Morgan Stanley - Global Economic Forum
http://www.morganstanley.com/views/...ml#anchoradbd473a-46d7-11df-8095-e5b9b2227d92
Spain
The Housing Market and Fiscal Policy - the Risks
April 13, 2010
By Daniele Antonucci|
Summary and conclusions
Sovereign risk and the so-called EMU periphery are once again taking centre stage. We have argued that the countries generally associated with this group (Italy, Spain, Greece, Portugal and Ireland) are a very heterogeneous bunch and that some of them are no longer a ‘pure' peripheral country (see Italy Economics - Inching into the Core, March 15, 2010).
However, we share investors' concerns on the Spanish economy. But while everyone seems to have a bearish view, we are more bearish than most. In this report, we focus on the ongoing structural adjustment in the economy, mainly in the construction sector. We also explore the challenges to the fiscal consolidation process. We reach six main conclusions:
• First, Spain is still dealing with the housing bubble aftermath. We expect a further 10% decline in house prices this year alone. The adjustment in the construction sector has further to go, in our view, and the backlog of unsold homes remains very sizeable.
• Second, there is no clear replacement as a growth engine for the construction sector - at least not in the short term, in our opinion. We feel comfortable with our below-consensus GDP growth forecast this year and next.
• Third, we believe that the probability of our bear case playing out has increased and the magnitude of the drop in GDP is likely to be bigger, should the downside risks associated with this scenario materialise.
• Fourth, we turned more bearish on the medium-term outlook too. Spain far outpaced the euro area over the five years prior to the financial crisis; we expect it to lag behind over the next five years and to expand at half the pace of the 2004-08 period.
• Fifth, overly optimistic GDP growth assumptions might make the fiscal consolidation targets more difficult to achieve - especially next year. Hence, market discipline might force Spain to step up its fiscal efforts, which so far have been very gradual.
• Sixth, with a sizeable debt redemption in July and two-thirds of the funding plan yet to complete, Spain might come under the market spotlight. The low degree of centralisation in its public finances is another factor that might raise some concerns.
What's more, there is a degree of uncertainty surrounding the outlook for the public finances. The debt markets' persistently negative view on the savings banks, for example, may force the government to provide additional debt guarantees. Should these contingent liabilities materialise, Spain's public finances might come under further pressure.
Quantifying the impact of these liabilities (or of an increase in the size of the Fund for Bank Restructuring) is subject to uncertainty. Indeed, the chances are that the emergency fiscal packages and financial operations of the past couple of years - which do not have an immediate impact anyway - could well be treated differently from the ordinary fiscal operations.
Eurostat, for example, has decided that "the final impact on government deficit and debt figures of these operations will be recorded in the core accounts if and when the associated risks crystallise, and can be measured objectively". But even so, the fact is that the outlook for Spain's public finances might turn out to be even more challenging.
1. Ongoing Adjustment in the Housing Market
The key driver of our below-consensus outlook is the structural weakness in the housing market. Of course, with the economy still shrinking in Spain - unlike in most other euro area countries - the decline in house prices we have seen so far was almost predictable. But the chances are that GDP growth will come back in positive territory over the next quarter or two. Will this trigger a renewed bout of activity in the housing market? We doubt it.
Despite a remarkable housing bubble, Spanish house prices have declined by about 11% from their peak in 1Q08. This compares with a peak-to-trough fall of around one-fifth in the UK, one-quarter in Ireland and one-third in the US. 
The first leg of the adjustment in the housing market had to do mainly with the volumes transacted rather than the prices of the transactions: sellers did not want to sell because they could not get an attractive price, thus triggering a fall in home sales.
However, this does not prevent the second leg of the adjustment from taking place through a further correction in prices too, which we see more as a lagging indicator at this stage. House prices might not continue to fall at the same pace - as the recent trend seems to suggest - but we believe that there are four reasons to expect further declines, to the tune of a further 10% this year alone:
1. The adjustment in the construction sector is not yet complete. Despite a 32% drop from its peak in 4Q07, construction investment still accounts for 13.8% of total economic output - half a percentage point above its long-term average. The equivalent figure for the euro area is 11.2% - half a percentage point below its long-term average. So, an additional 5% decline in Spanish construction investment would be required just to bring it, as a proportion of GDP, in line with the historical average. But this decade's construction boom has pushed up the average, which was just 12.1% from 1980 to mid-1998, i.e., before the housing bubble. To go back to that level, construction investment would need to fall by another 15%.
2. The backlog of unsold homes remains very sizeable. Indeed, to eliminate the existing oversupply, construction investment may need to fall by an even larger margin than envisaged above. The past five years witnessed the construction of 2.8 million new homes, but sales were far less dynamic, at just over 1.5 million. This means that more than half of the newly built homes may sit unoccupied. If new home sales remained at the current level - and assuming that homebuilding stopped altogether - it would take until 2015 to clear the existing oversupply of homes. Of course, building approvals seem to have picked up, but the housing overhang will last until 2012 even if they quickly return to pre-crisis levels.
3. Doubtful loans may continue to rise for most of this year. Indeed, they are unusually low relative to the spike in the unemployment rate. During the recession in the early 1990s, when the unemployment rate was close to 20% as it is today, doubtful loans accounted for about 6% of the total - twice the current share. Of course, ultra-low interest rates and the extension of unemployment benefits helped Spanish households cope with mortgage payments and the job shakeout. But these factors will not remain so favourable for much longer: the subsidy to the unemployed whose benefits have run out will expire, and longer-dated Euribor rates will rise - as the ECB reduces the maturity of its refinancing operations.
4. With an over-stretched private sector, a further period of belt-tightening is on the cards. The sum of household and corporate debt amounts to 220% of GDP in Spain, far higher than the euro area average of 165%, and its increase has been almost 400% from the inception of the EMU - the strongest expansion across the euro area. With variable-rate loans making up 90% of total mortgages - compared with an average of 50% in the euro area - Spain is very sensitive to changes in interest rates. When they resume their upward trend, Spain will struggle more than the ‘typical' EMU country.
The upshot is that a stabilisation in the construction sector is still far off, in our view. With house prices having fallen to a much lesser degree than in other hotspots - and, apart from Ireland, an arguably bigger credit-fuelled housing and consumer boom-turned-bust - we think that a further decline of around 10% this year is very much on the cards.
2. The Growth Outlook - How Poor? Three Scenarios
Thus, we conclude that the chances are that the structural adjustment in the housing market has further to run. The implications for the growth outlook are clearly negative and the drag on economic growth is likely to be significant, in our view. Indeed, the construction sector was one of the main drivers behind Spain's success story in the decade prior to the financial crisis, contributing to GDP growth both directly and indirectly - by supporting the purchasing power of low-income workers in the sector, thus boosting consumer spending.
Of course, the weakening of the euro - coupled with the strengthening of the global economy - suggests that a partial offset might come from a positive contribution to GDP growth of net trade. Indeed, this is already happening - though it has to do not only with strong exports over the past couple of quarters, but also with weak imports. However, while we acknowledge that an export-led recovery is clearly a positive development, the fact is that the downward pressures on the economy stemming from the ongoing downsizing of the construction sector are very substantial.
In all, we feel comfortable with our below-consensus GDP growth forecast. We expect the Spanish economy to contract outright this year too - unlike the other major European countries - and expand far slower than the euro area as a whole in 2011. The latest published median prediction across several market economists is a contraction of 0.4% in 2010 and an expansion of 1.1% next year. Both these forecasts are too optimistic, we think. Our base case is a deeper fall in GDP this year - to the tune of 0.7% - and a more muted recovery in 2011 of around 0.8%.
Moreover, the challenges for the Spanish economy go well beyond poor prospects of a swift recovery over the next couple of years. While Spain far outpaced the euro area over the five years prior to the financial crisis, we expect it to lag behind over the next five years. In other words, the Spanish economy expanded twice as fast as the euro area during the boom years. But with no clear substitute for the construction sector as its economic engine - and with still a lot of work to do in terms of rebalancing its economy away from domestic demand and towards external demand - it will now be a growth laggard and underperform the other major euro area countries, from an economic standpoint.
We present three scenarios - base, bull and bear cases - for 2010-11.
Scenario #1 - Base Case
The new underperformer: Further economic contraction this year - unlike in the other major euro area countries - followed by a much weaker recovery in 2011. Watch the labour market.
In this scenario, to which we assign a 45% probability, the economy continues to shrink for most of 2010, but starts expanding again before year-end - courtesy of the lagged effects of the policy stimulus on both the monetary and fiscal fronts. But house prices decline by a further 10% and construction investment drops by over 7% on a year earlier. In all, GDP growth remains in negative territory on average in 2010, to the tune of -0.7%.
Although the economy should start recovering next year, domestic demand stays remarkably weak on both a cross-country and historical basis - courtesy of a more restrictive fiscal policy and somewhat higher interest rates. Net trade will likely boost GDP growth - thanks to a weaker currency and stronger foreign demand - but this should be a partial offset. In all, GDP growth comes back in positive territory in 2011, to the tune of 0.8%.
The key driver behind our base case scenario is the labour market. Clearly, the job shakeout has been sharper (but probably shorter) in Spain than in the rest of the euro area. Indeed, despite accounting for less than 12% of the euro area GDP, Spain accounts for over one-quarter of total unemployment - up from about 15% at the start of 2007, i.e., prior to the financial crisis and economic recession. Despite having slightly more than half the population of Germany, Spain has now over one million more unemployed (using harmonised Eurostat data, 4.3 million in Spain versus 3.2 million in Germany).
Although most of the adjustment is probably already behind us, the labour market outlook remains challenging, we think. GDP growth and employment growth exhibit a very high correlation (95%). With no replacement in sight for the construction sector, the chances are that they will both remain subdued for quite some time. We don't expect any job creation whatsoever throughout the forecast horizon (end-2011): after having declined by 6.8% last year, employment should contract by a further 2% in 2010 and virtually stagnate next year. No wonder that the economic recovery will lag behind that of most euro area countries.
Scenario #2 - Bear Case
Three in a row: The economy continues to shrink - and at a substantial pace - not only this year, but also the next. Watch the housing market and bank lending to the private sector.
In this scenario, to which we assign a 40% probability, credit conditions remain restrictive for longer than expected. This is a key economic risk, in our view. Indeed, loan growth has declined more sharply in Spain than in the euro area as a whole across the board - and for a good reason: the loan exposure of the domestic banking sector to the property developers. The chances are that this trend will continue well into this year and possibly extend into the first part of 2011.
The likely restructuring of the domestic banking sector - which we expect to happen in our base case scenario too, but to a lesser degree - triggers a late-cycle credit crunch. Coupled with the announced fiscal tightening at around mid-year, this hits the economy hard. In turn, house prices fall more sharply than anticipated, to the tune of 15% this year alone, and construction investment drops by 20% - more than twice as much as in our baseline. Of course, this puts Spain's public finances under additional pressure.
The upshot is that a ‘growth scare' - which will negatively affect market sentiment - might well materialise, thus setting off a drying up of the capital flows that have been financing the current account deficit. In turn, with a more limited access to external financing, and an impaired domestic lending channel, a further downward correction in asset prices takes place. In this scenario, not only does the Spanish economy underperform the euro area economy as in the base case, but it also shrinks for an unprecedented three years in a row.
Scenario #3 - Bull Case
Export-led recovery: The further weakening of the exchange rate - and stronger global demand - boosts exports and helps Spain's economic rebalancing. Watch foreign trade data.
In this scenario, to which we assign a 15% probability, the Spanish economy broadly stagnates this year and expands by around 1.5% in 2011 - approximately twice the pace assumed in our central forecast. The main driver behind this more favourable outcome is a stronger-than-expected pick-up in exports. In part, this is already happening: courtesy of the strengthening in global demand, Spain's exports of goods and services rose sharply on a quarter earlier in the second half of last year.
The depreciation of the euro, which we expect at 1.24 against the dollar at year-end, will contribute to lift exports too - both in Spain and in the euro area as a whole. Should this happen, Spain might benefit from an export-led recovery further down the line. In turn, this might help the rebalancing of an economy that has been driven primarily by domestic factors during the boom years. However, although the likelihood of this more benign scenario is not negligible, we think that exchange rate changes alone are not enough to boost exports durably.
So, Where Does This Leave Us?
Of course, other plausible scenarios could be constructed by slight alterations of the above-mentioned assumptions; and different subjective probabilities could be assigned to the same scenarios. Bearing these caveats in mind, the main takeaway from our scenarios is that risks to the Spanish economy remain skewed to the downside. In other words, we think that the likelihood of our bear case playing out is relatively close to that of our base case. What's more, the upside is likely to be limited even in the bull case, not only in the short term, but also over the medium term.
What has changed from our previous in-depth report on the Spanish economy (see Finding a Balance - Where We Are, What's Next? November 25, 2009) is that we now believe that the probability of the bear case playing out has increased from around one-third to 40% or so. What's more, we turned more bearish on our bear case relative to our assessment at the end of last year. We now think that, should the risks associated with our more pessimistic scenario materialise, the magnitude of the drop in GDP is likely to be bigger. In particular, the restructuring of the domestic banking sector - coupled with the ongoing structural adjustment in the housing market - is a key risk, in our view.
3. Fiscal Tightening - Not an Easy Task
Spain is in the midst of a structural adjustment, as shown in the previous sections. The implications for its public finances are likely to be quite substantial. Indeed, Spain has to cut its budget deficit from an estimated 10% of GDP this year to below 3% in 2013, to meet the European Commission's demands.
The Commission has recommended an annual adjustment of Spain's structural budget balance (i.e., the budget balance adjusting for the cycle and one-off factors) greater than 1.5ppt - a more demanding request than in any other euro area country apart from Greece and Ireland.
Apart from overly optimistic GDP growth assumptions - which might make the fiscal targets more difficult to achieve - three different angles are relevant from a fiscal standpoint: what's already in place in terms of fiscal tightening; short-term rollover risk; and Spain's fiscal setup relative to the rest of the EMU.
Shrinking the Budget Deficit - How Much This Year?
Although fiscal policy has already turned somewhat more restrictive, Spain is adopting a gradual approach. For example, it aims at cutting the budget deficit from 11.2% of GDP in 2009 to about 9.5% this year. This compares with an upfront fiscal consolidation of around 4% of GDP in Greece - should the government implement the various announced measures in full. This is not to suggest that Spain and Greece should tighten their belts following the same agenda. Rather, it is an observation that, should markets start worrying about the fiscal position of other countries too, they might force them to pursue a more restrictive fiscal policy within a shorter timeframe.
Clearly, Greece is in a unique situation in Europe at this stage. From Portugal to Spain, the other EMU peripherals currently under the market spotlight - despite sharing some of Greece's economic and fiscal deficiencies - seem better placed on several fronts (see Portugal and the EMU Periphery, February 15, 2010). In particular, Spain's government debt is about half Greece's, as a share of GDP. And Spain has a good record of fiscal achievements. For example, it managed to run a budget surplus in 2005-07 - quite an improvement from a deficit of over 6% in the mid-1990s. What's more, the reliability of Spain's public finance figures has never been questioned.
The public purse has already become more stringent in Spain. For example, the standard VAT rate will be raised by two percentage points to 18% in July (and the reduced rate will be increased too), the €400 tax rebate has been eliminated except for low-income households, and dividend income, interest and capital gains have already been taxed more aggressively since the start of this year. This is appreciable. And, clearly, with the economy still in recession, an excessively aggressive - or perhaps too premature - fiscal consolidation agenda might further delay the recovery. These considerations are important too, in our view, and should play a role in defining Spain's fiscal strategy over the next few years.
Still, the fiscal challenges are bigger this time, and the risk is that markets may not differentiate to a great extent among the various EMU peripherals - if they are not constantly reminded of the heterogeneity within this group of countries. From this perspective, we believe that markets will respond differently to the various fiscal consolidation efforts in Europe, based on three factors: the pace of the fiscal tightening (gradual versus front-loaded); its quality (spending cuts versus revenue-raising measures); and the social tolerance that makes the belt-tightening easier or more difficult to implement in some countries than in others. In particular:
1. The pace of the fiscal tightening is gradual in Spain. The risk is that markets might perceive it as too gradual and only feel reassured with further belt-tightening measures - as was the case, to various degrees, with Greece and Ireland. An additional reduction in expenditure worth about half a percentage point of GDP has recently been announced; but the Central Government Austerity Plan - which aims at cutting spending by more than 2.5% of GDP - will only kick in next year.
2. Half of the fiscal restraint will happen on the revenue side this year. There is nothing wrong with higher taxes as part of a fiscal consolidation effort. Indeed, this is the case in all countries in the euro area. But the market seems to attach a higher value to spending cuts - which are under direct government control - than to revenue-raising measures. The hope is that the emerging emphasis on restraining wage outlays for all public administrations and reducing transfers and subsidies will continue.
3. Implementation delays are the key risk for the Spanish economy. There are different ways to tackle the same fiscal challenges. But regardless of the chosen policy mix, it is important to stick to a substantial belt-tightening within a set timeframe, we think. From this perspective, the (non-binding) senate motions protesting against plans to raise the VAT rate passed in late March, as well as the opposition appeal against the 2010 budget before the constitutional court, might result in a fiscal setback.
Rollover Risk - Biggest Payout Month in July
Another risk related to the fiscal prospects for the Spanish economy is the difficulty in refinancing the debt. So far, this risk has concerned mostly Greece, but to various degrees Spain and Portugal have come under the spotlight too. The schedule of coupons and redemptions helps us get a sense of the pressure points. Spain faces a sizeable €30 billion in July. For Portugal, May is the big payout month. For Greece, the pressure points are April and May.
Event risk and volatility are likely to remain high/increase at around those months. What's more, short-term rollover worries are likely to be magnified in the countries where there is still a lot to do in terms of issuance - all else being equal. From this perspective, Spain has so far raised less than one-third of its total funding needs - the same as Italy and Germany, but less than all other EMU countries apart from Portugal.
The Degree of Centralisation in Government Finances
Besides budgetary policy and debt refinancing issues, it is also worth exploring the role of regional and local governments. Obviously, a high degree of centralisation would make the pursuing of a given fiscal agenda easier - abstracting from other conditions. The Spanish government has announced regional and local government spending cuts worth about 0.5% of GDP. This is good news. But whether more can come from the local administrations - if needed - remains to be seen.
In several countries in the euro area - both at its core and at its periphery - the non-central government, i.e., regional and local administrations, carries a considerable weight:
• Non-central government spending accounts for over one-fifth of GDP in Spain - way above the euro area average of about 15% and the highest share across the region.
• Non-central government revenue too accounts for approximately one-fifth of GDP in Spain - some five percentage points above the euro area average and second only to the share of Belgium.
For the accompany charts and tables, and the effects on savings banks, please see The Housing Market and the Savings Banks' Restructuring, April 12, 2010.
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