After the so called “shock and awe” euro zone bailout which relied on a headline figure of 750 billion euros to have this impact on the tabloid press and a change in the European Central Bank’s rules to allow it to buy peripheral sovereign debt to have this impact on the financial media we now have some details on the promised response to this from both Spain and Portugal. This is in effect an attempt by the euro zone to demonstrate that it is not just transferring funds from prudent to imprudent countries and that they will have to have some form of punishment. At the announcement of the bail out Elena Salgado was somewhat embarrassed I felt as she was announcing a form of punishment for her own country. Also she has a bad track record in this area as I wrote on the 2nd February.
You may have read of a fiscal consolidation plan leading to 50 billion Euros of cuts by 2013. In fact the wool has been pulled over people’s (and many journalists) eyes because the pages for budget deficits in 2010,2011 and 2012 had some blank spaces in them. So Spain’s government wants to cut her budget deficit from 11.4% in 2009 to 3% in 2013 but is unable or unwilling to tell us how. I can only conclude that there is no real plan at all.
So to those who follow these issues her grandstanding and arrogance from the past might make you think that there were better choices to announce that Spain and Portugal will make budget cuts! There was also an interesting corollary to this as I remember writing on here that Ireland had been forgotten but perhaps we were being given an example of a country which has been considered to have done enough in terms of fiscal austerity and of course by implication two who have not in the eyes of the euro zone.
What has Spain Announced?
We got announcements of a considerable acceleration in Spain’s austerity programme and this time we do have some detail. There will be further cuts amounting to 0.5% of Gross Domestic Product(GDP) in 2010 and a further 1% of GDP in 2011 which added together come to cuts of approximately 15 billion euros.The details of this are.
1. Pay cuts with civil service salaries cut by 5% in June 2010 and then frozen in 2011 whilst Spain’s Ministers will take a 15% pay cut.
2. Spending cuts of € 6bn in public sector investment and €1.2bn cuts in local & regional governments.
3. Also state pension payments will be frozen and as well as a € 600m reduction in foreign aid we will see an abolition in 2011 of a 2500 Euro child-birth allowance.
The plan is to reduce Spain’s fiscal deficit to 6% of GDP in 2011/12 which contrasts with a level of 11.2% in 2009/10. She still plans to meet the euro zone’s’s 3% of GDP target in 2013.
Firstly this is a much better effort by Spain than her plan in February. However it does pose it own challenges as Jose Zapatero Spain’s Prime Minister who was re-elected in 2008 on promises of higher pensions, better welfare and full employment. With an unemployment rate of 20% the last promise has plainly gone and now he cannot fulfil the pensions promise either.
The ministerial pay cut of 15% did make me think of the UK’s own ministerial pay cut which of course is only 5%. I wonder if that is an omen. The cuts in general will have to be closely monitored as there is a danger of Spain being pushed back towards recession by them, however they do help solve the problem that for this year Spain’s fiscal deficit was looking likely to be worse than Greece’s
What has Portugal done?
Portugal has lowered its 2010 fiscal deficit target to 7.3 % of GDP, from a previous goal of 8.3 percent and this compares with 9.4% last year. For next year she has targeted a deficit of 4.6% of GDP which is down 2% from the previous target of 6.6%. This will be achieved by the following.
1. There will be tax rises under the “crisis tax” banner and they include a 2.5 % increase in corporate tax to 27.5% on annual profits which exceed 2 million Euros, a 1 % increase in value added tax to 21 per cent and increases of up to 1.5 percentage points in income tax.
2. There will be spending cuts including a general 5% pay cut for the public sector including ministers. There will also be a 100 million Euro reduction in transfer payments from central to local government.
Overall these budget cuts are planned to amount to 11 billion Euros over the next four years.
I wrote an analysis of Portugal’s economic position back on the 27th April and in it I asked for her government to take action so I welcome this move. It will not be easy for a socialist government to take this path and it can expect some unrest. My summary of her economic problems was as follows
Her main problem has been a lack of growth and this has caught her out in her plans for her public finances and left her vulnerable. The bit she shares with Greece is that her government lost its nerve at a crucial time and dithered.
This issue of Portugal’s lack of growth continues to trouble me and she has had in her time as a euro zone member her version of a “lost decade”, not the same as Japans but something that has been equally damaging. Another symptom of this is that I have been looking at is her balance of payments problems and I have looked at data back to 1980. Apart from a period in the mid-1980s following an IMF austerity plan Portugal has been perpetually in deficit. She used to have some net income from abroad to help with this but her external indebtedness has increased and since around 2005 this has turned negative too.
This is a very difficult quandary for Portugal as her external imbalance agrees with her fiscal deficit in the sense that she needs change. But she has already had a period of low growth which has gone on for ten or so years so the adjustment will be painful. My advice is to get out the IMF package from 1983 as it is the one thing over this period which has led to an improvement in Portugal’s economic situation. For my part I would suggest that the government suspends some or all of the large public works planned such as the extension of the TGV train system to Portugal. I agree with the chairman of Deutsche Bank that Portugal’s situation is “difficult” but I do not think that it is hopeless and do believe that it can be improved.
Comment for both Spain and Portugal
It is unfortunate that Spain and Portugal are such near neighbours sharing as they do the Iberian Peninsula. There is a danger that the austerity programmes in each country affect each other but unfortunately there is nothing that can be done about the geography! Todays news on inflation in Spain does have a disturbing note to it. There are bigger fans of the concept of core inflation than me but it is hard to ignore the fact that Spain’s core inflation was negative (-0.1%) last month. When you are trying to get out of a debt problem falling prices are somewhat unwelcome and Spain’s equity market and the Euro exchange rate have reacted badly to this. I think that the market and media response to this symbolise that this subject is currently a little bit of a raw nerve and is another sign of the fear and uncertainty that has persisted even after the euro “shock and awe” bail out.
Perhaps it has also focused the markets mind on another problem for Spain (and some others) which is that she needs cost disinflation to improve her competitiveness without debt affordability disinflation as it increases the real cost of her debt. This is indeed quite a quandary.
Speaking of fear and uncertainty many eyes remain on this issue which has if anything deteriorated this week in spite of the euro zone bail out. There are several ways of measuring this and let me give you two examples.
1.Three-month dollar LIBOR edged a little higher to 0.434 per cent yesterday which is its highest level for nine months and to give you a comparison it was below 0.3% a month or so ago. Also there are starting to be different quotes for different banks which is representing their risk position.
2. There is another measure which is the spread between three-month dollar Libor and what are called “risk-free” overnight rates and this spread rose to 0.215 per cent yesterday having been below 0.10 % a month or so ago.
These are significant because they are measures which headed in this direction before the collapse of Lehman Bros. Now I wish to emphasise that we are a fair way away from the scale of the move then. But of course since then we have seen a range of extraordinary monetary measures by central banks too.
I am pleased that (finally) Spain and Portugal had addressed their fiscal problems more seriously. This is a hopeful sign and I was also pleased to see that Portugal grew strongly in the first quarter of 2010 as she will need every ounce of growth she can get. But as time goes by I think that minds will be focused on two things. The first is that the euro zone still does not have the major reform programme that needs to come with the bail out to make give it a chance of success in the medium/long-term. The second is that the banking sector is still showing signs of creaking in spite of all the help and aid it has been given over the past two years.