The Pain in Spain

Spain appears to have dropped off radar screens. In part, a disorderly outcome of the Greek crisis continues to be threatened. Italian bond yields and CDS prices have risen above Spain's. Yet, ironically, earlier this week, Spain's central bank warned that its banking problems are bound to get worse.

Spain's 5-year CDS is trading at new record highs today near 440 bp. Before the ECB agreed to buy Spanish bonds as part of the controversial sovereign bond purchase scheme, the CDS hit 429 bp. Within two weeks of the ECB's decision, the CDS had fallen to 330 bp (Aug 15).

Unlike Greece, Portugal and Italy, Spain experienced a housing bubble. House prices in Spain are about 22% off their 2007 peak and land prices have fallen 30%. The Bank of Spain expects further declines next year and its base case is for an eventual 50% decline in prices.

Non performing loans are at the highest since the advent of monetary union. As of June non performing loans stood at 17.8% up from 15.3% at the end of March. But there is great skepticism over these official figures. For example, the Bank of Spain took over (and operates) Caja del Mediterraneo (CAM) that has a delinquency rate greater than 40%. The BoS wants to auction it off, but there does not seem to be any interested parties.

If land and house prices continue to fall, the troubled loan category can only rise. The government, through the FROB has injected 11 bln euro into the banking system before Sept and have injected another 15 bln this month. More will likely be needed.

Unlike Italy which is running a primary budget surplus (budget excluding debt servicing costs), Spain's primary deficit is was about 6% of GDP last year. This compounds the difficulty Spain is experiencing in stabilizing the debt/GDP ratio.

Moreover, the economic outlook is poor. The August PMI readings, released in early Sept, showed both the manufacturing and services in deepening contractions (45.3 and 45.2 respectively). Industrial output was off 5.7% year-over-year in July. Retail sales(real terms) were off 6% year-over-year in July and the August report is due at the end of next week and is unlikely to have improved.

Not only is Spain's growth outlook weaker than for the euro zone as a whole, but is also experiencing more inflation. August CPI in the euro zone was 2.5% year-over-year. Spain's was 3.0% and when the Sept EU harmonized figures are released next week, it is unlikely to have improved. It appears to be becoming less competitive, not more.

Ireland offers a stark contrast to Spain, even though Irish yields and CDS are well above Spain's. Ireland, like Spain, experienced a housing market bubble, but unlike Spain, is on an EFSF/IMF program. Its EU harmonized inflation is 1.0% in Aug and it announced this week its Q2 GDP rose 1.6% on the quarter (compared with 0.3% median guess) and Q1 was revised up to 1.9% from 1.3%.

The big event for Spain here in Q3 was the ECB's decision to buy Spanish bonds. This appears to be the most likely reason why Spanish bonds are not inversely correlated to bunds (60 day rolling) as they were during the past six months. In fact , just before the ECB's decision in early Aug, the correlation was -0.95 and for most of Sept the correlation has been steady just below 0.60.

Spain goes to the polls on November 20th. The polls suggest the most likely outcome is a victory by the Popular Party, which may fall shy of the absolute majority. In any event, there does seems to be a political consensus in favor of the current path of austerity. If it does fail to achieve an absolute majority it will likely have to form a coalition with smaller regional parties that will also server to prevent bold innovative action.

Lastly, before the year is out, there is a substantial risk of a downgrade. Our proprietary model suggests the rating agencies are 4-5 notches too high still and we think it is "really" an A- credit. The difficulty in stabilizing debt/GDP ratios and the fiscal overshoot by the semi-autonomous region were recognized as credit negative developments.