Spain: No Relief In Sight

Economic contraction in Spain continues for a fifth straight quarter as austerity measures keep inflation at a 17-month high. The economy, inflation, unemployment and austerity measures are all moving sharply in Spain, albeit in an undesired direction. Recession in Spain extends deeper into the third quarter as inflation remained high in October. The value added tax rose in September as part of the government’s 100 billion-Euro austerity program, pushing up prices. Austerity to cut the public deficit is also pushing up living costs as prices rose sharply in October, piling pressure on the government to revive a paralyzed economy as it stalls over requesting aid.

Prime Minister Mariano Rajoy has already introduced austerity measures worth over 60 billion euros ($77.6 billion) to the end of 2014 to try to deflate the deficit to below 3% of GDP from 9% last year. But rising social security costs, unemployment benefits and interest payments on public debt are undermining his cost-saving measures. Spain, Euro zone’s fourth largest economy has again moved to the forefront of the bloc’s fiscal crisis on concern that mounting debts owed by its regional administrations could make public finances unsustainable. The weakening Euro in the meanwhile also slipped further on doubts over whether Greece, the country that triggered Europe’s debt crisis, can agree to a deal on new austerity measures and its international lenders can figure out how to make its huge debts sustainable.

Will Delaying Request For Aid Help Spain?
Spain’s refinancing costs on international debt markets soared to Euro-era highs in July but have since eased after the ECB announced its sovereign bond-buying program for countries that ask for help. With debt premiums now at more manageable levels, Rajoy seems reluctant to apply for an aid program that might bring with it deeper austerity measures that would further hobble the recovery and fuel protests. Spain may miss its 6.3% goal for the overall deficit, which also includes the regions’ books and the social security system, according to a Bloomberg survey of economists, which points to a shortfall of 6.5% of GDP. Rajoy is in no hurry to apply for a politically humiliating financial rescue that would kick start an ECB bond-buying program and ease financing costs. But the worsening economy, along with spreading civil unrest, may force his hand. Rajoy will seek a credit line from the Euro zone’s rescue fund but said he would do so when I think it is in the interests of Spain. Rajoy maintains his ambiguity on the issue but will delaying or avoiding the request for aid help Spain in any constructive way? Italian Prime Minister Mario Monti said earlier this month that if Spain were to request a credit line from the Euro zone’s rescue fund, triggering ECB intervention, it would calm financial markets. Some market players are concerned by signs that Rajoy, having almost completed this year’s borrowing, will try to avoid the stigma of requesting a precautionary credit line from the Euro zone’s ESM rescue fund. Spanish Bond yields have stopped falling further and some analysts expect them to rise now on the longer Rajoy holds off. Meanwhile Germany, the biggest contributor to the ESM, continues to insist that Spain does not need a Bailout. Rajoy had rebuffed a German proposal for a European super-commissioner with powers to reject national budgets, saying it could not be taken in isolation but only as part of a grand bargain on closer Eurozone union.

The VAT Impact
Gross domestic product -- GDP shrank for the fifth straight quarter between July and September, dropping 0.3%, while consumer prices rose by 3.5% year-on-year in October, the two sets of National Statistics Institute data showed. GDP reading was slightly better than forecasts for a fall of 0.4%, but it only shows that families have brought forward purchases ahead of the VAT hike. The looming VAT hike on Sept. 1 encouraged consumers to only bring forward spending. GDP will therefore decline more deeply in the fourth quarter than in the previous three months. On an annual basis, the economy shrank 1.6%, in the third quarter suggesting Spain was in line to meet its end-of-year GDP target. The prolongation of Spain’s five-year slump, which is prompting record loan defaults at the nation’s banks and job cuts at companies including Gamesa SA, adds to pressure on Prime Minister Mariano Rajoy as he resists requesting international aid. While the tax hikes he’s implementing as part of his austerity program are depressing consumption, they are also spurring inflation, which threatens to add three billion euros ($3.9 billion) to the country’s pension bill.

Retail Sales Hit Hard
Retail sales in Spain fell at their fastest pace on record in September as already battered consumer confidence took another hit from a hike in value added tax. Sales fell 10.9% year on year, National Statistics Institute data showed, reflecting an economy struggling through its second recession in three years and plagued by chronically high unemployment. Consumer prices rose by 3.5% year-on-year in October, reported Reuters. The drop was the biggest in calendar-adjusted terms since current records began in January 2004, and marked the 27th monthly decline in a row. Spain has been in recession since the first quarter of the year and is not likely to grow again until late in 2013, based on the most optimistic estimates. The headline (retail) figures show a sharp drop and indicate that domestic demand is not going to be anywhere near what the government is anticipating. The retail slump is good news for some firms as Spaniards seek out cheaper options along the high street.

Unemployment Remains At Record High
The country had the highest unemployment rate at 25.1% in the European Union in August according to EU data. Unemployment is expected to rise further as a large public deficit forces the government to implement deeper spending cuts and further tax hikes to persuade markets it can control its finances. Economists expect unemployment to rise above 27% by 2014, while the government sees joblessness starting to fall. Economists also forecast a worse economic outlook for next year than the government, which aims to cut the deficit to 4.5% in 2013. Spanish GDP is seen shrinking 1.4% against the Spanish government’s 0.5% prediction.

'Bad Bank' Established
Spain is setting up a so-called 'bad bank', a mechanism also used in Ireland, to help lenders that receive state aid sell real estate that has plunged in value. Spain will discuss the planned structure of the bad bank with potential investors in coming days. The creation of the vehicle is a condition of a European bailout of as much as 100 billion euros for Spain’s banking industry agreed to in July. Spain’s bad bank will buy foreclosed real estate assets at an average discount of 63% as the state seeks investors to become shareholders in the 60 billion- euro ($77 billion) facility, the bank-rescue fund said. The bad bank, known as SAREB, will apply an average discount of 46% to gross book value on loans to developers, the so-called FROB rescue fund said in a presentation yesterday in Madrid. Nationalized lenders will transfer 45 billion euros of assets to the bad bank, while other lenders with capital shortfalls may transfer about 15 billion euros, FROB Chairman Fernando Restoy said. This Bad Bank, which will exist for as long as 15 years, will be profitable, with a 14% to 15% annual return on equity as a “conservative” estimate. For foreclosed assets, the transfer prices seem reasonable but on the loans side they haven’t been tough enough and this will mean the vehicle will generate losses, said Mikel Echavarren, chief executive officer of Irea, a Madrid-based financial adviser. Echavarren said he was also skeptical about the estimates given for the possible future return for the vehicle, whose equity will be equivalent to about 8% of total assets. How can they predict that? Echavarren said in a phone interview. To make a 15-year business plan in Spain on the real estate sector today, not even God could do that. It may prove hard to find private investors to put money into the bad bank, Andrea Filtri and Andres Williams, analysts at Mediobanca SpA in London, said in a research note, adding that the government may ask Spanish lenders to “foot the bill.” This would trigger an infra-sector transfer risk, defeating the purpose of the bad bank in the first place.

Italy Faces Political Jitters
Investors’ attention has swung back to Italy from Spain after former Prime Minister Silvio Berlusconi threatened to withdraw his center-right party’s support for Mario Monti’s technocrat government before elections in April. Berlusconi’s struggling party suffered a heavy defeat in regional polls in Sicily at the weekend, however, while the anti-establishment 5 Star Movement led by comedian Beppe Grillo scored highly -- a possible foretaste of the national elections. Analysts said the market was still being supported by the European Central Bank‘s pledge to buy bonds of weaker Euro zone countries, so that investors appeared to have taken renewed political uncertainty in Italy in their stride, reported Reuters. I think that Berlusconi has been marginalized to some extent, so that’s having less of an effect on the market, said Elisabeth Afseth, fixed income analyst at Investec in London. Investors seem to have shrugged off domestic political jitters and also the risk-off sentiment as the Treasury sold four billion euros of five-year bonds and three billion euros of 10-year paper. The yield on the latter came in at 4.92%, down from 5.24% on month ago, with seen demand from foreign primary dealers. Borrowing costs for the five-year BTP came in at 3.8% today, down nearly 30 basis points from 4.09% at a similar sale a month ago.