Romania's Economy Heads Off Quietly, And With No Fanfares, Into It's Deepest Crisis in a Decade

Controversy surrounding the Romanian economy is nothing new, nor, as Manuel points out in his post on the recent election, are Romanian politics strangers to tumult. Nonetheless the intensity of controversy has grown considerably of late, with a wide variety of assessments being offered concerning the likely impact of the intensifying international credit crisis on the short to medium term outlook for the Romanian economy. National Bank of Romania (NBR) governor, Mugur Isarescu, has been consistently arguing that the country should be able to avoid an excessively "hard landing"as the bank attempts to cool its evidently overheated economy and engages of fire-extinguising activities in the banking sector trying to control the impact of set of adverse external circumstances that are largely beyond its control. But most of these comments (or at least the more convincing ones) preceded the meltdown in the international financial markets which followed the Lehman Brothers bankruptcy, the fallout from which has surely had a strong negative impact on Romania's economy and greatly complicated the task of conducting macroeconomic policy which faces the new government to be be formed following last weekends elections.

The other complicating factor has been the "own goal" scored recently by the Romanian political process, with one politician after another proposing fiscal deficit raising policies, at just a time when the international financial markets have become extremely sensitive to just this development in countries which are, due to their large current account deficits, mainly dependent on external borrowing to finance their lending needs. The accommodative fiscal policy being run by the Romanian government has also been extremely ill advised at a time when the central bank was busy trying to cool overheating by applying a restrictive monetary policy. For policy to be coherent, the two main levers need to be operated in tandem, and not at cross purposes.

However, despite all odds, Romania has been hanging on in there, and GDP remained strong in the third quarter, a situation which has lead some commentators to use the term "gravity defiers" to describe those East European economies, like Romania and Bulgaria, that have so far avoided having a sharp adjustment, despite having evidently unsound macroeconomic fundamentals, and in particular unsustainably large external deficits.

Not everyone has been convinced by the positive posture being assumed from within Romania, however, and Fitch Ratings agency had already downgraded Romania's outlook (together with that of the Baltic states and Bulgaria) from stable to negative by August pointing out in the process that the economy was extremely vulnerable to external financial pressure. This association of Romania with the Baltics is not incidental, since the Baltic economies were until only very recently - as Romania is now - the fastest growing in the European Union (with rapid credit expansion and large current-account deficit, sound familiar) but have subsequently experienced a very sharp growth slowdown following a sharp tightening in domestic credit demand and a dropping-off of external demand after high internal inflation fuelled by very large annual wage rises destroyed competitiveness. Indeed both Latvia and Estonia are now in deep recession, and have moved in a matter of months from being the EU's fastest growing to being the EU's most rapidly contracting economies. This is precisely what the expression "boom-bust" really means.

The million dollar question at this point is whether or not the Romanian economy is destined to follow along the same path. In the analysis that follows I will basically be arguing that this is exactly where the Romanian economy is now headed. Some evidence to back the view can be seen in the latest reading on the EU economic confidence indicator (see below) which after months of trending slowly and steadily downwards suddenly lurched sharply south in October and November. Another detail which we would do well to bear in mind is that after many months of consecutive rises, seasonally adjusted retail sales fell in Romania (by 2.1%) in October over September. Indeed a growing quantity of anecdotal evidence now suggests that something important changed in Romania in October, even if we may yet need to wait several months to see the in the cold clear light of day the actual consequences of what happened. Another signal we have is that all is not exactly well, is that the number of newly-established companies increased only 0.7 percent in the year up to mid-November when compared with the same period last year, while bankruptcies soared according to the latest data from the Trade Registry Office (ONRC) - and in fact October was the month with most cases of insolvency, up a whopping 79 percent over October last year. In addition Romania's banks experienced a sharp liquidity crisis in mid October (see more below) and needed to borrow a total 49 billion lei (13 billion euros) in October from the central bank (using its lombard credit facility). This is 28 times the total amount borrowed between January and September 2008, according to NBR data. Banks only borrowed 20 million lei in lombard credits in September, while the total value of the loans issued was 1.75 billion lei between January and September.







Events Take Their Course

A capital-inflow-driven absorption boom has underpinned rapid catch-up growth but also fuelled macroeconomic imbalances. In particular, the external current-account deficit has risen to unsustainable levels. And, since mid-2007, headline CPI inflation has surged well above the central bank’s target, in part reflecting the firstround effects of food and energy price shocks. Rapid credit growth has raised risks to financial stability, although the largely foreign-owned banking system remains wellplaced to absorb shocks. In this setting, fiscal policy has been highly procyclical and lacked medium-term orientation.
IMF Article IV Consultation, July 2008

The IMF quote above basically spells out the general understanding economists have of what has been happening in Romania. Real GDP growth has been robust,but has increasingly been running up against capacity bottlenecks. Largescale emigration, notably to Italy and Spain, and high demand for workers, especially in construction, have resulted in tight labor market conditions. As a result, real wage growth has outpaced productivity growth, with buoyant public-sector wages adding to private-sector wage pressures. With core inflation under pressure, headline inflation has surged, partly owing to the firstround effects of shocks to energy and food prices, and to some extent reflecting the 2007 drought. However the initial shock has evidently moved over into second round effects, and price setters, faced with higher unit labor and other input costs, have been struggling to maintain their markups, as also indicated by surging producer-price inflation.

It is in this context that the fact that fiscal policy stance in 2007 was highly procyclical becomes a problem. The fiscal deficit increased in 2007 to 2.25 percent of GDP, up from 0.5 percent of GDP in 2006. Adjusted for the automatic effects of the booming economy on the fiscal position, the IMF estimated that the 2007 structural deficit rose to almost 4 percent of GDP. As a result, the fiscal stance was highly expansionary, adding an estimated net fiscal stimulus of 2 percent of GDP to an already overheating economy. Thus the Romanian economy was simply booming along just waiting for something unfortunate to happen, and, of course, true to form and as was to be expected, it eventually did.

Octobers "Sudden-Stop" Credit Crunch

Bank lending seems to have ground to a virtual halt in Romania in mid October (and October is the latest month for which we have statistics from the National Bank of Romania). After rising at a monthy rate of 4% (or a 50% annual rate) in September, total lending to households and non financial corporations actually fell in October (when compared with September) by 0.6%. For an economy which has been experiencing a debt driven consumer and construction boom it is hard to overstate the significance of this single fact. We seem to have what is known as a "sudden stop" in aggregate bank lending here, and the Romanian economy may now well fall rapidly into recession, following the tried and tested path so recently pioneered by Latvia and Estonia.

While RON denominated lending continued to advance slightly, the largest hit appears to be being taken - not really surprisingly - by forex loans, which fell in total by 1.5% in total month on month (-1.9% corporates, -1.2% households). Given that the RON strengthened slightly against the euro during the month the decline was probably less than it appears (since the book value in RON of forex loans falls when the Leu strengthens - and vice versa - and this revaluation is of course the great danger represented by a sudden Leu slide, since not only will the monthly payments on the mortgages shoot up, so too will the capital value of the outstanding mortgage, as anyone unfortunate enough to have taken out a loan in Japanese Yen, or CHF, surely already knows to their cost). But basically, since the currency fluctuated wildly but was actually up against the euro by 1.5% in October, we really do need to wait till we get to see what happened in November to have a clearer picture.

However, if we look back over the two months of September and October (where the currency fluctuations to some extent cancel each other out, but that overall the leu weakened 4.5% against the euro) then it is clear there has been a sharp slowdown in forex lending, and the effects of this slowdown will gradually be felt over the next six to nine months. Well, gradually or not so gradually, since new car sales (which obviously normally need finance) fell by nearly 30% year on year in October (to 20,478 from 29,347 a year earlier), according to the latest data from the Romanian Association of Automobile Producers & Importers. Basically if we look at the pattern which we can see in other economies which have been affected by the credit crunch, what started off as a slowdown in demand for cars as oil prices rose "transited" to an inability to finance purchases as oil prices fell back again. Hence the current difficulties of motor industry "majors" like Ford and General Motors.



Fiscal Deficit Issues

Another area of concern has been Romania's budget deficit, which stood at 2.4% in 2007, and is expected to widen in 2008 and 2009 . A number of factors are contributing to this steady deterioration:

1) the rising cost of government borrowing;
2) forecasts of a sharp decline in GDP growth for 2009
3) enactment of spending pledges made by candidates ahead of Nov-08 elections


Romania's loose fiscal policy stance and the growing public spending commitments were among the key reasons cited by credit ratings agencies for the recent downgrades in Romanian debt to what is effectively 'junk' status. Indeed Finance Minister Varujan Vosganian recently estimated that spending increases authorised by parliament before last weeks elections could widen the budget deficit considerably beyond the EU’s 3% of GDP limit, and some estimates suggest that, on a worst case scenario, it could possibly even amount to as much as 7% of GDP in 2009.

Indeed it looks as if the deficit could even pass the 3% level in 2008 (the year of such a rapid expansion, there is surely no excuse for this) since the 11 month budget deficit widened to 2.9% of GDP following a sharp drop in budget revenues over the last two months according to Varujan Vosganian last week. Vosganian told a press conference that budget revenues in October and November were 1.3 billion euros below the projected level.

Perhaps the highest profile decision in the context of the recent Romanian fiscal deficit "cause celebre" was the one taken on 8 October by the Romanian Parliament, when it agreed to a pay rise for teachers which was calculated to be in the region of 50%, and this against the explicit wishes of Calin Popescu Tariceanu, the prime minister, who headed the then minority liberal government. The main worry arising from the teachers’ pay increase, aside from the concerns over how it will be funded, centres on the impact it will have on the pay demands of other public-sector workers and, in turn, of private-sector workers. If such wage pressures are not resisted, then they will obviously only weaken further an already weakened Romanian competitiveness and in all probability would drive inflation back above the 10% mark in 2009. This would be the result in normal circumstances, but the Romanian economy is not in normal circumstances right now, and it is highly unlikely that the present credit crunch and the pressure from the international financial markets will leave time for this inflation spiral to run its course. Much more urgent matters are likely to make their presence felt first.

Varujan Vosganian seems to be tirelessly explaining in the face of deaf ears that the proposed increase could push the budget deficit up in the direction of 7% of GDP in 2009, as no provision had been made to raise taxation, and the outgoing government issued an emergency ordinance on October 28th postponing the increase, following a warning from the IMF about the likely fiscal consequences.

Defenders of the recent decisions, however, are quick to point out that Romania's accumulated public debt, at around 12% of GDP, is still extremely low. But this is to miss the force of the macroeconomic argument against running such annual deficits at time of high GDP growth. Basically, at this point, the Romanian economy has been overheating (and has not been stuck deep in recession), so the principal macro argument would be in favour of fiscal surpluses (and substantial ones, say 3% or 4% of GDP) to try and drain excess demand from the system. This is doubly the case when you look at the underlying difficulties of applying standard monetary policy (the central bank has been raising interest rates since to try and keep inflation better under control) in a context where foreign exchange denominated loans have been freely available at what effectively amount to negative interest rates.

Although the government has made an effort to promote a more prudent fiscal policy, the temptation to win more voters has proved to be stronger. Consequently, the government decided to increase the benchmark index for calculating individual pensions by 20 % to RON 697.5 as of November earlier than originally planned. The benchmark index was already increased in November 2007 by 35 % and by another 7.5 % in January 2008. It will be further raised next January to complete the promised reform of the pension system aimed at bringing the average pension to 45 % of the average gross wage from the level of 35.5 % in November 2007. Doubtless we will soon here complaints about how "internation financial speculators" have brought the Romanian economy to its knees, but such voices would do a lot better looking at the degree of responsibility exercised by Romanian politicians in the face of the world's worst financial crisis in over 75 years, in a climate were concerns about procyclical fiscal deficits are known to be widespread.

Substantial Inflation Pressures Remain

Inflation lies at the heart of the mechanism which has been steadily - via the expansionary fiscal posture - undoing the Romanian economy, and, right on cue, Romanian inflation increased again in October, hitting 7.4 percent, after dropping back to 7.3 percent in September. Consumer prices were up 1.1 percent month on month.

In the Romanian context it is impossible to relate this inflationary pressure exclusively to rising energy and food costs, doubly so since these latter have now been falling steadily since July. The Romanian economy has been running at a much faster pace than it can comfortably sustain, and nowhere has this been clearer than in the strong upward pressure on wages, with net wages growing at an annual 24.6 percent in September while unemployment continued to hover near a 16-year low. In fact annual net wages increases have averaged around 24% over the last 6 months (see chart below), while real wage increases (allowing for inflation) have averaged around 15% throughout 2008.




Monthly unemployment has been running at around 3.9% of the labour force (or 350,000 people) according to data from the Romanian Labour Ministry, or at around 5.9% according to the EU harmonised rate published by Eurostat (the difference between these two numbers is due to the different methodologies and criteria used). In either case these are historically quite low rates for the Romanian economy, and it needs to be borne in mind that there are at least a million Romanians (or another 10% of the labour force) working abroad (largely in Spain and Italy) most of them sending monthly remittances home to their families and relatives, remittances which in their turn fuel domestic demand, demand which the economy lacks sufficient capacity to meet without putting pressure on inflation.

Of course, having made the point so forcefully about how much of a problem inflation has been in the Romanian economy, I think I should point out that this problem may well be set to disappear, or at least become somewhat less important in the general picture, should the Romanian slowdown prove to be as dramtic as I fear it might. We could move very rapidly from a situation of undercapacity and overheating to one of excess capacity, and sharp cooling as domestic demand folds and exports stagnate. Naturally everything depends on what happens to the Leu, since if we see a further substantial weakening in the currency this in itself will tend to add to inflation pressures, depending on how large a fall in the currency we are talking about.


Monetary Policy and the Leu

The Romania central bank which has been using monetary policy as best as it is able to try and fight the inflation threat, kept its key policy rate - which is the second highest in the EU after the 11% rate in Hungary - unchanged at 10.25% in October, although they did lowered reserve requirement on leu deposits (to 18% from 20%, as of November 24) in an attempt to ease the growing pressure on domestic liquidity which has been so evident since the mini financial crisis of mid October.

Further monetary tightening (following the Hungarian example) might have seemed a more prudent strategy, particularly given the current comparatively low level of the real policy rate (only 2.75% above inflation), the continuing inflation pressures, the continuing loose fiscal stance and the recent credit rating downgrade from S&P. There is also the credibility issue to take into account, since Romanian inflation is still running well above the central bank year end target of 3.8%. On the other hand, if we take account of the rapid deterioration in the internal economic climate since October, then exercising caution may have been more sensible than it seems at first sight. The problem is that the Romanian central bank - like its Hungarian counterpart - is now caught between the need to protect the value of the Leu (given the prior level of forex borrowing) and the need to try to offset the rapid and dramatic decline in internal demand.



Just what kind of pressure we could see on the Leu in the coming weeks was illustrated during the days between 10 and 20 October, when the tremendous pressure on the currency (see spike in chart above) forced the Romanian cenbank to intervene directly in the foreign exchange market to defend the currency. Questions remain about the extent to which any local tightening policy can work while private indebtedness continues to be fueled by forex denominated (largely euro) loans and the NBR is sure to face increasingly difficult decisions as growth slows in the coming months

In fact central bank Governor Mugur Isarescu argued that the bank responded to an "attack on the leu'' which had drained lei from the market and driven overnight interbank market rates sharply higher. The Banca Nationala a Romaniei sold 40 million euros on October 10 for lei on the interbank market and the Finance Ministry sold 291 million lei of three-year bonds on October 16. Overnight Interbank Bid Rates (ROBID) soared to 19 percent on October 17 (up from 16.53 percent on October 16) as banks frantically tried to get their hands on lei. Rates have subsequently come back down again, but at the start of December they were still hovering in the 12% to 13% range, well above the 7% to 8% range of January 2008, and also well above the 10.25% targeted central bank policy rate. Basically these rates seem to have gotten completely out of alignment with central bank policy towards the end of August, and there seems to be little evidence (or likelihood) that they will be coming back into line anytime in the near future (see the time series for yourself here - also anyone looking for a quick and handy list of banks with exposure to the Romanian market, the quoting banks for ROBOR are ABN Amro, Bancpost, Banca Transilvania, BRD Groupe Société Générale, BCR, CEC, EximBank, ING, Raiffeisen Bank and UniCredit Tiriac Bank).

Some analysts question whether Romania can fin­ance its 59 billion euros in external debt without International Monetary Fund support of the kind secured by neighbours Hungary and Ukraine if such "attacks" continue to occur. The leu has now slipped 7 per cent against the euro since August, while the Romanian stockmarket is down 71% in the year to date and the leu has weakened by 21% against the US dollar over the same period.

Romania's GDP Continues To Grow Strongly


Romania's economy continues to put in a very strong performance and grew by an annual 9.1 percent in the third quarter, driven forward by the continuing consumption and lending boom, although most observers - including the the government - are agreed that all of this is now about to slow, and sharply. Indeed the government itself has forecast that growth will slow to about 4.5 percent next year, although others consider this to be rather overoptimistic under the circumstances and the big question is, just how "sharply" is sharply? Are we about to see one of those famous "hard landings"? There are reasons for believing that we may well be.

At this point it is very hard to see just how far the economy actually slowed in the third quarter (at an annual rate it fell back from 9.3% to 9.1%, which really doesn't seem like very big beer), in the first place since we still lack detailed data, and in the second because don't publish or supply to Eurostat seasonally adjusted quarter on quarter data, which is really the most informative number we could get are hands on at this point, if it existed. So we are really stuck with "proxies" like short term retail sales data, and confidence indicators (unfortunately Romania doesn't seem to have much in the way of PMI surveys).

Despite all this, you could say, couldn't you, that Romanian GDP growth still does look pretty robust. You could say this, that is, until you look at what actually happened to Latvian GDP growth following the onset of a credit crunch in that country. As we can see in the chart below, the Latvian economy was cruising along at a nifty 11% annual growth rate until the third quarter of 2007, at which point things started to go nastily wrong, and headline GDP growth fell off a cliff, reaching the dizzy low of around minus 5% a mere four quarters later. And of course Latvia is now stuck in a very, very deep slump.


So just what happened? Well basically, the Latvian economy was being driven to grow way too fast by a rapid increase in foreign exchange credit. And Latvia, like Romania, had large numbers of workers outside the country, busily sending home remittances, while wage inflation at home went up and up. As we can see in the chart below, this credit was effectively cut back sharply in the spring of 2007, and down came the Latvian economy on the back of the cut. As we can see in the earlier chart I presented, year on year increases in Romanian forex lending have now been slowing since the mid summer, and I think it is not unreasonable to suggest that there is a strong danger of following the Latvian path, especially after the "short sharp shock" of mid-October.

So just when will Romania enter recession? At this point it is hard to say, but if the Latvian pattern is anything to go by, negative year on year growth could arrive as early as Q3/Q4 2009, and we might even see quarter on quarter contractions starting with Q1 2009 (although we won't necessarily know this, since, as I say, the data we need simply isn't published).

Government Aid Package

In response to this deteriorating outlook the outgoing government did announce a stimulus package, which is scheduled to take effect in January, and involves items like exempting reinvested dividends from a 16 percent tax, giving companies a bonus of 1,000 euros for every person they hire who has been unemployed for more than three months and faciliating 500 million euros worth of investments and other aid for farmers. There is also an allocatation of 3 billion euros for job-creating investments, lower social insurance payments and a 250 million-euro credit line for medium and small businesses via a cash injection into state-owned bank CEC.

The government will grant aid of as much as 50 million euros to companies planning to invest more than 100 million euros and create at least 500 jobs, according to the plan. Investments of less than 100 million euros that generate at least 300 jobs stand to receive aid which could total up to 28 million euros. It will also give companies a 5 percent reduction in their tax bill in exchange for paying taxes on time and exempt new car sales for a year from a "pollution tax'' that ranges from 150 euros to 700 euros per car.

Credit Downgrades


But all of this is likely to be of little avail, since it is mainly small scale counter cyclical stimulus if the international financial standing of Romania continues to deteriorate. In late October the international ratings agency Standard & Poor’s (S&P) cut Romania’s long- and short-term foreign-currency sovereign credit ratings from BBB-/A-3 to BB+/B, and its local-currency long-term rating from BBB to BBB-. S&P pointing out the growing risks posed by high and rising private-sector leverage and dependency on an increasingly uncertain external financing channel. Given the size of Romania’s macroeconomic imbalances, they argued, the economy is highly vulnerable to any sudden tightening in external financial conditions which could cause a sharp downturn in economic growth.

On November 10 Fitch followed suit, and downgraded Romanian debt - together with that of Bulgaria, Hungary and Kazakhstan - two notches to what is effectively 'junk' status (specifically BB+) as a result of their "concerns about the macroeconomic policy framework in Romania" and the country's ability to avoid a severe economic and financial crisis. Noting the widening current account deficit - which is expected to exceed 14% of GDP this year - a deficit which Fitch believes has been fuelled by excessive credit growth, the agency argued that a much stronger policy adjustment, especially in the fiscal policy area, would have been needed to avoid a currency crisis. Fitch specifically drew attention to the private sector foreign currency balance sheet mismatches, and argued that any imminent currency crisis would "require substantial external financial support from the international community to prevent a sovereign credit crisis."

Fitch specifically singled out Emerging Europe as the most vulnerable Emerging Market region to the deterioration in the global financial and economic environment owing to the fact that so many countries have large current account deficits and relatively high levels of short-term external debt, and that these render them particularly susceptible to reduced capital and financial market flows (including from foreign parent banks).

Since the onset of the credit crunch in August 2007, Fitch has now downgraded the foreign currency ratings of nine countries in emerging Europe (by a total of 11 notches), and this contrasts with just three upgrades that have been made over the same period. Eight countries are now on Negative Outlooks - which a record level for the region - while no countries are on Positive Outlooks, signalling that ratings remain under downward pressure.

IMF Aid In The Pipeline?

Obviously with the EU institutionally bogged down in its own issues of core and systemic bank bailouts, it is clear that the community's ability to offer meaningful assistance to Romania is going to be limited. Thus all eyes in Eastern Europe have been looking hopefully over in the direction of Washington, and the International Monetary Fund. The IMF has already offered aid to Hungary, Iceland, Serbia and Ukraine to help them cope with the difficult coktail of a credit drought, falling investment and shrinking government revenue. Romania, has so far not openly sought IMF help, although this does not mean that channels of communication and "dialogue" have not been opened. The sheer size of the current account deficit and the short term increase in the very sensitive area of government spending may make it increasingly difficult to fund the country’s $75 billion in external debt without IMF aid. In a statement to the local media, Juan Jose Fernandez-Ansola, the International Monetary Fund's (IMF) senior representative for Romania and Bulgaria recently observed that "The initiative to increase teachers' wages by 50% may need to be reconsidered. We estimate the impact on the budget would be modest in 2008, but would reach over 0.75% of GDP in 2009. In addition, if the increase were extended to other public sector employees, the impact could reach over 4% of GDP in 2009. This would send a wrong signal to financial markets." So it is not hard to see the kind of tack the IMF will be taking in any negotiations.

However, there are important differences in the monetary systems of Romania on the one hand and the Baltic states and Bulgaria on the other, and these differences may facilitate rather than complicate the issue of IMF aid. The Baltics and Bulgaria all operate some variant of the currency board system, whereby the currencies are pegged to the euro at a fixed exchange rate (or within a narrow band), a feature which effectively prevents these economies from conducting their own independent monetary policy, thus placing the entire burden of macroeconomic adjustment on fiscal policy. The appreciation of the euro against the US dollar damaged the competitiveness of those economies vis-à-vis those economies whose currencies are linked to the dollar. Romania's managed-float on the exchange rate side has, in contrast, provided it with greater flexibility and some ability to utilise monetary policy as part of its macroeconomic stabilisation programme.

Thus Romania has been able to resort to some degree of exchange rate depreciation to preserve external competitiveness over the past 12 months, while the central bank pushed up interest rates to keep real rates at positive levels and contain inflationary pressures. The complicating factor here has been the availability of substantial foreign exchange credit, at rates well below those imposed by the NBR. This has undoubtedly taken much of the cutting edge off central bank monetary policy in the short term, although as we are seeing, this supply of cheap credit has now, suddenly, "run dry".

At the end of the day there is substantial agreement between all the main institutional actors (leaving aside Romania's own political class) - the NBR, the IMF, the EU Commission and the ECB - that Romania's external deficits are unsustainable in the long run; that fiscal policy has been ill-advisedly pro-cyclical; that wage growth has been excessive; that rapid credit-growth has been fuelling an unsustainable growth in consumption; and that a sharp and significant correction is now about to take place.

The Immediate Outlook


This year's extremely good agricultural harvest has undoubtedly offered strong support to headline GDP growth in recent quarters, but this fortuitous virtuous circle may well repeat itself in 2009. On the other hand, the financial position of private households, after becoming ever more strained as domestic interest rates have steadily risen, together with the costs of servicing a growing volume of private debt, may well now deteriorate substantially as the lack of available credit and the rising layoffs in manufacturing industry exert an ever-tighter grip. In general terms, private consumption was already slowing before the onset of the credit crunch in October, and increased by 12.2 % yoy in Q2, following the record high of 14.3 % yoy in Q1.

Investments also continued at a strong pace in Q2, driven mainly by new construction projects (up 34.8 % yoy), while investments in equipment was already slowing (down to 23.8 % yoy in Q2). In the first half of the year the construction sector absorbed 20 % of total investments in the economy, and it is this sector which will now be particularly hard hit.

Slowing construction activity is now expected for the rest of the year, and should become more pronounced as we enter 2009 and new project steadily dry up. Prices of new housing and real estate transactions generally have been losing momentum in recent months, especially in the capital city Bucharest. This slowdown can also be observed in the national construction activity index, which has seen the value of construction works drop to an annual 19.1 percent rise in October (down from 28.3 percent in September, and down even further from the average 33 % yoy increase registered in the first half of 2008) . Month on month, construction growth slowed to 5 percent in October from 8.5 percent in September. More importantly, the number of new building permits issued has now been showing a steady monthly decline. Evidently the volume of construction activity continues to rise (even if at a slower pace) since existing projects need to be completed - credit crunch or no credit crunch, and regardless of whether there will actually be buyers for the completed properties. But at some stage activity may well grind to a near halt, as the appetite for new building projects suddenly evaporates. This is what we have seen in other similarly affected economies, and there is no good reason why Romania should be any different here.

This view is reflected in the recent press statements made by Gabor Futo, executive manager of real estate developer Futureal Group. Futo takes the view that no new real estate projects will be started in the next two years and that 90 percent of the forthcoming ones already announced will be called off for lack of financing. Futo testifies to the way in which banks are now much more cautious in making loans and how developers are experiencing increasing difficulties in obtaining financing. Futureal recently started work on the new commercial center "Gold Plaza" in the northern city of Baia Mare. The center will have 30,000 square meters - all of them available for rent. The project aims to be completed in the first quarter of 2009 and will cost about 97 million euros. The company is a leading developer in Central and Eastern Europe, with projects worth more than 1.6 billion euros, including more than 6,000 residential units and some 500,000 square meters of commercial area.

And, of course, it isn't only the construction sector which is getting hit. Since the problem is the availability of credit rather than interest rates per se, then anything which can't simply be bought on a credit card will be affected, and first in line here is the Romanian auto industry which could register its first bankruptcies towards the end of the first half of 2009 according to Alin Tapalaga, Manager of Porsche Inter Auto, the retail division of the Porsche Romania . Tapalaga feels the most affected companies will be those who have recently built showrooms, and especially in the past year using bank loans as finance,.

The Romanian banks themselves are expecting a massive drop in lending to individuals in the last quarter of the year, especially for mortgage loans, despite forecasts of cheaper land and properties, following a worsening in lending conditions, according to a recent survey carried out by the central bank. Not surprsiningly, credit cards are the only lending product for which banks expect to see a slight increase in use in the last quarter, but even here they expect a much smaller increase than the one registered between July and September 2008.

And all this reticence to spend comes despite (or perhaps because of) the fact that property prices are now falling. Three-room apartments in Bucharest have fallen by around 15 percent since the beginning of the year according to the the ZF real estate index. ZF suggest that prices nationally have dropped by 2 percent to 3 percent over the last six months, following stagnation or even slight increases earlier in the year. ZF compile their index by analysing prices asked by sellers on the anuntul.ro website. The value at which the deal is actually closed may be as much as 20 percent below the asking price they say. Whereas a typical seller was asking an average of 140,000 euros for a 70-square metre three-room apartment in January, the price reached 118,000 euros in November, or over 20,000 euros less. The sharpest monthly decline was registered in November, when the average price per square metre reached 1,686 euros, 5 percent lower than in October, according to the ZF analysis.

Exporting Your Way Out Of Trouble?

With domestic demand now set to fall sharply, as people buy less property and large ticket items, while companies prune back investment in response, the only way forward for Romania to achieve economic growth - and pay off its debts - would appear to be through exports, since the fiscal policy arm has, as we have seen, been basically frittered away during the good times. But here we hit a big snag, since Romania runs a large goods and services trade deficit. In fact, between January and September 2008, Romania's balance-of-payments current account posted a deficit of 12.7 billion euros, up 14.8 percent over January-September 2007. The deterioration was largely a result of the wider trade deficit (13.7 billion euros), which was up 11.7 percent over the same period of last year. On the positive side exports did grow (19.4%) more rapidly than imports, but that will be of little consolation if exports need to drive an economy where domestic demand is either flat (best case) or declining.

And funding this deficit could become increasingly problematic, since foreign direct investment now covers only around one third of the gap in the current account, which means that foreign debt is on a strong upward spiral. Effectively this situation makes Romania susceptible to capital outflows in the medium term, and, were this to happen it would trigger a harsh real adjustment for Romania's economy and its citizens.

Romania needs to attract capital inflows (including FDI) in the region of 15 billion euros per year to cover a current-account deficit which is expected to exceed 13% of GDP. In 2008 alone it is estimated that the net external indebtedness of Romania will rise by some 6 billion euros. Non-publicly guaranteed external debt came in at 31.501 billion euros at the end of September, up 25.9 percent from year-end 2007. The NBR has, of course, built up a strong foreign exchange reserves (27 billion euros at the end of November, or around 8 months imports) and can more than likely ride out the change in market sentiment in the short run. Also foreign direct investment of 7.2 billion euros covered 56.6 percent of the current account deficit over the January-September period, with equity stakes and reinvested earnings making up 52.7 percent of the total, while intra group loans accounted for the other 47.3 percent.

But at the end of the day, having the reserves to ride out the crisis (with or without the aid of the EU and the IMF) isn't really the problem. The problem is how you turn a credit-driven internal-demand-boom economy into one where new-found export competitiveness means external demand drives growth. And how you do this, while protecting all those heavily-forex-leveraged households form the more or less inevitable downward correction in the value of the leu. Obviously the path from one point to the other passes through a hell of a lot of what we economists call "creative destruction", but lets just hope for the sake of all those who have to live through this "correction" inside Romania don't find the whole process a far too painful one.

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.