To End Up Like El Rosario De La AuroraNovember 19, 2012by: Edward Hugh

| includes: EWP

The exact origins of the expression are unknown. They are lost back then, somewhere in the mists of time. But themeaning of the phrase is perfectly intelligible. In Spanish "to end up like the Rosario De L'Aurora" (acabar como elrosario de la aurora), means to end up badly. Very badly. The Rosario in question is a procession (of the kind to beseen in this YouTube video) and aurora here is not a woman's name, but the Spanish word for dawn. According tolegend, the procession which gave birth to the phrase was characterized by a dispute which developed into an outrightbrawl during which all those precious sacred artifacts being carried by the devout got unceremoniously destroyed.

One popular theory has it that two rival processions tried to advance in opposite directions down an extremely narrowstreet, with neither being prepared to give way. Similarities with what is currently happening here in the Euro Area is, ofcourse, entirely coincidental. What with the quantity of alcohol that people wandering the streets in the early hoursduring fiesta time would likely have consumed, and the fierce rivalry between the two "comparsas", the outcome issurely not that hard to foresee, or that worthwhile explaining. We can leave such details to the imagination of thereader.

But moving forward in time, and while again the versions of the story may differ, there seems to be little doubt that

Spain's economy is in bad shape. Very bad shape. Such bad shape in fact that, according to Tobias Buck in a recentarticle in the Financial Times, it has left most of the country's population "bewildered". Bewildered, and increasinglydesperate and despairing, or as blogger Matthew Bennett puts it, dogged by the feeling that the modern Spain theyknow and love "is in danger". Indeed if we aren't all careful, the country could end up in a worse state than the onewhich befell that legendary rosario.

You know the Modern Spain you love is in danger.

Thankfully, you can still eat abundant amounts of tasty Spanish ham whilst drinking adecent Rioja, and the Spanish national football team is still beating all-comers atinternational level-a truly world class achievement-but in your heart of hearts, you know acataclysmic future outcome is a plausible option for a Spanish society that is struggling toadapt to a new world economically, politically and constitutionally.

What happens to a society when tens or hundreds of thousands of its own citizensabandon the country to go and live and work abroad, with the approval of parents,government ministers and even the king? When record numbers of citizens-25%, nearly 6million Spaniards-are unemployed, with no economic recovery or new jobs visibleanywhere on the horizon? When the 12th largest economy in the world is ranked 136 forease of starting a new business, behind Burundi, Afghanistan or Yemen?

What happens when Spain's existing national institutions aren't capable of offering all of itscitizens and residents a prosperous existence, or when political leaders steadfastly refuseto listen to their voters' repeated cries for change and prefer instead to repeatedly lie to thenation, ignoring their own electoral programmes?

Put The Telescope To Your Blind Eye And You Will Surely See Recovery Ahoy!

For all the nay-saying to which those who watch the country passing thorough its agony are now subjected on analmost daily basis, there can be no denying one point - better days Spain has surely seen. Despite the constant andrepeated assertions that great progress has been made with the reform programme, or that exports are doing just fine,it's hard to see evidence for this in the ever longer lines of unemployed, or the now daily diet of home evictions to beseen in neighbourhood after neighbourhood. The number of reported green shoot sightings to which we have beensubjected must now surely exceed the long term total accumulated for that other legendary beast, the Loch Nessmonster. Yet this most terrestrial and long awaited of all resurrections has still not taken place.

But while the self-deluded continually claim to be envisioning signs of recovery, the data tell us another story. Almostevery indicator we have points to deterioration, and the forward looking ones we have suggest there is worse to come.

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The latest in the long line of examples I could cite comes to us in the shape of the third quarter GDP results,announced last week by the national statistics office. Between July and September the economy shrank by 0.3%quarter-on-quarter, or by 1.6% when compared with a year earlier, making for the fifth consecutive period of negativeeconomic growth. This put the Spanish economy back at a level approximately 4.25% below the highpoint achieved inthe first three months of 2008, just before it entered the great recession.

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But, of course, all of this isn't over yet. At the start of last week the Spanish newspaper El Pais published details ofleaked EU Commission forecasts for the country, showing that GDP is expected to decline by 1.5% in 2013, scarcelybetter than a 1.6 percent drop this year. Growth of 0.5% is then expected in 2014, and even if this result is eventuallyconfirmed, what about 2015? Who is to say we won't be back to minus 0.5% again, or worse? Spain's economy won'tbe surging back to life again, the accumulated debt problems and continuing competitiveness issues virtuallyguarantee that, and only those who clutch hold of some kind of "but economies always recover, don't they" quasireligious type of fig leaf can summon the energy to convince themselves otherwise. The data and the analysis almostall point in another direction.

Yet, just like those historical reports that lie behind the rosario legend, this latest piece of economic data doesinevitably allow for a plurality of alternative readings, and you can just glimpse a glass half full if what you really want todo is convince yourself that what is so obviously happening to the country actually isn't . Some will make a great dealof play of the fact that the rate of inter-quarterly contraction slowed when compared with the April through June period.Even the EU forecast can be used to this avail, since the annual rate of decline would seem to fall by one tenth of apercentage point next year. So thing are getting better!

Others will rejoin by pointing to the slew of other economic data which points to continuing deterioration, while yetothers will argue that the fact the contraction wasn't deeper suggests the possibility that the austerity programmehasn't been all it is being made out to be, with the consequence that the deficit correction process is surely once morewell off course. Indeed the EU and the IMF seem to now openly recognise this. Plus ça change!

At the end of the day, however, all of these interpretations miss what is surely the main point - Spain is and willcontinue to be stuck in depression, and not simply passing through a garden variety recession. Growth may be minus0.3% one quarter and plus 0.3% the next. Frankly that doesn't change anything. Or at least not anything important.Without a more substantial set of growth restoring adjustments the economy will simply hover between growth andcontraction for the rest of this decade, always assuming some major life-threatening event doesn't intervene first. Theeconomy is broken, and there is no hidden hand at work on which to base expectations for an automatic fix. Recoverysimply won't happen all by itself. That is to say, if someone somewhere doesn't do something to stop what looks set tohappen happening, Spain and its economy can end up a lot worse off than even that famous rosario.

Let's look at some examples of what now seems to be more like a horror than an adventure story.

Credit, Houses and Jobs

The economic crisis afflicting Spain and its economy has many aspects, dimensions and layers, but through the fogthree interconnected elements stand out clearly - the availability of credit, the stock and price of houses, and the levelsof employment and unemployment. Whatever starting point you chose, the final outcome always turns out to be thesame. The country seems to be trapped in some sort of modern adaptation of the traditional children's game "ring aring o'roses". There is a shortage of credit in Spain because the economy is losing jobs, causing the demand for andprices of homes to fall, leading banks to accumulate unwanted assets and clock-up a growing number of bad loanswhich in turn makes them reluctant to advance new credit due to the fear of have to assume even more losses. But wecould equally say that the economy isn't creating jobs precisely because of this shortage of credit, and that the risingunemployment is affecting the housing market. Or, if we are still not satisfied we could put it like this: the fall in houseprices is reducing demand for houses, and weakening household consumption (via the wealth effect - 75% of allhousehold saving in Spain is held in the form of property). This drop in consumption is causing the economy tocontract, with the result that it is constantly shedding jobs leading the banks to incur even more losses.

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Whichever way you look at it these three interconnected components lie at the heart of the Spanish malaise. There willbe no resolution of the Spanish "problem" without a turnaround in all these areas, and at one and the same time. Kick-starting the Spanish economy means inducing an expansion in the number of those employed, a freeing up in thecredit gridlock and establishing a bottom in the downward march in house prices. At the present time none of theseobjectives are anywhere in sight. Unemployment is rising, and will continue to rise in 2013. People are leaving thecountry, credit is falling, and house prices have just had one of their biggest inter-annual drops since the crisis began.This dynamic produces a vicious circularity which puts the country at risk of enduring the same fate as all thosegenerations of children who have participated in the aforementioned ritual, namely that the climax is reached wheneveryone cries A-tishoo! A-tishoo! and then lies down.

Water Water Everywhere, But Not A Drop To Drink

The question of credit flow is an especially complex one, since it is both cause and effect of the depression. Linearthinking will always have trouble with this kind of phenomenon. The banking system cannot freely supply credit sincesuch a significant part of its balance sheet is "encumbered" with existing loans, some of which are already noneperforming. But there are many more which are in danger of becoming "troubled" if the crisis continues through theyears ahead. Yet it is this very encumberment which virtually guarantees the crisis will continue. The loans in questionare not only those made to property developers (many of these have in fact already been drastically written down).They are also syndicated loans to large companies, loans to small and medium enterprises, and loans to individualsfor residential mortgages. As it is none of these portfolios are exactly going well, but the quality of the loans withinthem will continuously deteriorate for as long as the listless drift continues.

In addition, we need to remember that during the "good" years Spain's banking system became considerably"overleveraged" - that is it gave an excessive number of loans in relation to the system's deposit base - in much thesame way the Irish one did. So as well as working off distressed loans, the Spanish financial sector needs to reduce itsleveraging which means (without a substantial increase in the volume of deposits) it has to cut back on lending.Naturally the kind of deposit flight Spain's banks saw in the first half of this year doesn't help matters.

So while the creation of the bad bank and the recapitalisation of the entire system will help clear some of the worstrubbish off the balance sheets, this doesn't necessarily mean that the clean up will lead to a flow of new credit, andindeed what has happened in Ireland (see chart below) tends to confirm this view. Irish banks handed over a large partof their distressed property assets to the bad bank NAMA, yet the inter-annual loan numbers continue to be in negativeterritory, just like the Spanish ones are.

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To top it all, despite the fact that the country's banks had a net 378 billion Euros outstanding with the ECB inSeptember, credit is still not cheap.

Wholesale funding (where available) still comes at a hefty surcharge, and building the deposit base doesn't comecheap in a country where prices are rising at the rate of 3.5% a year. Typical fixed-term deposits now pay around 4%.Hence, according to the most recent ECB data (August) for lending rates to small and medium enterprises, Germancompanies seeking a loan of €1million over a term of between one and five years typically pay something in the regionof 3.8% - a record low for the Euro era - while their Spanish equivalent is paying 6.6%, the highest level since late2008 when central banks cut rates after Lehman Brothers collapsed. So it isn't only wage costs that need to bereduced in Spain, capital costs need to come down to. This is naturally one of the objectives of Mario Draghi's OMTprogramme, but Mariano doesn't want to play ball, a strategy which may seem politically convenient but which comesat a high price for Spanish companies and those forming part of Spain's growing jobless mountain.

The second major issue facing Spain is how to stop the fall in property prices. Residential housing has seen falls nowfor almost 5 years, and prices are down around 30% according to real estate valuers TINSA, dropping by an annual12.5% in October. Put another way, prices have fallen from something over 2000 euros a square metre, to around1500. Spain's banks hold roughly 600 billion in home mortgages, and back of the envelope calculations suggest thatonce prices hit the 1,000 euros a square metre level the whole system (on aggregate) will be in negative equity - that isthat homeowners will be standing on values in their property portfolio below the outstanding quantity owed in mortgageloans. At that point a critical moment will be reached, with the danger of implosion being much greater than "non

negligible".

Spanish property prices have been being supported by a combination of three factors.

1) banks holding repossessed assets on their balance sheets

2) the illiquidity of the market, with very few transactions in new property taking place

3) a completely unfair distribution of risk between property developers (who can simply give back the keys) and thosewho bought the properties they built at the ludicrous prices they charged (who can't).

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The nationalised banks are now set to move their "troubled assets" off balance sheet and into the newly created badbank, Sareb. Although many questions still remain about the way Sareb will operate, its creation is unlikely to producea turning point in the housing market, discounts may still not be sufficient to attract buyers in large numbers, and it isnot clear how the mortgages those buyers who do appear will be financed.

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Mortgages are not freely available in Spain, the volume of credit extended for house purchases is falling steadily yearby year (see chart above) and attractively priced mortgages are normally only available to those buying properties onthe balance sheet of the issuing bank. Those who seek mortgage finance for other property normally have to pay ahefty surcharge. Since Sareb will not be a bank, it will not have "own funds" with which to grant mortgages.

In the meantime Spain's unemployment continues to rise, hitting a record 25.8% in September. It is hard to say wherethis will peak, but the level looks certain to hit 27% in 2013. More importantly, simply getting the level back down to20% again looks set to be a mammoth task, and one which is unlikely to be achieved this side of 2020. So many moreyears of pain certainly await the country.

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One of the reasons the unemployment rate should peak reasonably soon is that people are now leaving the country ingrowing numbers. With 52.9% of the under 25 population who would like to work now unemployed a lot of youngpeople are simply giving up and voting with their feet. According to data from the national statistics office, in June thisyear a net 20,000 people left the country. That may not sound like much, but it is a rate of one quarter of a million ayear, or a million every four years. More worryingly the rate of outflow is on an accelerating trend (see chart below).

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Naturally this wouldn't matter so much if the Euro Area was one single federal state, since health and pension costswould be shared across the region, so it wouldn't matter whether people were paying taxes or social securitycontributions in one place or in another. Indeed such movement would be a rather positive sign of the existence of asingle labour market, and labour force flexibility. But the Euro Area isn't a single state, and contributions and costsaren't shared. So some countries risk becoming unsustainable.

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Several years ago, according to UN estimates, Spain looked destined to become one of the oldest countries on theplanet come the 2020s. That picture changed dramatically during the first decade of this century as some six millionmigrants came to live in Spain and the population shot up from 40 to 46 million in just a few years.

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Before the arrival of the migrants Spain's population was virtually stationary. Really it is impossible to give any sort of

precise forecast at this point of the Spanish population in 2020, or the rate of aging, since the size of the population isso obviously path dependent on the evolution of the economy. It shot up as the economy was booming, and now it isfalling back again as the country languishes in depression. It is almost a certainty that the population will continue tofall (births are also down) but how far and how fast depends very much on what happens in the job market.

This population exit has two important consequences. In the first place it reduces the future demand for housing, thusmaking it even more difficult to stabilise the market. And in the second place it means the pension's system, which isalready becoming a significant drag on the fiscal deficit will continue to weigh ever more heavily on public finances,and will surely lead to ever more urgent and drastic modifications to the parameters in the country's pension system atsome point in the future.

Exports Looking Good

Well, that is all obviously extraordinarily bad news. But Luis de Guindos (the country's economy minister) would retort,that some things are going well. Exports, for example, have put in a strong showing in 2012.

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Not only that, the goods trade deficit is reducing:

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The current account has also improved substantially, and in fact went positive in July and August for the first time inmany years.

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The improvement in the current account is evidently good news, and it is even better news that it is accompanied by arise in exports, and not just a fall in imports as consumption declines. But the disappointing reality here is that evendespite these improvements Spain's economy is still contracting, contracting and running an 8% fiscal deficit. Thereason for this is that Spain's export sector is still way too small for the work it has to do. I have been over thesearguments time and time again, so I don't propose to go into them here and now. You can find the issue thoroughlydiscussed here (from June 2011), and here (from August 2010), and all I can say is that the arguments I use are justas valid today as they were then. I'm not sure how many others can say the same.

With the private sector deleveraging, and the government trying to reduce spending the only thing which can reallygrow to the economy is the export sector, but until that is bigger the impetus given to the economy won't be sufficientto offset the drag from the other two sectors, and the economy will hover around the zero growth mark. One sign thatthings were really getting better would be a surge in investment, which would be reflected in demand for capital goods,but as can be seen in the chart below this demand just isn't there.

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Where Is The End Game?

The future of Spain is now very hard to see (so "que sera, sera"), and with it rests the future of the Euro. Interest rateson Spanish debt may well come down eventually if Mario Draghi starts the OMT bond buying programme, but as Iargued in this post, intervention from the ECB alone isn't going to solve the Euro Area's underlying problems, onlycloser political union will be able to begin to address these, and that seems farther away than ever (or here and here).At the present time everything seems to be on hold, with Mariano Rajoy on the one hand reluctant to formally ask for abailout, while Angela Merkel on the other is in no rush to do anything till after the German elections are over.Meanwhile those without work, and those about to be evicted from their homes just have to wait and see.

Even the deficit seems to no longer be a priority. Olli Rehn announced last week that Spain will not be asked to applyany additional austerity measures until at least the end of next year, despite the fact that everyone acknowledges thecountry will substantially miss its deficit targets both this year and next. The most recent EU Commission forecasts see

an 8 per cent deficit this year and 6 per cent in 2013, but even these may be to generous now that the straps are off.

Obviously this loosening in the policy stance could be seen as positive, if you thought that measures taken over thenext two or three years would return the country to sustainable growth, but the sad reality is that the vast majority ofthe structural reforms being enacted are only likely to have marginal effects on the countries overall economicperformance, and the one that could, the labour market reform, was described by the ECB in its August bulletin asbeing too little coming too late. As the bank puts it, "the authorities finally approved in February 2012 a far-reachingand comprehensive labour market reform that could have proved very beneficial in avoiding labour shedding if it hadbeen passed some years ago." As it is, the bank continues, "given the low level of competition, further significantreductions in unit labour costs and excess profit margins are particularly urgent….To achieve this, first, flexibility in thewage determination process has to be strengthened, for example, where relevant, by relaxing employment protectionlegislation, abolishing wage indexation schemes, lowering minimum wages and permitting wage bargaining at the firmlevel".

In other words, the country needs to initiate some sort of internal devaluation process to restore competitiveness,something I have and others been arguing for over several years now. But looking at the political landscape insideSpain after five years of unending crisis, this policy is extremely unlikely to be implemented as the political will just isn'tthere. The recent attempt by the Portuguese government to try something similar was over in a week on the back ofstrike and protests. Too much time has been lost, and too much weariness has set in. So the rot stays stuck in thewood, and one way or another we are on collision course.

But the biggest catch in the deficit loosening agenda is the impact this will have on Spain's debt trajectory. As I arguedin this post, putting the submerged part of Spanish government debt on the table was always going to be a risky move,since the debt level could rise dangerously near the critical 100% of GDP mark, above which no one in this crisis hasyet risen and come back to tell the tale.

Well next year it looks very probable we will now cross that particular threshold, and what's more Spain's deficit willcontinue adding to the level for several more years to come. In addition there are still unquantified risks in the financialsector. Despite all the lauding of Mario Draghi's OMT programme, it could well turn out that Germany backing off fromthe June agreement on mutualising the bank recapitalisation costs could in fact mark the critical turning point in thedebt crisis. One of two groups of people are going to be bitterly disappointed after the coming German elections -German voters who are being promised they will not have to bear part of the costs of recapitalising the Euro Area'stroubled economies, or investment funds who are being constantly reassured in the background that once theelections are over this is exactly what is going to happen.

So this year Spain's banks are going to be adequately capitalised, but what about in 2014, or 2015, or later if the crisisdrags on and on? The new banking union may well be in place, but if the principal of not mutualising legacy debtproblems is maintained, then it is hard to see how the losses on debt obligations which are currently being rolled over -like the large number of residential mortgage resets which are being used to avoid eviction - are going to be fundedonce the finally have to be recognised.

This week the tragedy of Spain's ongoing evictions drama has been in the news, (and here), and a new code ofpractice for evictions has been put in place by the government. But this is only scratching the surface. If, as seemsprobable, house prices continue to wend their way down then there really will be no way round the passing of somesort of new personal insolvency law to enable people to write down part of their mortgage, as we have seen in Ireland.The days of full recovery in Spain are numbered, since the social clamour, as in Ireland, will just become too great.Interestingly, ratings agency Moody's pointed out that in Ireland negative equity rather than unemployment was nowbecoming the main driver of mortgage default (and here) - and indeed they predicted that one in five Irish mortgages

would be in default by 2013. This is interesting because the models used by Oliver Wyman and Roland Berger tostress test the Spanish banking system do not use negative equity as a parameter, relying mainly on unemploymentlevels and GDP movements for their default estimates. Spain's entire mortgage system is likely to fall into negativeequity on aggregate within 2 or 3 years, meaning the capital requirements could then well be very different from theones we are seeing now.

Then there are the regions. On the worst case scenario Spain could see a 20% drop in GDP as Catalonia exits stageleft (elections are being held on the 28th - I have written extensively about this here, and the separatist case is puthere), and if the Spanish government insists on carrying out its threat to veto continuing EU membership for any newstate which might be created, the reality is that the rump country's debt level will surge to 125% of their remainingGDP, even assuming there aren't worse dislocation problems for the economy. Naturally one would assume that theSpanish government would negotiate rather than shoot themselves straight in the foot (typical prisoner's dilemma typestuff this), but you can't be sure, and maybe you should take them at their word. It doesn't matter it seems if the wholeEuro project falls apart, if the Catalans vote to be independent they will not be permitted to remain in the EU.

Naturally, intransigence is seldom a good policy, and investors who want to take an interest in the issue might askSpain government representatives who are locked in to their "total veto" and blocking strategy how, if they ever had toimplement it, they intend to get their exports out to Europe. The lines in blue in the chart below show the national railnetwork, and those who know some geography will quickly see that there are only two connections with France, onethrough Catalonia and the other through the Basque country. I have no idea whether Catalonia will be in or out ofSpain 5 years from now, but what I am pretty sure of is that if the Catalans left the Basques wouldn't be far behind.

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So there we have it. What we have is a country where not only are people of working age leaving in growing numbers,whole regions may want to go. A country where deficit numbers have been flouted time and again while bankinterventions have been consistently implemented using the principle of always try to do too little too late. The countrysuffers from what the ECB calls deep competitiveness problems, yet there is not a single proposal on the table atpresent which would do anything substantial to correct this.

The pension system is spiraling quickly into a substantial structural imbalance, yet the government will hear nothing ofany deep long-lasting pension reform. I could go on and on. I would like to be optimistic, but five years of watching thistrain crash in slow motion have left me with the feeling that this one now has no solution. The country's political leadersjust aren't up to the levels of complexity involved (see this excellent summary of some of the "matters arising" in thisregard from César Molinas here, and Europe's leader not only drag their feet, they stick their heads in the sand at thesame time. The exact details of how and when escape me, but this situation now has all the hallmarks of ending up inthe same way as that legendary Rosario whose untimely demise gave the title to this post.