Spain And The Euro

In my Moneyweek column this week, I've been writing about Spain and the euro. Here's a taster.

Almost one year on from the credit crunch, one verdict at least seems reasonably settled. The euro had a good crisis. Despite all the warning, particularly in this country, about the fragility of the system, the single currency sailed through the collapse largely unscathed. The banking system didn’t implode. The European Central Bank dealt with the challenge smoothly. There were no rioters on the street demanding the return of the deutschemark or the franc. If the key test of a currency is its ability to deal with tough times, then the euro appears to have acquitted itself with credit.
But hold on. Maybe it is too early to tell. The euro still has to deal with the unfolding horror story of the Spanish economy.
Spain always looked like the weakest link in the chain. It had the biggest property bubble of any of the major euro-area economies – only Ireland came close. It had the fastest expanding banking sector, and the most spectacular economic growth. Now it also looks like facing the deepest downturn of any of the main developed economies, with soaring unemployment, crashing property prices, and a crippling dependence on foreign capital.
In truth, they key test for the euro over the next five years is going to be how it deals with the Spanish patient. If Spain can recover, then the euro can survive most shocks. But don’t be surprised if a long and grinding recession tests its faith – and at some point people start clamouring for the return of the peseta.
Right now, the economic figures coming out of Spain look wretched. It has been hit harder by the global recession than most of the euro area, and shows no sign of sharing the modest recovery currently being enjoyed by Germany and France. In the latest quarter, the economy was still shrinking at an annual rate of more than 4%. Unemployment has already climbed to a staggering 18% of the workforce and will inevitably climb higher still before the economy recovers. According to forecasts by the OECD, Spain will be the third worst-performing nation of its thirty members this year. Only Hungary and Ireland will do worse. Already the government is running a budget deficit of 9.5% of GDP, almost as bad a Britain: the big difference is that the UK isn’t supposed to be keeping its deficit to 3% of GDP as required by the euro rules.
And that is just the surface. Look underneath, and the picture doesn’t get any better. Spain now has as many unsold homes – more than a million - as the US, even though the American economy is more than six times size of the Spanish. About a third of the new homes built in the EU since 2000 were built in Spain, even though it accounts for only about 10% of the euro area economy. Most of that was with money borrowed from the rest of Europe: there are now close on 500 billion euros of loans outstanding to Spanish developers and construction companies. It is hard to believe that very much of that money is going to be paid back.
“Spain is set for a long, painful deflation that will manifest itself via a spectacularly high unemployment level for an industrialised economy, a real estate collapse and general banking insolvencies,” argued analysts at the economic consultancy Variant Perception in a recent report.
Much as it might like to, the rest of Europe won’t be able to ignore Spain’s problems. Between 2003 and 2005, 39% of the growth in the euro-area came from Spain. Without it, the euro area would have hardly grown at all. Banco Santander, now a familiar name on British high streets, is the biggest bank in the euro area, measured by market value. BBVA is one of the top five euro area banks.
Without a Spanish contribution, Europe will hardly grow. And if the Spanish banking system collapses, it will take blow a hole in the euro’s hull that could easily capsize the whole vessel.
So far, the banking system has sailed through the crisis largely unscathed. None of the big Spanish banks have collapsed. Indeed, Santander has taken the opportunity to expand, taking control the UK’s Abbey and Alliance & Leicester at what might well prove to be the bottom of the market.
But the troubles may well be hidden. The Spanish banks are estimated to have been raising around 40% of their funds abroad at the peak of the property boom, and it is hard to believe they will find it easier to rollover those loans when the time comes. True, the banking system in Spain is generally held to have been more prudent than elsewhere. A system of ‘dynamic provisioning’ forced the Spanish banks to salt away more money when the times were good: other countries, such as the UK, may well end up copying that. Even so, it is unlikely that the banks have built up enough of a cushion to pull through a property collapse on the scale Spain now faces without some serious losses. They may be hidden for a time by lax accounting rules, by artificially inflating the value of assets, or by expanding abroad to raise more money. But banks can seldom hide their losses permanently: the market always catches up with them in the end.
The outlook of Spain is now dire. Traditionally, a country in that fix would devalue its currency sharply, as Britain has in effect done. But that door is now shut. Instead, Spain faces a protracted slump, and one that will test its social fabric to breaking point. Unemployment could go as high as 25%: that’s a lot of punishment for any country to take.
In truth, Spain remains the euros key testing ground. Without doubt, the next few years will be tough for the Spanish economy. If it can pull through, and start to grow again, the currency will have survived its biggest test. Investors will conclude, quite rightly, that it can survive just about everything. But it is far from certain. And it is too early too conclude we won’t be hearing calls for the return of the Spanish peseta in the next few years.