Late on Friday after Europe’s financial markets had closed the Fitch ratings agency downgraded the Kingdom of Spain. This downgrade had been rumoured earlier in the week but in the end Fitch chose to let European trading finish before revealing it. Many may well wonder as to whether the timing just before a weekend followed by a bank holiday in some of Europe (Spain for example!) was deliberate. As to the move itself, Fitch said it had downgraded Spain’s long-term foreign and local currency ratings by one notch to AA+ from triple-A. This of course may well have implications for Spain in the areas of issuing new debt and rolling over previous loans on the bond markets. The Fitch announcement followed a similar move a month ago by Standard & Poor’s. The third ratings agency Moody’s, has so far kept Spain at its highest level. Some may consider the way that the ratings agencies have not acted in concert (as after all there is only one set of events concerning Spain) shows a weakness in the triumvirate of ratings agencies and I agree with that.
The Fitch Report on Spain
Whilst the ratings agencies are often inconsistent they do have some interesting things to say when they publish a full analysis of a country and in this respect Fitch’s report on Spain had some revealing truths in it. So we get some general analysis.
The downgrade reflects Fitch’s assessment that the process of adjustment to a lower level of private sector and external indebtedness will materially reduce the rate of growth of the Spanish economy over the medium-term
Fitch anticipates that the economic adjustment process will be more difficult and prolonged than for other economies with AAA rated sovereign governments, which is why the agency has downgraded Spain’s rating to AA.
Which is then followed by the real meat of the analysis and the reasons behind the downgrade.
Although the rebalancing of Spain’s economy is firmly underway, the inflexibility of the labour market and the restructuring of regional and local savings banks (cajas) will, in Fitch’s opinion, hinder the pace of adjustment, particularly in the aftermath of the real estate boom………In addition, the final costs of restructuring the ‘caja’ sector could be substantial
Fitch believes that the economic recovery will be more muted than that forecast by the government.
Is there something in what Fitch says?
Regular readers of my articles will know that I feel that Spain has serious problems with its savings banks or cajas and has delayed further reform in this area. I wrote on this subject in detail on Monday 24th May. This article also looked at the problems in Spain’s property market (of which it looks like there is more to come). When you look at Spain’s unemployment rate which has passed 20% it is hard to argue with a conclusion of labour market inflexibility and when you look at youth unemployment exceeding 40% it becomes impossible to argue with,in my view.
Fitch also feels that Spanish economic growth will be lower than that forecast by her government.Having written in the past on this subject I can only agree with that conclusion. Over optimism on economic growth has been a general feature of Spain’s governments response to the economic crisis which conveniently not only improves sovereign debt forecasts but also allows for recovery in the banking and property sectors.
So Fitch’s analysis is in fact well founded.
Spanish economic growth and her government
Spain’s government has persisted in its argument that economic growth is just around the corner throughout the past 6 months or so. As described above this has many advantages for projections for Spain’s economic future. There are two main dangers in a “hoping for the best strategy” and they are bad news and being forced to contradict yourself. Sadly for Mr. Zapotero’s government both have happened.
The being forced to contradict yourself problem was forced on Mr. Zapotero by the euro zone with its call for further austerity measures for Spain. Previously he and his Finance Minister Elena Salgado had dismissed calls for a further austerity package on the grounds that it would reduce Spain’s economic growth. However they found themselves having to implement a further 15 billion Euros consisting of cuts to Spain’s public-sector and tax rises. Apart from the embarrassment of this (probably quite small as it is not something politicians as a class seem much bothered by) there is the issue of what will Spain’s growth be now? The bad news was the collapse of Cajasur’s merger plans which focused everyone’s eyes on the wider problems in Spain’s cajas and by implication her property market.
Earlier on Friday Elena Salgado had lowered forecasts of Spain’s economic growth.The new forecasts are as follows,economic growth is now expected to be 2.5 % in 2012, down from an earlier figure of 2.9 %, and at 2.7 % in 2013, down from 3.1 %. The government had a week ago cut its 2011 growth forecast from 1.8 % to 1.3 %. In 2010 it expects the economy to shrink by 0.3%. So an improvement,perhaps, but I still feel that these numbers are over-optimistic. As an example of this Fitch in its report expects Spanish economic growth to be 0.5% in 2011 and not 1.3%.
What is Spain’s government afraid of?
The problem for Spain goes as follows. To hit the new euro zone austerity targets she needs to reduce her fiscal deficit from approximately 10% of Gross Domestic Product to 3% over a period of three years. So her economy loses 7% of GDP from the initial effect of her austerity plan. Therefore to avoid falls in economic output Spain’s private-sector as in her households and businesses will have to contribute or spend more, and/or she will have to improve her trade balance, whatever combination occurs it needs to add to up to 7% of Spain’s GDP . This is not impossible on first sight but think again, you see Spain’s private-sector is already very indebted mostly as a by-product of her property boom. So it is unlikely to borrow more and an improvement in her trade balance is possible but unless something extraordinary happens in world trade then it is unlikely to happen on anything like the scale required. Just as an example her nearest neighbour Portugal is unlikely to be of much positive help as she is embarking on her own austerity programme.
Then in my view problems tend to build up for Spain. As she already has an unemployment rate of 20% then tax rises and public-spending cuts have a danger in them. The danger is that Spain’s economy is driven backwards and not forwards. Wages are likely to fall and prices too. Now in themselves they are a required adjustment for Spain but if we move on from considering factors in isolation we get to the real danger. Putting everything together we could get wage and price cuts,fiscal austerity,rising unemployment,falling property prices and banking sector problems. Ouch
Conclusion: the enigma
Here we come to the enigma which faces Spain. The proposed solution to Spain’s debt solvency issues is a squeeze on public spending. Unfortunately such a policy runs the danger of weakening Spain’s economy such that it undermines her solvency again as economic growth disappoints and maybe does not happen at all. In a worst case scenario then the current austerity programme could end up worsening Spain’s solvency and such a scenario has horrible echoes of what happened in the 1930s. For those concerned about any drift towards such an outcome there are some clues from Latvia’s austerity experience which I discussed on the 12th March 2010.
Spain has economic strengths and not all is dark for example even under the new economic forecasts from Fitch the ratio of her national debt to GDP is not expected to pass 74%. But she has problems too and unless she can find economic growth from somewhere they are likely to mount. Only time will tell if her current governments response to the credit crunch which to a degree involved sticking its head in the sand and hoping for the best has left Spain vulnerable. If it had acted more promptly the measures required are likely to have been on a more reduced scale.