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By George Friedman
Spain's economic and political situation is fragile. The country faces continued economic downturn, high deficits, rising debt and increasing social tensions. Consequently, the newly elected government of Spanish Prime Minister Mariano Rajoy has seen its standing diminish since it took office in December 2011, a trend likely to continue as economic and social conditions worsen in 2012. The deteriorating economic and political situation in Spain is of great concern to the rest of Europe. Spain's economy is larger and more integrated with the rest of Europe than Greece's economy, meaning trouble in Spain more readily causes trouble elsewhere on the Continent.
The International Monetary Fund forecasts that the Spanish economy will contract 1.7 percent in 2012 after growing 0.7 percent during 2011. Madrid's public debt-to-gross domestic product (GDP) ratio is relatively low compared to its fellow European economies at risk -- Greece, Ireland, Italy and Portugal -- but has skyrocketed since the beginning of the crisis, currently standing at 66 percent, up from 40 percent before the crisis of 2008. The real problem for Spain is the transformation of the high private sector debt, equivalent to 227 percent of GDP, into public debt. While currently public debt stands at 66 percent of GDP, it is up from 40 percent before the crisis and rapidly approaching the 70 percent mark. As it stands, public debt has increased at a rate of about 10 percent every year since 2009. Of that, household debt is equivalent to 82 percent of GDP while corporate debt is equivalent to 145 percent of GDP. Having most of its debt in the private sector places Spain in a different category from Italy or Greece, where public debt is the major issue.
In normal times, private debt is a necessary instrument of growth for an economy. In the years following its entrance into the eurozone in the early 2000s, Spain received a wide availability of cheap credit but did not use this debt for investment. Instead, it used it for the consumption of imports and fueled the construction boom, neither of which translated into sustainable growth in the long run. Lending volumes have remained at the recessionary low of 2009 for corporations and households, marring domestic consumption and overall economic growth.
When the subprime mortgage crisis hit Spain in 2008, Spanish banks saw many of their assets destroyed, thus cutting off private lending. The ensuing recession, followed by dropping credit ratings and soaring bond yields, ensured that lending volumes have remained at the same level since the recessionary low of 2009.
With the bursting of the Spanish real estate bubble, households saw their net wealth deteriorate. This made borrowing more difficult, leading to even lower consumption as households tried to repay their debt but could not take on new loans. Spain currently has the lowest ratio of household savings in relation to government and corporate debt, nearly half that of second-place Italy.
Austerity measures and harsh budget balancing required by the European Union do little to address private debt problems and could prove less effective as private lending is further restricted, deepening the recession. This partially explains Rajoy's refusal to abide by the EU budget deficit goals, which are perceived in Spain as deepening the credit crunch and limiting growth.
The ongoing transformation of private debt into public debt is fueled by the absence of steady growth and the lack of credit availability. This is the main reason why EU economists predict that Spain’s debt-to-GDP ratio will reach 72 percent over the next year. Through financial assistance to failing banking institutions, private debt (both household and corporate) is shifted on the state balance sheet. Ireland, which bailed out its entire banking system after the sector collapsed in 2008, is the prime example of such a transfer. The bailout led to a tripling of Ireland's national debt and the need for an EU and IMF bailout for Dublin.
While the situation in Spain has not reached the levels of Ireland, there is no question that the Spanish banking sector is faltering. The global financial downturn and the bursting of the construction sector boom exposed gaping deficits in the complex and bloated Spanish banking system. Today, just four banks in Spain (Santander, BBVA, CaixaBank and Basque Country savings bank Kutx) can operate independently and cover capital shortages with their own revenue. All others steadily are transferring private debt to Spain's central bank (or to the European Central Bank) through various government help packages. Only 10 lenders are slated to remain in the Spanish market in 2012, down from 40 before the crisis, following continued emergency mergers and consolidation efforts.
To some extent, Spain's biggest banks, Santander and BBVA, have survived the crisis because profits in Latin America have offset their poor performance in Spain. Half of Santander's profits come from its Latin American operations, compared to one-third for BBVA. Delinquencies of credit extended by banks, savings banks, cooperatives and credit institutions rose in November to 7.61 percent, the highest percentage in 17 years. By contrast, smaller regional saving banks, known as "cajas," are in a very precarious financial situation. This largely stems from their high nonperforming loan ratio and from local governments' tendency to use them as financing mechanisms.
Spain's banks have undergone a period of widespread upheaval since the beginning of the crisis, as a binge of lending into an overheated real estate market left many nonperforming loans and repossessed property and land considered by many analysts to be worth far less than the purchase price. According to the Bank of Spain, construction companies' debt to banks stands at about 300 billion euros ($390 billion), of which 176 billion euros are in toxic loans.
According to a December 2011 report by the European Banking Authority, Spanish banks will need 26.17 billion euros in recapitalization before July 2012, the deadline established by the banking authority.
In February 2011, Madrid ushered in a new round of banking sector reforms, including an additional 50 billion euros in provisions against soured property loans. As a result, a fresh wave of consolidation is expected now that banks have received an incentive to swallow up smaller rivals.
Spain's private sector is attempting to deleverage in a variety of ways. According to the World Bank, Spanish exports account for 26 percent of Spanish GDP. The European Union accounts for almost 70 percent of Spain's exports, with France, Germany and Portugal as its most important trading partners. It is true that, according to the OECD, Spain's exports grew 9.9 percent in 2011, making exports one of the few sectors of the Spanish economy that are still growing. But its worker productivity is low, proving less competitive than even Italy, let alone Germany. Without this instrument, it is difficult to see Spain regaining a measure of growth sufficient to tackle the spiraling debt problem.
Rajoy's Popular Party (PP) swept November 2011 regional elections, winning 186 parliamentary seats in the 350-seat Congress of Deputies in the biggest win for the center-right party since the democratic transition. The Spanish Socialist Workers' Party (PSOE) suffered the worst defeat in the party's history, losing 59 seats.
The size of the PP parliamentary majority allows the government to pass laws without opposition cooperation. Meanwhile, the PSOE remains in disarray well after former Prime Minister Jose Luis Rodriguez Zapatero called for early elections and former Interior Minister Alfredo Perez Rubalcaba led the party to a historic defeat.
But the new government's political capital is eroding rapidly, both domestically and internationally. Three main factors are weakening Rajoy.
First, unemployment is growing quickly, and social unrest with it. Between 2008 and 2011, the Spanish economic crisis did not spark major protests or violence. This changed rapidly in early 2012, leading to expectations of a traumatic year ahead. Several factors explain this. For one thing, Spain is suffering the consequences of a lingering crisis with no foreseeable solution. Moreover, recent deficit data shows that PSOE did not apply as much austerity as expected. The possibility of "real" austerity has frightened many. And finally, the conservative party seems less willing to talk with unions and with students.
Second, Madrid has only limited control over the autonomous regions' budgets. This is a major factor behind the Spanish economy's instability. The regions account for debt equivalent to 12 percent of Spanish GDP. Regional governments are increasingly unwilling to heed Madrid and tighten their finances. The central government has recently presented a law that would give Madrid oversight of the autonomous regions' budgets and the power to penalize those that miss budget targets. This back-and-forth between the central government and the region poses an existential question for post-Franco Spain, where the balance between the central government and the regions is delicate. If Madrid hopes to meet budget balancing goals, it increasingly will have to amend the budgetary autonomy policy toward the autonomous regions in place since the return of the democracy in the early 1980s.
Third, Rajoy's relationship with Brussels has deteriorated in recent weeks. In mid-February, Madrid announced that its budget deficit in 2011 had been higher than originally announced. Rajoy blamed the socialist government for this situation and asked for softer 2012 deficit goals, but the European Union at first refused. Brussels suspects Rajoy of manipulating economic numbers for domestic political reasons. While Spain and the European Union finally reached an agreement in March to soften Spain's 2012 budget deficit goal, this situation forced Brussels to choose between punishing a weak economy or losing political credibility.
The social situation in Spain is deteriorating rapidly. Spain has the highest unemployment rate in Europe at 23 percent. The situation is particularly difficult for young people -- 45 percent of those under 25 are unemployed.
While protests in 2011 were mostly peaceful, in early 2012 demonstrations began to become violent. In February, police clashed numerous times with students protesting against cuts in education. According to Spanish police, radical elements among the protesters caused the violence. The uptick in unrest is likely to continue, as demonstrators come to feel that peaceful measures have failed and as the deepening recession swells the ranks of the youthful unemployed.
So far, unions mostly have been passive and disengaged from protests, but this is expected to change. Spain's biggest trade unions are the Comisiones Obreras and the Union General de Trabajadores. Though technically independent, these unions traditionally have been close to the PSOE. Consequently, they were ill disposed toward the PP government from the outset. The unions have now announced a general strike for March 29 in response to the government's pushing through of labor reform.
According to the National Statistics Institute (INE), half a million people leave Spain each year because of the lack of job prospects. Around 10 percent of people leaving are Spanish. According to official statistics, this mass emigration began in 2008. As a result, 2011 was the first year in more than a decade that emigration outpaced immigration. Before the crisis, Spain tried to reverse its demographic problem by incorporating foreigners, preferably Latin Americans. A decade later, those immigrants are returning to their home countries due to the crisis.
This demographic reversal could place an additional strain on the already strained public finances as Spain's population continues to age. According to the INE, the Spanish population will fall to 45.6 million by 2021 from 46.3 million in 2010. Births will decrease by 18.1 percent and deaths will increase by 9.7 percent compared to 2010. There will also be a negative net migration beginning in 2011, since the 450,000 new immigrants will be offset by the departure of 580,850 people.
Comparison With Greece
Spain is the European economy at risk that most resembles Greece in terms of potential social unrest. While Spain has not reached Greece's levels of violence and unrest, the social situation is deteriorating at a fast pace. The recent student protests suppressed by police show growing resentment that young people feel about the lack of jobs and cuts in education. The youth unemployment rate is not sustainable in the long term and is highly likely to generate more violence in 2012.
The political situation, however, seems more stable in Spain than in Greece. The Spanish had the opportunity to vote in November 2011, and the current conservative government has a comfortable majority. Ongoing spending cuts will continue to weaken the government in the coming months, however.
On the international front, EU-Spanish relations have become strained. The size of the Spanish economy and the importance of its financial sector for the European Union give Madrid more leverage than Athens. Even if Brussels doubts the credibility of the Rajoy government, it is highly unlikely to punish Spain for its excessive deficit because this could damage the union even further.
2012 will be a crucial year for the Spanish government to show if it has real control of the country. Although PP controls the parliament, it is losing control elsewhere as unions, students and even regional governments increasingly defy Madrid.
Unemployment, social unrest and tension with the regions swiftly have eroded the young government's standing. Combined with Madrid's need to implement more spending cuts in the short term, this means social and political tensions will grow in the coming months. While Rajoy is likely to stay in power, his authority increasingly will be challenged in the following months.
It is unlikely Spain's deficit problem will be solved in the short term. The government is not likely to even meet the softened deficit goal agreed with the European Union this year. Surging borrowing costs and a regression into recession threaten serious damage to Spain's debt dynamics, pushing public debt up even further.
The deteriorating economic outlook has led the Bank of Spain to forecast a 1.5 percent GDP contraction in 2012 and a recovery of just 0.2 percent in 2013. An added wave of mergers in the Spanish financial sector is likely to result in a restriction of credit available from Spanish banks.
European Economies At Risk - Spain is republished with permission of STRATFOR.
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