reset the rates to devalue against the euro later, when markets have calmed,'' Hauner said.

This attracted the following warning from unidentified commenter LV, who would seem to me to quite possibly be a member of the above mentioned "Keystone Cops" group.

Apparently you are disseminating false information about the Latvian financial system. Please note that this may constitute a crime under Latvian law. In order to prevent the spreading of false rumours regarding the Latvian financial system the Latvian Security Police has also opened a telephone hot line so that false rumour spreaders can be reported and tracked down.

He then cited some rigmarole in Latvian which he invited me to use a Google translator to understand. I replied as follows:

Well I don't know what the Latvian law says, and quite frankly I don't especially care. You stopped having a dictatorial system when the old Soviet Union broke up, and there is a UNIVERSAL right to express an OPINION under any concept of democracy I know.

Actually the extract you cite comes from an analyst from Bank of America, and it is an opinion and not a fact. As far as I know he has no priviledged information, but if you have any doubts better you contact him direct.

My OPINION is also that the peg is impossible to hold in the longer term (ie it needs to be corrected before euro entry, for the reasons I explain), and logically since there is then a further delay in entering the euro after the devaluation it is better to do it sooner rather than later.

This is my opinion as a mecro economist and specialist in the Latvian economy, if expressing this opinion is illegal in Latvia, then really I don't know what Latvia is doing in the EU, let alone thinking about euro membership. For tyhis kind of thing you'd be better off with Putin and Medvedev. Open economies don't work that way, or didn't you notice, 22 world leaders just met to affirm that the best way out of the present financial crisis is to have the maximum TRANSPARENCY possible.

As I say above, this is all a very delicate issue, and university lecturer Dmitrijs Smirnovs was undoubtedly ill-advised to use the specific wording he did, not because he committed any known offence, but simply becuase he could have provoked a run on the banks, and this would only make the matter worse. On the other hand - and assuming they do have to devalue - it is a very unfortunate state of affairs that all those who actually know and understand what is happening have already changed their money over, while "ordinary Latvians" (like those in Smirnovs' audience) who have no idea what is happening, but (ill-advisedly perhaps) like to trust their leaders will simply lose a significant part of their savings.

Better never to have come to this point, but then, saying that doesn't help very much, does it?

Back in August 2007 I was asked the following question by a reader of my Latvian blog:

I want to thank you for your continuing efforts to explain what is happening in the Baltics in general and Latvia in particular. I live in Latvia and will be heading to the bank tomorrow to move our family's savings out of Lats and into Euros while the peg is still intact. (Or is there a better idea?).

To which I diplomatically replied as follows:

I wish I could be the bearer of better tidings. I think history has been so unkind to all the peoples of Eastern Europe, they really do seem to be entitled to be dealt a kinder set of cards than the ones they actually have. Really, I think you will appreciate that, even if I could hardly claim to be widely read on this blog, I do want to be responsible, and thus am unlikely to say anything which I feel could be in any way damaging to the Latvian outlook.

However, if you ask me this question:

"Or is there a better idea?"

Then I have to say that I personally can't think of one. For the rest, at this point, you will have to read between the lines I'm afraid.

I will try, when I find the time, to treat the currency peg issue in a somewhat theoretical fashion, but I fear it is reality itself which will put it back on our collective agendas in a much more practical one. I simply don't see how you can have the level of cost inflation (and the wage increases have still to feed through to producer prices and the end customers over many months) and still hope to sell exports. And if you are going to cut domestic demand, which is what they are doing, then selling exports is the only effective way to live.

Basically, as the observant reader will note, my core discourse has not changed very much over the last 18 months or so, nor will it - Latvian State Police or no Latvian State Police.

Will They Be Investigating The EU Commission?

One of the very sad and ironic aspects of the present case is that the Latvian government is currently, as I indicate at the start of this post, in discussions with both the EU Commission and the IMF about the future of the Latvian economy, and I think it is hardly a closely kept secret that both these institutions favour a floating currency, and thus logically a "flexibilising" of the Lat peg as a way forward out of the present crisis,

The European Union was really as explicit as it could be at the end of last week when it make clear that it is more than ready to provide financial assistance to Latvia, but that any aid will be conditioned on a programme to underpin balance-of-payments stability. And what could bring more stability to the Latvian balance of payments (ie induce more exports and suck in less imports), well evidently a change in the relative values of the Lat and the Euro - really at this point there are no other alternatives.

The EU, in their statement said they were "in close consultations" with Latvian authorities, and with the International Monetary Fund in order to develop a joint response to what were described as the "growing tensions'' in Latvia's financial markets.

``The EU stands ready to participate in a coordinated financing package with the IMF conditional upon a strong commitment by the Latvian authorities to implement a rigorous and credible adjustment program in order to underpin balance-of- payments sustainability in Latvia".

The statement did not specify when the aid would be granted or the amount involved. As regards the Latvian extenal position, the chart below of the current account deficit says it all. There is a whopping imbalance, and even though the deficit will be less this year, this is largely due to a collapse in imports as domestic demand has collapsed, and the need to export competitively issue still remains to get to grips with.

Repsol, Lukoil and Sacyr Vallhermosa Also Try Their Hand At Happy Families

“Happy families are all alike; every unhappy family is unhappy in its own way”
Tolstoy

Well this is an interesting little fable of modern family life, even if all the families involved may not be ones which many of my readers would normally wish to belong to.

As is now reasonably well know Russian private oil company Lukoil is currently making a bid for the shares in Spanish energy company Repsol which are owned by the deeply indebted Spanish property company Sacyr Vallhermosa.

Shares in what is Spain's fifth biggest builder, and which currently occupies the somewhat ignominious position of being Spain's worst-performing stock this year, jumped the most in two years last Thursday (20 November) on reports they were about to sell their 20 percent stake in Repsol YPF to the Russian oil company OAO Lukoil. Sacyr, which said last week it was in talks over the possible sale of the stake, rose as much as 14 percent after EFE newswire identified Lukoil as a possible bidder. Lukoil is also reportedly willing to buy a further 9% of Respol stock owned by Criteria Caixacorp, the investment company established by Catalan savings bank La Caixa.

In fact Sacyr spent 6.5 billion euros building up their the Repsol holding, between October and December 2006, paying an average of 26.71 euros a share for the stake. It is estimated that the proposed sale of the shares may fetch 20 percent to 30 percent more than their current market value of 4.9 billion euros. To give an idea of what this means, we might bear in mind that Repsol shares closed in Madrid on Thursday at 13.61 euros, and rose 2.3% on Friday, while the Spanish newspaper El Economista reported that Lukoil was offering Criteria and the other shareholders 28 euros a share for the combined stake which constitues just under 30 percent of Repsol. An offer at this price would value the combined stake at about 10.2 billion euros, and would mean that Sacyr would walk away covering their initial investment almost completely, which in these hard times must seem almost incredible. I mean, you might like to ask yourself just why it is that Lukoil is able and willing to pay so much. Certainly Russian investors were asking just this very question since Lukoil shares dropped on the news - falling 4.6 percent to 778.74 rubles on the Micex stock exchange in Moscow on Friday (for my explanation of the apparent analogy more on this topic below).

But before going further there is perhaps one other little detail which is worth including at this point, and that is that since the combined stake of Sacyr and Criteria falls just short of the 30% mark which would give Lukoil effective control of the energy company (and make it obligatory to make a takeover offer to the other shareholders I think) it should not surprise us to find that the midewives of the deal are busy trying to identify those extra few shares which would push Lukoil over the 30% stake mark, and various names are being bandied around - like Mutua Madrileña (who have a two percent stake) or even La Caixa itself, since they effectively control another 6.1% of Repsol through their subsidiary company Repinves.

It's The Income Balance That Matters, Silly!

Now before we go into all the gory little details as to why exactly it is that Sacyr Vallehermosa find themselves so pressed to sell, perhaps a little of the background macroeconomics would not go amiss here.

Basically, as I explain in more detail in this post, the principal problem facing Spain's economy at the present time is financing the large external deficit, which has been running at around 8-9,000 million euros a month (8 to 9 billion in anglo saxon language, or around 10% of GDP) for most of this year. This deficit was previously financed by an inflow of mortgage funding when external investors were willing to supply this, but since these investors became increasingly nervous following the US sub prime turmoil in August 2007, Spanish banks have had problems funding the deficit (and funding mortgages) as we have been seeing via the dramatic slowdown in the Spanish economy that this reluctance to lend has produced.

Now.......

The principal way to resolve this external deficit is to have a major macroeconomic correction such that exports start once more to be larger than imports, but this process is a huge and painful one, and it is not surprising that the patient, lead by the country's government, and the prime minister, is extremely reluctant to enter the operating theatre. So we struggle on, month by month, but the monthly deficit still has to be paid. And this is where the sale of Repsol to Lukoil comes in. The issue is not that Lukoil being a non-Spanish company is a disadvantage (which is why the sort of criticism of the proposed deal which is coming from the PP is also completely out of touch with reality), but rather that it is absolutely essential to find an external buyer to raise more liquidity for the Spanish banking system, and if no other bidder is in a position to pay Sacyr what they need to make the sale viable for them, then Lukoil it is, "por las buenas o por las malas", as they say in Spanish. When you are up against the wall, and the only question is "do I shoot you today or tomorrow", the answers you give are not always coherent and well-thought-out ones.

However, just how dangerous trying to handle the Spanish problem in this way actually is, can be seen from the fact that one of the country's flagship companies is effectively being sold off for less than two monthly installments on the current account deficit (the August deficit was 6 billion euros). The problem really is that Sacyr has to sell (see more details below) but there is no ship left among what used to be called the "new Spanish armada" who still has the creditworthiness needed to be able to buy. Gas Natural (who were one of the last stalwarts) had their Long-term Issuer Default rating of 'A' and Short-term IDR of 'F1' placed on Rating Watch Negative by Fitch last July after they announced they would need a new 19 billion euro syndicated loan to finance their acquisition of a sizeable chunk of energy company Fenosa from another debt laden Spanish construction giant ACS.

Essentially going about things in this way eventually becomes totally unsustainable. Let me explain a little more. It is important to understand that the external accounts of a country are divided into two parts - a current account and a financial account - rather like the finances of a houshold can be divided into long term and a short term components like the acquisition of a property and the monthly mortgage installments which finance it. Well basically the structure of national financing isn't that different. Spain Incorporated can raise funds on the capital account by selling the shares of Repsol to an external purchaser, but we should never forget that these shares will then pay dividends, and these dividends will subsequently show up on the current account under the monthly income balance heading.

Now normally, in a developed economy, the income balance should hover around the neutral zone, as external investments attract income, while FDI etc from abroad carry associated outflows. Indeed I would say that the normal difference between a developed and a developing economy is in the underlying dynamics of the income section of the current account.

Well......

It is precisely when we come to examine this aspect of the Spanish case that we see the extent of the hole that has just been blown in the flagship's main bulkhead, since the income balance (which was never perfect) has been turning steadily negative (which was only to be expected with all those loans coming in) since the early years of this century, and now runs at a monthly outflow of 3 billion euros, or thereabouts. That is to say, the first 3 billion of any goods and services surplus which Spain eventually does manage to generate will be earmarked to pay interest and dividends on loans and shares previously sold to finance the property and merger boom. So roll your sleeves up lads and lasses, since there is a lot of sweating to be done to work off all this accumulated excess fat. Or maybe you would prefer to try liposuction?

And of course, the more we go down the road of selling off the country's underlying assets (and, of course there is plenty more to come here, see below on Acciona, Endesa and Enel, or think of the recent agreement to sell Iberia to British Airways due to Caja Madrid's urgent need for liquidity - Caja Madrid is Iberia's largest single shareholder) to pay for petrol for all the SUVs we have been buying with the loans we sold, the worse the long term position becomes.


Sacyr In Danger Of Having To Make Firesales

Rumours have been growing in investor circles of late that Sacyr Vallehermoso could be in such a tight financialcorner that it may forced into fire sales as time passes, if it fails to find buyers for assets it has put on offer to try to cover the massive debts it has hanging over it. Sacyr's share price has lost 69 percent of its value since the beginning of the year - as compared to a 39-percent slump in Spain's main IBEX stock index.


Like many Spanish builders, Sacyr borrowed heavily during the final years of the boom in an attempt to diversify out of residential property as the nine-year-long domestic housing boom clearly started to wind down. But as in so many other cases, those who buy near the end of a wave buy dear, and risk, if things don't go right, having to sell cheap, very cheap, unless of course a gleaming white knight in shining armour like Lukoil gallantly comes to your rescue (or is it so gallant, see below). Sacyr had net debt of 18.3 billion euros at end-June, or eight times market value. The ratio of net debt to net equity was 5.3, outweighing peers like Ferrovial at 3.9 and ACS at 1.2.

Sacyr thus announced on September 12 that it was putting assets up for sale, including its toll road unit Itinere and the 20 percent stake it has in Repsol YPF, all part of a major effort to pay down some of the debts. However, outside Lukoil no firm expressions of interest have materialized, and analysts are suggesting that this is because the prices being asked are far too high, as evidently it is hard to get good prices for assets in a bear market accompanied by a credit crunch. But this raises of course, the not simply incidental issue of why exactly it is that Lukoil is willing to pay so much over the going market rate, but we will get to that part later.

Sacyr did have around 347 million euros of debt maturing in the second half of 2008, but they have so far managed to refinance this, although there are somewhere in the region of another 2 billion euros worth set to expire in 2009, and worries about the difficulties which are likely to be associated with this process during the deep recession which Spain is now entering are putting a lot of pressure on the company.


Sacyr has been attempting to cover next year's debt haemorrage using a mixture of renegotiation, housing sales, dividend payments and the possible sale strategic assets, like its road toll unit Itinere. Citi infrastructure fund had been reported to be showing some interest in a possible purchase of Itinere, but there has been no concrete evidence of progress.

Press reports and analysts say the asking price for Itinere is in the region of 3.9 billion euros plus debt, and this sum is 400 million euros greater than the value of Itinere's failed initial public offering last April. Analysts tend to be rather dismissive of this kind of approach in the present climate.

"They were unable to do an IPO at 3.5 billion euros and four months later they
want to sell it for 3.9 billion? It's a joke," said an analyst at a major bank
who asked not to be named.

Apart from the asking price there are also clauses in existing Itinere loans that require a renegotiation of terms if it changes ownership, which also are reported to present a stumbling block to any Citi-type deal.


But the main problem which Sacyr faces right now is the current performance of Repsol itself, since the 5.1 billion euro bank loan which partially funded their purchase of the Repsol stake was guaranteed with Repsol shares, and on a margin trade basis. So when Repsol's share price falls, Sacyr must stump up more guarantees, putting further strains on the group's liquidity. And, of course, Repsol shares have been having a very hard time of it recently, evening fell by as much as 20 percent in a single day on October 22 over concerns about the energy company's exposure to Argentina, which is itself getting into ever deeper water with the international investment community: a further Argentine default would be the last thing that Repsol (and naturally Sacyr) need right now. Subsequently Repsol stock has regained some of the lost ground (and is now trading at around 15 euros) but this is still a far cry from the 26.7 euros a share Sacyr paid in 2006.

Sacyr has so far pledged 40 percent of its rental property business Testa as additional collateral for debt taken out to buy the Repsol stake, and Goldman Sachs in a recent note suggest that as long as Repsol's share price remains above 12.9 euros per share, Testa will cover the collateral under current terms, but in Sacyr's present state that is a very wobbly if. And if Testa shares become no longer sufficient, then Sacyr will have to reconvene with banks to discuss alternative collateral, and this they need like a hole in the head, hence all the haste and attention being lauded on the Lukoil suitor.

Analysts are agreed the longer it takes to sell assets to shore up its balance sheet, the more worrying Sacyr's borrowing levels will become and the greater the risk of fire sales.


Spain's leading water company Aigues de Barcelona (Agbar) has also expressed an interest in the water division of Valoriza part of Sacyr's environemntal division. Valoriza is valued at around 1 billion euros. Agbar and Sacyr do not seem to be in actual talks at the present time, since the sum involved is insufficient to materially change the main problem, and Sacyr is more focused on Itinere and its Repsol stake. The Spanish newspaper Expansion reported that the sale process of Valoriza is being handled by Italy's Mediobanca and that as well as Agbar interest has been shown by Veolia which is a former partner of another Spanish builder - FCC - and operates in the environmental services business in Spain.

Any eventual sale of these units would not be the first such move by Sacyr to keep moving ahead by selling assets, since back in April Sacyr sold its stake in French builder Eiffage, following a bungled takeover bid, and in the process cutting its borrowing by 6 percent.


Sacyr representatives also recently met with lenders on its Repsol loan - who are lead by Banco Santander - to discuss the collateral clauses in their agreement. In principle under the original terms of the loan up until December 21 Sacyr have to put up collateral equal to at least 105 percent of the total loan, after that date this figue increases to 115 percent. In addition the interest rate on the loan rises to 1.10 percentage points more than euribor benchmark rates from the present 1 percentage point after the same date, and this is another reason why Sacyr would like to see their Repsol stake turned into history before xmas.

The company has already pledged the maximum amount, 1.275 billion euros, of shares from its property unit Testa Inmuebles en Renta SA allowed under the terms of the loan. Sacyr began using Testa stock in January after Repsol, whose shares were initially assigned as collateral, declined below the 20 euro a share watermark, according to a regulatory filing Sacyr made on January 23 2008. Repsol fell to 12.92 euros on Oct. 28, the lowest in more than five years, and are down 40 percent over the past year. Sacyr has fallen 71 percent this year, the largest fall of any of the 35 most-traded stocks included in Spain's IBEX Index.

So What About Lukoil, Why Should They Be So Interested In Repsol?

On the face of it the justification for Lukoil's interest in Repsol is not as self-evident as it at first appears, but then little in modern Russia ever is.

Lukoil has itself been struggling from a liquidity crunch back home in recent months, as the price of oil has dropped and lack of investment by the Russian oil majors means that field depletion is leading to ever lower levels of domestic output. Indeed the price of Urals crude, which is Russia's principal export blend, was down 68 percent from the July peak last week, hitting the "bargain basement" level of $44.80 a barrel.

Lukoil, which already owns refineries in Bulgaria and Romania, agreed in June to pay 1.35 billion euros to buy into an Italian refinery with partner ERG SpA. Lukoil, which has $1.9 billion in debt and loans scheduled to mature this year (although obligations will drop to $609 million in 2009 and $525 million in 2010) had only $1.66 billion in available cash at the end of June. So what is going on here?

Well, as I have said, Russia is facing its own credit crunch and construction slump, and as a result Vladimir Putin did recently introduce his own $180 billion dollar bank-bailout and loan guarantee scheme. Could it be that Lukoil want, in some shape and form or another, to take advantage of this potential funding to acquire the Repsol stake? Well, there are reasons for imagining that there might be a very strong incentive we haven't yet touched on for them to do just this. The principal reason among such reasons (or the bitter and compelling inner logic of the issue) was basically put under the spotlight by the recent announcement (and large gaffe) made by central bank Chairman Sergey Ignatief when he said that Russia's currency (aka the ruble) had a "certain tendency toward weakening'' . Since the ruble normally trades in a tighly controlled trading band this widely interpreted as meaning that the ruble is about to be devalued, and while estimates of the extent of the devaluation vary, something in the 15% to 20% range would be a good guess, I think.

Viewed in this light, a loan of some 6 or 7 billion euros (denominated in rubles) under the Putin bank bailout and credit guarantee scheme wouldn't look to be too bad a proposition, especially if it was subsequently to be repaid in rubles following a substantial devaluation. (I mean I don't think I will get here into any rather Machiavellian type of speculation about how a hypothetical demand for 7 billion euros from the central bank foreign exchange reserves - which are of course under considerable pressure right now - would effectively constitute a very large "devaluation put", and offer us all the hallmarks of being a self-fulling declaration of intent). And don't start imagining that such an idea is very far fetched, since IMF Managing Director Michel Camdessus effectively had to resign at the end of the 1990s following continuing scandals about IMF support loans being diverted into currency speculation. And that such activity is not entirely dead in today's Russia was confirmed by last week's threat by First Deputy Prime Minister Igor Shuvalov that Russian banks who convert government aid into foreign currency rather than lending to troubled companies would risk losing access to state funding .

Obviously, in addition to any incidental gains they may make in the forex markets, Lukoil would also gain access to Repsol's extensive refining capacity - 1.23 million barrels a day according to their website - which includes five refineries in Spain, three in Argentina and one in Peru. Repsol also has holdings in another refinery in Argentina and two more in Brazil. And indeed the deal has a certain logic from the Repsol point of view, since the tie-in with Lukoil would give access to Russian supplies while the company currently relies on South America for about 95 percent of its present oil reserves. But then, as is normally the case, nothing in life ever comes free, and in this case the strings attached are important ones, very important ones.

Spain's Builders Up To Their Eyes In Debts

Obviously Sacyr is far from being alone in its current "tight fix". Acciona SA, is another Spanish builder struggling under the weight of a growing mountain of debt. Acciona came to international prominence when it bought joint control of power company Endesa SA last year together with Italy's Enel SpA. Well, the Madrid-based builder said July 30 that first-half net income fell 15 percent to 314 million euros as the takeover had increased debt costs, with Acciona net debt rising to 17 billion euros in Q2, up from 10 billion euros a year earlier. Acciona has recently stated it is in talks with creditors in an attempt to refinance the debt it contracted to make the purchase of the Endesa stake, but strongly denied that it has already committed to selling the stake in 2010. This denial followed a report on Spanish financial website El Confidencial that Acciona has assured its creditors that it will exercise an option it has to sell the 25 percent stake in Endesa to Italian partner Enel in 2010.

Despite the denial the decision to sell would be a logical one, and appears as if it may well form part of an agreement Acciona have reached with a group of banks lead by Banco Santander not to link Endesa's share price to the collateral required for the 7.1 billion euro in loans it received for the stake buy, as previously agreed. The 2 loans were due to have expired on 31 December 2012, but Acciona was obviously anxious to get the conditions changed.

"Acciona has not committed to exercising the March 27, 2010 put option but that
does not mean that the company will not exercise it on that date or at a later
date," the Spanish builder said in a statement to the stock market regulator.

Under the previous contract Acciona needed to give additional guarantees in the case that Endesa stock fell below 25 euro per share and this had been the case since October 6. Such guarantees -or margin calls - disappeared under the new contract. In exchange the new contract increased interest rates on the entire sum of the debt - doubling the premium when compared with the previous rate of 60 basis points over Euribor. Thus we find ourselves in exactly the same position vis-a-vis margin calls as Sacyr has with Repsol. The 21 syndicated banks behind the principal Acciona loan include Santander, ING, La Caixa, RBS, Caja Madrid, Calyon and Natixis, and the loan effectively financed the original 25 percent stake that Acciona took in Endesa following a 42.5 billion euro bidding contest in alliance with Italy's Enel which currently owns some 70 percent of Endesa. At the time Enel and Acciona came out in front of competing bids from Germany's E.ON EONG.DE and Catalonia-based Gas Natural.


Back in July the Italian newspaper Corriere della Sera reported that Enel was in talks to buy out Acciona for 10 billion euros, adding the point that any such deal would needs the approval of Spanish prime minister Jose Luis Zapatero - so Zpt is going to be busy, since he has already flown to St Petersburg. Corriere also suggested that Endesa's development was currently being paralysed by an ongoing dispute between the two principal shareholders. The paper stated that there was an urgent need to find a solution to overcome the repeated obstacles raised over Endesa board decisions by Jose Manuel Entrecanales, who is chairman of both Acciona and Endesa. Enel has plans to expand Endesa outside of Spain, while Acciona is simply looking to sell its stake to pay down some of its 18 billion euros of debt, according to the paper.

Valuation of Acciona's stake in Endesa depends on valuation of Endesa's wind power generating plants, which Acciona would like to acquire. Any finally agreed exit price for Acciona would also need to take account of the put option it holds to sell the Endesa stake by October 2010 to Enel at a price of 10 billion to 12 billion euros.


Meantime another Spanish building dynosaur - Ferrovial - labours on with its heroic attempt to try to sell its Stanstead airport holding in the UK - but at least in this case the asset being disposed of does not form part of Spanish national patrimony. The Spanish builder that spent $20 billion buying the British Airports Authority is taking longer than anticipated to sell London's Gatwick airport because of the global financial crisis, according to its Chief Financial Officer Nicolas Villen.

``It's difficult to say where we are in this crisis,'' Villen said in an
interview in New York late on Nov. 14. ``In this financial crisis it will always
be more difficult for potential bidders of this asset to obtain financing. So I
think it's going to be a lengthier process than usual.''

BAA currently provides poor service and has failed to plan for extra capacity, according to a recent report from the U.K. Competition Commission, adding a recommendation that the company be stripped of the capital's Gatwick and Stansted airports and either Glasgow or Edinburgh in Scotland. Both Heathrow and Gatwick had a drop in traffic of about 0.5 percent in the first nine months of the year, described by Villen as a "moderate decline" when compared with earlier economic crises, when traffic fell by 3 percent or more.

Ferrovial had a third- quarter loss of 17 million euros, which compared with a year earlier profit of 49.6 million euros. The company's total debt fell 5.4 percent from a year earlier to 28.6 billion euros in September.

Fomento de Construcciones y Contratas (or FCC) - Spain's third largest builder - on the other hand had net debt of 8.51 billion euros at the end of the first quarter, 54 percent more than a year earlier, and up from 7.97 billion at the end of 2007.

And It's The Same Picture Among Property Developers

Spanish property group Tremon last week became the first major property developer to follow in the footsteps of Martinsa Fadesa, and file for administration after failing to meet debt payments, causing a fall in the shares of those banks which have total exposure of around 1 billion euros to the company. Tremon is thus the second large Spanish property group to seek
administration this year following the July decision of Martinsa Fadesa. Among Tremon's biggest creditors are Banco Popular, which has an exposure of around 200 million euros exposure, unlisted savings bank Bancaja with 100 million and Banco Pastor which has 95 million.

"Our debt is up to 1 billion euros, and more than 90 percent is held by a
pool of 16 banks. Administration was filed last thing on Friday," said
lawyer Angel Romero, who is acting as Tremon's spokesman.

Other Spanish property companies with large debts are Metrovacesa (6.991 billion euros), Colonial (10.086 billion euros) Realia (2.26 billion euros) and Reyal Urbis (4.672 billion euros)


Spanish property firm Metrovacesa recently stated they expect to meet the terms of a 3.2 billion euro syndicated loan by the end of the year. At the end of September, Metrovacesa's core earnings were 2.13 times its financial costs, below the minimum limit of 2.25 times the company is obliged by creditors to meet by the end of 2008. Among other conditions attached to Metrovacesa's 3.2 billion euro loan is that the company maintain its 6.9 billion euros of debt at no more than 55 percent of asset value. The company said its debt stood at 54.4 percent of assets on Sept. 30 when it published its third-quarter results. If Metrovacesa does not comply with the conditions of the syndicated loan, the banking syndicate can order its immediate repayment and order the company to talk to its creditors.

Spanish stock market regulator CNMV last week requested Metrovacesa to provide it with details on where it stands with repaying the syndicated loan, as well as with refinancing 810 million pounds worth of borrowing with HSBC, the money was used to buy the bank's London offices. Metrovacesa stated in reply that the company was still in talks with several financial entities over refinancing the HSBC debt, which falls due at the end of November, but had yet to reach a deal.

Real estate company Reyal Urbis also recently reached a deal with creditors to refinance debt of 3.006 billion euros. In a statement to the Madrid stock exchange regulator, Real Urbis stated it had obtained two new credit lines which gave it "the necessary liquidity for its operative management". The new deal refinances two syndicated loans signed in 2005 and 2006 in addition to other loans and debt issues. Under the new financing terms, the company has been able to postpone the next payment on its debt until October 2011 and signed up to twice-yearly payments after that date until 2015. Thus it seems there is a tendency to postpone into the future - to 2011 at least - and then perhaps at that point a critical moment will be reached in all this, assuming that is that it doesn't come before, which if we look at the very dramatic state of the contraction in the Spanish economy is a possibility which certainly can't be excluded.

In 2015 - should we get that far - the company will then have to pay off the remaining 40 percent of the debt. One of Spain's largest developers, formed through the merger of Urbis and Reyal in 2007, Reyal Urbis said it had net debt of 5.5 billion euros when it reported its first-half results.

Another Spanish real estate company, Colonial, recently reported a nine-month net loss of 2.475 billion euros after taking charges for plunging asset values. The loss compared to a profit of 356.9 million euros for the same period last year. Group sales for the nine months to end-September dived 23.7 percent to 472.8 million euros, but still the "walking dead" real estate firm managed to put through a debt restructuring in September. Funding banks had previously taken partial control of Colonial earlier this year when some of its shareholders failed to meet obligations. Residential land sales fell by over a half in the fisrt nine months of 2008 and Colonial's net debt stood at 8.975 billion euros as of the end of September.

And As Spain's Government Sells Bonds......

Spain's government still effectively seems to be in denial about where all of this more or less inevitably leads, and is still trying to keep alive the ailing builders and property developers on an emergency life support ("reanimator") system by selling government debt to guarantee the ever more risky private variant. Thus last Thursday (20 November) the (previously-postposed) first special "reverse auction" was held and the Spanish government bought 2.115 billion euros of bank assets out of a maximum possible of 5 billion euros. Spain's Economy Ministry said a total of 4.562 billion euros of assets had been offered. Spain's Fund for Acquiring Financial Assets (FAAF) held the reverse repo auction for investment grade, 2 year asset-backed-debt issued after Aug 1 2007. It plans to purchase up to a further 5 billion in 3-year mortgage-backed debt in December.

The government has said it plans to buy up to 50 billion euros in bank assets in 2008 and 2009 to provide a market for longer-term bank debt which institutions cannot sell to investors or the European Central Bank. The head of the State Credit Institute (ICO) Aurelio Martinez argued after the auction that some banks may have felt inhibited from participating due to fear of being stigmatised. FAAF received 70 bids worth 4.56 billion euros from 28 banks. Of those, 51 bids from 23 different banks were accepted, the rest were rejected after failing to meet criteria ranging from their size and interest rate to the participation of the bank in lending markets. Questions are being raised by analysts about the effectiveness of the fund given the limits on how much banks can sell, the stigma attached to sales, and the comparative ease of borrowing more anonymously from the European Central Bank.

The other side of this particular coin is however the little question of just how all this bank funding is going to be paid for. To some extent this became clearer this week since the day before the auctions the Spanish government previously paid its first visit to debt markets for funds in connection with the programme, and the first programme-specific auction was duly held on Wednesday 19th November. Remarkably the sale generated quite strong demand and even revealed comparatively stable spreads. Indeed demand was such that the Spanish treasury was able to issue 200,000 euros more in debt than initially anticipated in the special 4.4 billion euro sale to cover bank asset acquisitions.

That outcome is especially surprising as it compared with a disappointing demand in a sale of new 10-year German bunds held the same day, and which met fewer bids than the sum issued. Amazingly even the spreads remained stable. Investor appetite may be cautious in view of the high levels of uncertainty surrounding sovereign issues and debt levels over the next few years, and may be showing a preference over debt with a somewhat shorter maturity horizon. Anecdotal evidence (as encountered by the author of the present post) also suggests that many Spanish people may be seeing treasuries as a "safe haven" against a banking system where lack of reliable information makes them nervous about using deposit accounts.

Spain has said it plans to issue issue up to the full 50 billion euros earmarked for this kind of bank support in public debt (thus raising around 5% of GDP in new debt) over the next two years. Spain's deepening economic problems has caused the spread between 10-year Spanish bonds and the benchmark German bund to widen to 60 basis points in October from 8 bps a year earlier.

The much smaller yield differential on shorter term debt was reflected in a yield of 2.7 percent on the Spanish two-year debt sold on Wednesday which compared favourably with a rate of 2.71 percent in the secondary market the previous day. This paper traded in a band of 2.503/687 on Thursday in the secondary market and its spread against comparative German debt remained steady at 25 basis points.

Spain is to hold further auctions December and January to sell bonds and bills. Of course it is not clear who exactly is buying this paper. If it is the Spanish themselves then it will be of little avail (as per the above external financing argument), but Industry Minister Miguel Sebastian did tell Reuters on October 20 that Spain was appealing to Arab sovereign wealth funds to buy the bonds. With what success we have no idea.

........The Government Deficit Rises Sharply

As a result of all this selling Spain's budget numbers are deteriorating fast and could hit the EU 3 percent fiscal deficit limit as early as by the end of this year, according to a statement from central bank governor Miguel Angel Fernandez Ordoñez before the Spanish Senate last week. The limit itself is only a technicality at this point in time, but it is astonishing to learn that in the space of less than one year Spain will have gone from a budget surplus equal to 2 percent of GDP to a deficit of 3 percent. This is a shift of 5 percentage points in a year, and of course, if this continues into 2009 and 2010, then the debt to GDP levels will start to shoot up rapidly.

Fernandez Ordoñez may well not tell you (as I say here) the whole truth, but he normally does tell you the truth and nothing but the truth, andn he is thus fast becoming one of the main sources of reliable information in what is now a worm-infested Spanish communications system (just as another piece of anecdotal evidence here, I was to have travelled to the Basque Country tomorrow to appear on a regional TV programme about the merger between local cajas Kutxa and BBK, but the programme was cancelled - for the second time now - for the simple reason that the production team could find absolutely no one apart from me who was willing to talk in front of the cameras about this kind of topic. Thus hundred of Tertulias, thousands of empty words, and little in the way of cool clear light on the subject. The wheels of metaphysics turn round and round, but I see no motion in the drive shaft...). Anyway, Fernandez Ordoñez has been quick to pick up on the fact that the government's present forecast of 1 percent growth next year — unveiled just weeks ago in the 2009 budget — is already well out of date and the budget provisions need to be revised accordingly, and on the basis of much more realistic economic forecasts. If they don't start to do this, then the spreads will inevitably only start to rise further and faster as investors get more and more paniky about the actual underlying debt dynamics in the absence of any kind of realistic information.

"We must make a downward revision of prospects for economic growth in the next
few quarters," Fernandez Ordoñez said.

I think everyone now accepts what Prime Minister Jose Luis Rodriguez Zapatero explicitly said last Thursday: namely that Spain will inevitably exceed the European Union budget deficit limit as it tries to spend its way out of recession. EU budget rules specifically allow for countries to breach the deficit limit of 3 percent during exceptional circumstances, and Zapatero rightly said such conditions existed in Spain, where the economic contraction is about to become much sharper than elsewhere in Europe.

"Whether it (the deficit) goes to 3.5 or 4 or 4.2, we will have to wait to seehow the economy develops," Zapatero said during a press conference. "The Spanish government is not going to resign itself to recession, we're going to try to grow and provide jobs,' he said. "We're going to use the public deficit to keep social promises"

Of course, Zapatero is right here, Spain does need to use its fiscal leverage - Spain's debt to GDP ratio was around 20 percentage points below the EU average at the start of 2008 - to address the probelms. But just one more time Bank of Spain Governor Miguel Angel Fernandez Ordonez is also right in urging Zapatero to show some sort of fiscal prudence and hold back some public funds in case (I would say for when) conditions get even worse. Ordonez is explicitly expressing his fears that a focus on short-term, emergency measures, without a total restructuring plan, may rule out deeper structural labour and service market overhaulswhich will be needed in the future to raise competitiveness and promote long-term growth.

I will be even more explict. As I have argued here, and in numerous other posts, the present Spanish depression is being caused by deep-seated structural problems, and not by transitory cyclical ones. Thus, using fiscal policy as if this was simply a classical problem of the business cycle is a big mistake, on my view, and is needlessly using up vital ammunition which will be badly needed to take us through the battlefields which lie ahead.

We are now facing an economic slump of unprecendented proportions in Spain, and more than likely an ongoing problem of outright price deflation. To fight this combination using the traditional fiscal and monetary policy tools simply will not work - they are likely trying to drain an ocean with a teaspoon. We need new tools, fresh thinking, and a complete change of course. And the sooner we get them the better.

Well, this has been a very lengthy post. If anyone else has actually arrived this far, I can simply thank you for your patience and your perseverence. You are undoubtedly the kind of enduring person the new Spain is going to badly need. I hope you have learnt as much in reading this as I have learnt in the doing the background research which was necessary for writing it.

The Bank Bailouts Are Very Well Intended, But Where Is All The Money Going To Come From?

As every woman who has ever had dealings with a man knows only too well, it is a lot easier for people to make promises than it is for them to keep them. And when Europe's leaders met in Paris on the 12 October, a lot of fine promises (which were all, surely, very well intentioned) were made. The reality of having to live up to them, however, is turning out, as might only have been expected, to be much more complicated.

Basically, the kernel of the plan which is now being operationalised seems to have been thrashed out in Washington on 11 October, when key G7 leaders met with Dominique Strauss Kahn of the IMF, and it was decided to try and erect two great firewalls (corta fuegos) - at least as far as Europe is concerned. One of these was to be co-ordinated by the EU governments, and the other by the IMF, who were to act in the East. Both these parties essentially agreed to guarantee the banking systems in the countries for which they took responsibility, so the action, in a sense, moved from the banks (which are now, more or less "safe") to the governments and the IMF (who is ultimately backed by cash from governments), and it is the "safety" of these institutions which is likely to be more or less tested by the markets, with the first trial of strength taking place right now in Iceland.

So the big question now is, do these various institutions have the resources to back up their guarantees, should the need arise?

Problem Selling Bonds


In this context the Financial Times had a very interesting article yesterday about the fact that the Austrian government had decided to cancel a bond auction.

Austria, one of Europe’s stronger economies, cancelled a bond auction on Monday in the latest sign that European governments are facing increasing problems raising debt in the deepening credit crisis.

According to the FT article the difficulties Austria, which has a triple A credit rating, is facing only serves to highlights the extent of the deterioration in the sovereign bond market, where benchmark indicators of credit risk such as the iTraxx index hit fresh record spreads yesterday.

Austria now is the third European country to have cancelled a bond offering in the last few weeks - in the Autrian case the markets are getting more and more nervous over the exposure of some of its key banks (Erste, Raffeison) to the mounting disaster over in Eastern Europe - both Hungary and Ukraine received IMF loans this week (see below) and they certainly won't be the last.

Austria seems to have dropped its plans for a bond launch next week due to the size of the premiums (spreads) investors seemed likely to demand, although the Austrian Federal Financing Agency did not give any explanation for the decision.

Spain, which alos currently has a triple A rating, and Belgium have both cancelled bond offerings in the past month because of the market turbulence, with investors again demanding much higher interest rates than debt managers had bargained for.

So really many European governments are now facing similar problems to those their banks faced earlier, they can get finance, but only at rates which they consider to be punitively high (remember, the interest has to be paid for from somewhere, in the present recessionary climate from cuts in services more than probably, since, remember, if we look over at Eastern Europe, investors are very likely to "punish" those governments who try to go down the easy road, and run large fiscal deficits over any length of time).

Market conditions have steadily deteriorated in recent days with the best gauge to credit sentiment, the iTraxx investment grade index, which measures the cost to protect bonds against default in Europe, widening to more than 180 basis points, or a cost of €180,000 to insure €10m of debt over five years, on Monday.

This is a steep increase since only as recently as Monday of last week, when the index closed at 142 base points. Also the cost of default protection on European companies has risen to record highs this week on investor concern that the global economic slowdown will curb company profits. The Markit iTraxx Europe index of 125 companies with investment-grade ratings fell 3.5 basis points yesterday to 166.5, after hitting a record high on Monday.

The FT cites analyst warnings that the there is now a huge quantity of government debt building up in the pipeline, and the government bonds due to be issued in the fourth quarter and early next year will only add to the problems some countries are facing, and particularly those countries like Greece and Italy who already carrying large amounts of debt that needs to be refinanced or rolled over.

It has been estimated that European government bond issuance will rise to record levels of more than €1,000bn in 2009 – 30 per cent higher than 2008 – as governments seek to stimulate their economies and pay for bank recapitalisations.

The eurozone countries will raise €925bn ($1,200bn) in 2009, according to Barclays Capital. The UK, which is expected to increase its bond issuance from the current €137.5bn in the 2008-09 financial year, will take the figure above €1,000bn.

Italy, and Greece, both with a debt-to-GDP ratios of over 100 percent, are certainly the most exposed to continuing difficulties in the credit markets, (with analysts forecasting that Italy alone will need to raise €220bn in 2009). At the present time the Libyans are lending the Italian government a helping hand (and here) in struggling forward, but even oil rich Libya doesn't have the money to fund the long term needs of the Italian banking, health and pension systems.

IMF Have Only $250 Billion


On the other hand Bloomberg had an article yesterday on the growing pressure on the IMF's somewhat limited resources, as one country after another in Central and Eastern Europe joins the "consultation queue" in the hope of getting a bail out.

Bloomberg report that the cost of default protection on bonds sold by 11 emerging-market nations has now either approached or surpassed distress levels, raising the very immediate likelihood that the International Monetary Fund's ability to bailout countries may soon start to be put to the test.

Credit-default swaps on eight countries including Pakistan, Argentina and Russia have now passed the 1,000 basis points mark, the level which is normally considered to signify "distress", according to data provided by CMA Datavision. Funding one basis point on a contract protecting $10 million of debt from default for five years is equivalent to $1,000 a year.

``The resources of the IMF may not be sufficient for wider bailouts if needed,'' said Vivek Tawadey, head of credit strategy at BNP Paribas SA in London. ``If it can't raise the money, some of the more distressed emerging markets could end up defaulting.''

Ukraine, Hungary, and Iceland have already received IMF loans, while the fund is currently in "consultation" talks with Belarus, Turkey, Latvia, Serbia, Romania, Bulgaria and Pakistan, at the very least.

According to Simon Johnson, former chief economist at the fund the IMF only has up to $250 billion it can currently lend (as quoted in the Financial Times yesterday).

Credit-default swaps on Pakistan currently cost 4,412 basis points. Contracts on Argentina are at 3,650 basis points, Ukraine at 2,850, Venezuela at 2,400 and Ecuador costs 2,072. Default protection on Russia, Indonesia and Kazakhstan also costs more than 1,000 basis points, while Iceland costs 921, Latvia 850 and Vietnam 837. Contracts on Turkey cost 725 basis points.


The IMF agreed at the weekend to lend Ukraine $16.5 billion for 24 months and stated yesterday that they would contribute $12.5 billion towards a $25.5 billion loan for Hungary (with the other participants being the EU and the World Bank. Iceland got a $2 billion loan on Oct. 24 and Belarus has asked for at least $2 billion. Just how many more loans are now in the pipeline, and if the IMF does start to see its funds stretched, just who exactly is going to step up to the plate and fork the necessary money out? The sheer fact that they only put part of the cash for the Hungarian loan, and that the World Bank had to come on board with a symbolic $1 billion shows they are already aware that the problem may arise.

Update

Well just after writing this, I see from reading the FT that Gordon Brown got there just before me. Beaten by a short head!

Gordon Brown on Tuesday spearheaded calls for a multi-billion pound "bail-out fund" to prevent the global crisis spreading to more countries, and warned of the need to stabilise economies "across eastern Europe".....

The prime minister on Tuesday urged the oil-rich Gulf states and China to provide "substantial" funding to the International Monetary Fund, before flying to France for talks on an increase to the European Union's bail-out fund. The government is keen to emphasise the link between global action and domestic voters' interests, as well as portraying Mr Brown as a world leader.

The prime minister said it was "in every nation's interests and the interests of hard-working families in our country and other countries that financial contagion does not spread". While he did not rule out the UK making a contribution, he insisted the "biggest part can be played by the countries that have got the biggest [balance of payments] surpluses".

The IMF's $250bn (£158bn) bail-out fund "may not be enough" to prevent the crisis destabilising more countries, Mr Brown said. His spokesman added the UK was "looking at a figure in the hundreds of billions of dollars" for the IMF. Mr Brown called for "action on this new fund immediately".

Also, another story in Bloomberg gives us a further glimpse of how the EU governments are planning to do all that financing. The German government, it seems, is going to print IOUs (sorry, bonds) and give them directly to the banks. That is, they are not going to auction bonds and give the proceeds, they are simply giving the paper, and presumeably paying a coupon (or interest). Oh yes, and the bonds will not be sellable, since this would, of course, damage the yield curve via the supply and demand process, but they will count as debt, which means that the German government is being very naieve here (assuming the report is accurate) since of course the rise in the debt may well mean a breach of the 2011 balanced-books commitment, and falling back on this will almost inevitably have an impact on the extra implied risk investors will be looking to get paid for holding the bonds.

Germany plans to finance part of its 500 billion euro ($636 billion) bank rescue package by issuing bonds to banks in exchange for new preferred stock, according to Finance Agency head Carl Heinz Daube.

``The banks will not be allowed to sell the injected government bonds,'' Daube said in an interview in Tokyo today. ``So far there's obviously not a huge demand for any rescue measures, but this might change in the coming weeks.''

Germany's rescue plan, approved by lawmakers on Oct. 17, amounts to about 20 percent of the gross domestic product of Europe's biggest economy. Chancellor Angela Merkel's administration pledged 80 billion euros to recapitalize distressed banks, with the rest allocated to cover loan guarantees and losses.

....Hypo Real Estate Holding AG, the Munich-based lender that's already had a 50 billion euro bailout, today asked the Deutsche Bundesbank for 15 billion euros to cover short-term liquidity needs. ....Frankfurt-based Deutsche Bank AG may also need 8.9 billion euros of new capital, more than any bank in Europe, Merrill Lynch & Co. analysts Stuart Graham and Alexander Tsirigotis wrote on Oct. 20.

The bailout plan is still being discussed in Berlin and more information will probably be released at the end of this week, Daube said.

Germany may meet additional funding needs for its bank rescue by selling six-month bills before examining options for borrowing using longer-term securities, Daube said. The government plans to offer between 212 billion euros and 215 billion euros of debt through its 2009 program, about the same as the 213 billion euros scheduled for this year.

The debt-for-equity swap will probably have ``next to no effect'' on the country's yield curve because the notes offered to banks won't trade in the so-called secondary market, he said. The yield curve plots the rates of government bonds according to their maturities, and increases indicate higher borrowing costs.

``The government deficit of course will increase, the outstanding volume of bonds will increase as well,'' Daube said. ``The number of outstanding bonds available in the secondary market will stay exactly the same.''

Gentlemen, we are out of our depth here.