Tuesday, November 25, 2008

With Italy In Recession Consumer and Business Confidence Decline Further In November

Italian consumer confidence fell back to its lowest in three months in November, with the Isae Institute’s consumer confidence index dropping to 100.4 from 102.2 in October.

“Recession news may have dented household morale more than the market turmoil,” said Marco Valli, an economist at UniCredit SpA in Milan. “In the next few months darkening savings and labor market prospects should add to the gloomy outlook.”

Italian business confidence also fell - to its lowest in more than 15 years - in November, and the Isae Institute’s business confidence index dropped to 72.2 from a revised 76.9 in October.

Italy entered its worst recession since 1992 in the third quarter of 2008. The Italian government is scheduled to present an 80 billion-euro ($101 billion) stimulus plan on November 28, and the government also plans to increase the funding for temporary unemployment benefits as joblessness rises. However with approximately 103% of GDP outstanding in debt and a substantial bank bailout to finance, possibilities for additional counter cyclical spending are limited.

According to the newspaper l'Unita at least 400,000 Italian workers with temporary contracts may lose their jobs by the end of the year, citing data coming from a study carried out by the country’s biggest trade union, CGIL. The union forecasts that almost one in four of the 1.8 million part-time workers in Italy’s private sector will not have their contracts renewed at the end of December.

And the outlook next year seems to be even bleaker. The recession is almost universally expected to deepen ,and the International Monetary Fund forecast earlier this month that Italy’s economy will contract 0.2 percent this year and 0.6 percent in 2009. The IMF itself, in their latest Article IV Consultation Report - published on 20 November - described the outlook for the Italian economy as “bleak.”

“Beyond the present cyclical slowdown, the real economic crisis confronting Italy is the decline in productivity over the last decade, which has spawned stagnating incomes, rising unit labor costs and tepid growth,” the IMF said.

Obviously Italian consumers are getting some relief from the sharp drop in oil prices which means that gasoline and heating costs are falling as is the inflation rate, which has been falling steadily back from a six-year high of 4.1 percent in August. Thus the level of the consumer confidence index is still somewhat above the very low level we saw back in June. But having consumer confidence lying around just above all-time lows is hardly much consolation at this point I think.

The IMF expect Italy's fiscal deficit to widen in 2008. According to the fund the structural fiscal balance improved substantially in 2006-07, but this was mainly due to exceptionally strong revenues - and the overall deficit narrowed to 1.6 percent of GDP in 2007. But, with the 2008 budget anticipating a continued expansion and revenue waning as the recession started to bite, the overall deficit is expected to be close to 2½ percent of GDP this year.

The Italian government three-year fiscal package had targeted a broadly-balanced budget by 2011 - in line with Italy's undertakings under the EU Stability and Growth Pact. The adjustment plan was expenditure-based and targeted a structural consolidation of 0.8 percent of GDP in 2009, increasing thereafter, with the respective public debt and spending ratios falling accordingly. As the fund notes these plans were based on GDP growth rates of 0.5 percent in 2009 rising to 1.2 percent in 2011.

Since these forecasts are now rather outdated the near-term fiscal outlook is expected to deteriorate in line with the present macroeconomic environment. The IMF project a higher fiscal deficit in 2009 due to the weaker growth outlook, with the expenditure ratio rising further, even if the nominal spending limits continue to be observed. In addition, they note the danger that tax elasticities shift adversely during the downturn and expenditure savings are not fully realized. In this case the debt ratio will almost certainly rise further, reflecting the gap between the still-high average interest rate on government debt and falling growth rates, higher deficits, and possible bank support operations. All in all, it will be interesting to see how the credit ratings agencies react to this turn in events.

Sunday, November 23, 2008

Repsol, Lukoil and Sacyr Vallhermosa Also Try Their Hand At Happy Families

“Happy families are all alike; every unhappy family is unhappy in its own way”

Well this is an interesting little fable of modern family life, even if all the families involved may not be ones which many of my readers would normally wish to belong to.

As is now reasonably well know Russian private oil company Lukoil is currently making a bid for the shares in Spanish energy company Repsol which are owned by the deeply indebted Spanish property company Sacyr Vallhermosa.

Shares in what is Spain's fifth biggest builder, and which currently occupies the somewhat ignominious position of being Spain's worst-performing stock this year, jumped the most in two years last Thursday (20 November) on reports they were about to sell their 20 percent stake in Repsol YPF to the Russian oil company OAO Lukoil. Sacyr, which said last week it was in talks over the possible sale of the stake, rose as much as 14 percent after EFE newswire identified Lukoil as a possible bidder. Lukoil is also reportedly willing to buy a further 9% of Respol stock owned by Criteria Caixacorp, the investment company established by Catalan savings bank La Caixa.

In fact Sacyr spent 6.5 billion euros building up their the Repsol holding, between October and December 2006, paying an average of 26.71 euros a share for the stake. It is estimated that the proposed sale of the shares may fetch 20 percent to 30 percent more than their current market value of 4.9 billion euros. To give an idea of what this means, we might bear in mind that Repsol shares closed in Madrid on Thursday at 13.61 euros, and rose 2.3% on Friday, while the Spanish newspaper El Economista reported that Lukoil was offering Criteria and the other shareholders 28 euros a share for the combined stake which constitues just under 30 percent of Repsol. An offer at this price would value the combined stake at about 10.2 billion euros, and would mean that Sacyr would walk away covering their initial investment almost completely, which in these hard times must seem almost incredible. I mean, you might like to ask yourself just why it is that Lukoil is able and willing to pay so much. Certainly Russian investors were asking just this very question since Lukoil shares dropped on the news - falling 4.6 percent to 778.74 rubles on the Micex stock exchange in Moscow on Friday (for my explanation of the apparent analogy more on this topic below).

But before going further there is perhaps one other little detail which is worth including at this point, and that is that since the combined stake of Sacyr and Criteria falls just short of the 30% mark which would give Lukoil effective control of the energy company (and make it obligatory to make a takeover offer to the other shareholders I think) it should not surprise us to find that the midewives of the deal are busy trying to identify those extra few shares which would push Lukoil over the 30% stake mark, and various names are being bandied around - like Mutua Madrileña (who have a two percent stake) or even La Caixa itself, since they effectively control another 6.1% of Repsol through their subsidiary company Repinves.

It's The Income Balance That Matters, Silly!

Now before we go into all the gory little details as to why exactly it is that Sacyr Vallehermosa find themselves so pressed to sell, perhaps a little of the background macroeconomics would not go amiss here.

Basically, as I explain in more detail in this post, the principal problem facing Spain's economy at the present time is financing the large external deficit, which has been running at around 8-9,000 million euros a month (8 to 9 billion in anglo saxon language, or around 10% of GDP) for most of this year. This deficit was previously financed by an inflow of mortgage funding when external investors were willing to supply this, but since these investors became increasingly nervous following the US sub prime turmoil in August 2007, Spanish banks have had problems funding the deficit (and funding mortgages) as we have been seeing via the dramatic slowdown in the Spanish economy that this reluctance to lend has produced.


The principal way to resolve this external deficit is to have a major macroeconomic correction such that exports start once more to be larger than imports, but this process is a huge and painful one, and it is not surprising that the patient, lead by the country's government, and the prime minister, is extremely reluctant to enter the operating theatre. So we struggle on, month by month, but the monthly deficit still has to be paid. And this is where the sale of Repsol to Lukoil comes in. The issue is not that Lukoil being a non-Spanish company is a disadvantage (which is why the sort of criticism of the proposed deal which is coming from the PP is also completely out of touch with reality), but rather that it is absolutely essential to find an external buyer to raise more liquidity for the Spanish banking system, and if no other bidder is in a position to pay Sacyr what they need to make the sale viable for them, then Lukoil it is, "por las buenas o por las malas", as they say in Spanish. When you are up against the wall, and the only question is "do I shoot you today or tomorrow", the answers you give are not always coherent and well-thought-out ones.

However, just how dangerous trying to handle the Spanish problem in this way actually is, can be seen from the fact that one of the country's flagship companies is effectively being sold off for less than two monthly installments on the current account deficit (the August deficit was 6 billion euros). The problem really is that Sacyr has to sell (see more details below) but there is no ship left among what used to be called the "new Spanish armada" who still has the creditworthiness needed to be able to buy. Gas Natural (who were one of the last stalwarts) had their Long-term Issuer Default rating of 'A' and Short-term IDR of 'F1' placed on Rating Watch Negative by Fitch last July after they announced they would need a new 19 billion euro syndicated loan to finance their acquisition of a sizeable chunk of energy company Fenosa from another debt laden Spanish construction giant ACS.

Essentially going about things in this way eventually becomes totally unsustainable. Let me explain a little more. It is important to understand that the external accounts of a country are divided into two parts - a current account and a financial account - rather like the finances of a houshold can be divided into long term and a short term components like the acquisition of a property and the monthly mortgage installments which finance it. Well basically the structure of national financing isn't that different. Spain Incorporated can raise funds on the capital account by selling the shares of Repsol to an external purchaser, but we should never forget that these shares will then pay dividends, and these dividends will subsequently show up on the current account under the monthly income balance heading.

Now normally, in a developed economy, the income balance should hover around the neutral zone, as external investments attract income, while FDI etc from abroad carry associated outflows. Indeed I would say that the normal difference between a developed and a developing economy is in the underlying dynamics of the income section of the current account.


It is precisely when we come to examine this aspect of the Spanish case that we see the extent of the hole that has just been blown in the flagship's main bulkhead, since the income balance (which was never perfect) has been turning steadily negative (which was only to be expected with all those loans coming in) since the early years of this century, and now runs at a monthly outflow of 3 billion euros, or thereabouts. That is to say, the first 3 billion of any goods and services surplus which Spain eventually does manage to generate will be earmarked to pay interest and dividends on loans and shares previously sold to finance the property and merger boom. So roll your sleeves up lads and lasses, since there is a lot of sweating to be done to work off all this accumulated excess fat. Or maybe you would prefer to try liposuction?

And of course, the more we go down the road of selling off the country's underlying assets (and, of course there is plenty more to come here, see below on Acciona, Endesa and Enel, or think of the recent agreement to sell Iberia to British Airways due to Caja Madrid's urgent need for liquidity - Caja Madrid is Iberia's largest single shareholder) to pay for petrol for all the SUVs we have been buying with the loans we sold, the worse the long term position becomes.

Sacyr In Danger Of Having To Make Firesales

Rumours have been growing in investor circles of late that Sacyr Vallehermoso could be in such a tight financialcorner that it may forced into fire sales as time passes, if it fails to find buyers for assets it has put on offer to try to cover the massive debts it has hanging over it. Sacyr's share price has lost 69 percent of its value since the beginning of the year - as compared to a 39-percent slump in Spain's main IBEX stock index.

Like many Spanish builders, Sacyr borrowed heavily during the final years of the boom in an attempt to diversify out of residential property as the nine-year-long domestic housing boom clearly started to wind down. But as in so many other cases, those who buy near the end of a wave buy dear, and risk, if things don't go right, having to sell cheap, very cheap, unless of course a gleaming white knight in shining armour like Lukoil gallantly comes to your rescue (or is it so gallant, see below). Sacyr had net debt of 18.3 billion euros at end-June, or eight times market value. The ratio of net debt to net equity was 5.3, outweighing peers like Ferrovial at 3.9 and ACS at 1.2.

Sacyr thus announced on September 12 that it was putting assets up for sale, including its toll road unit Itinere and the 20 percent stake it has in Repsol YPF, all part of a major effort to pay down some of the debts. However, outside Lukoil no firm expressions of interest have materialized, and analysts are suggesting that this is because the prices being asked are far too high, as evidently it is hard to get good prices for assets in a bear market accompanied by a credit crunch. But this raises of course, the not simply incidental issue of why exactly it is that Lukoil is willing to pay so much over the going market rate, but we will get to that part later.

Sacyr did have around 347 million euros of debt maturing in the second half of 2008, but they have so far managed to refinance this, although there are somewhere in the region of another 2 billion euros worth set to expire in 2009, and worries about the difficulties which are likely to be associated with this process during the deep recession which Spain is now entering are putting a lot of pressure on the company.

Sacyr has been attempting to cover next year's debt haemorrage using a mixture of renegotiation, housing sales, dividend payments and the possible sale strategic assets, like its road toll unit Itinere. Citi infrastructure fund had been reported to be showing some interest in a possible purchase of Itinere, but there has been no concrete evidence of progress.

Press reports and analysts say the asking price for Itinere is in the region of 3.9 billion euros plus debt, and this sum is 400 million euros greater than the value of Itinere's failed initial public offering last April. Analysts tend to be rather dismissive of this kind of approach in the present climate.

"They were unable to do an IPO at 3.5 billion euros and four months later they
want to sell it for 3.9 billion? It's a joke," said an analyst at a major bank
who asked not to be named.

Apart from the asking price there are also clauses in existing Itinere loans that require a renegotiation of terms if it changes ownership, which also are reported to present a stumbling block to any Citi-type deal.

But the main problem which Sacyr faces right now is the current performance of Repsol itself, since the 5.1 billion euro bank loan which partially funded their purchase of the Repsol stake was guaranteed with Repsol shares, and on a margin trade basis. So when Repsol's share price falls, Sacyr must stump up more guarantees, putting further strains on the group's liquidity. And, of course, Repsol shares have been having a very hard time of it recently, evening fell by as much as 20 percent in a single day on October 22 over concerns about the energy company's exposure to Argentina, which is itself getting into ever deeper water with the international investment community: a further Argentine default would be the last thing that Repsol (and naturally Sacyr) need right now. Subsequently Repsol stock has regained some of the lost ground (and is now trading at around 15 euros) but this is still a far cry from the 26.7 euros a share Sacyr paid in 2006.

Sacyr has so far pledged 40 percent of its rental property business Testa as additional collateral for debt taken out to buy the Repsol stake, and Goldman Sachs in a recent note suggest that as long as Repsol's share price remains above 12.9 euros per share, Testa will cover the collateral under current terms, but in Sacyr's present state that is a very wobbly if. And if Testa shares become no longer sufficient, then Sacyr will have to reconvene with banks to discuss alternative collateral, and this they need like a hole in the head, hence all the haste and attention being lauded on the Lukoil suitor.

Analysts are agreed the longer it takes to sell assets to shore up its balance sheet, the more worrying Sacyr's borrowing levels will become and the greater the risk of fire sales.

Spain's leading water company Aigues de Barcelona (Agbar) has also expressed an interest in the water division of Valoriza part of Sacyr's environemntal division. Valoriza is valued at around 1 billion euros. Agbar and Sacyr do not seem to be in actual talks at the present time, since the sum involved is insufficient to materially change the main problem, and Sacyr is more focused on Itinere and its Repsol stake. The Spanish newspaper Expansion reported that the sale process of Valoriza is being handled by Italy's Mediobanca and that as well as Agbar interest has been shown by Veolia which is a former partner of another Spanish builder - FCC - and operates in the environmental services business in Spain.

Any eventual sale of these units would not be the first such move by Sacyr to keep moving ahead by selling assets, since back in April Sacyr sold its stake in French builder Eiffage, following a bungled takeover bid, and in the process cutting its borrowing by 6 percent.

Sacyr representatives also recently met with lenders on its Repsol loan - who are lead by Banco Santander - to discuss the collateral clauses in their agreement. In principle under the original terms of the loan up until December 21 Sacyr have to put up collateral equal to at least 105 percent of the total loan, after that date this figue increases to 115 percent. In addition the interest rate on the loan rises to 1.10 percentage points more than euribor benchmark rates from the present 1 percentage point after the same date, and this is another reason why Sacyr would like to see their Repsol stake turned into history before xmas.

The company has already pledged the maximum amount, 1.275 billion euros, of shares from its property unit Testa Inmuebles en Renta SA allowed under the terms of the loan. Sacyr began using Testa stock in January after Repsol, whose shares were initially assigned as collateral, declined below the 20 euro a share watermark, according to a regulatory filing Sacyr made on January 23 2008. Repsol fell to 12.92 euros on Oct. 28, the lowest in more than five years, and are down 40 percent over the past year. Sacyr has fallen 71 percent this year, the largest fall of any of the 35 most-traded stocks included in Spain's IBEX Index.

So What About Lukoil, Why Should They Be So Interested In Repsol?

On the face of it the justification for Lukoil's interest in Repsol is not as self-evident as it at first appears, but then little in modern Russia ever is.

Lukoil has itself been struggling from a liquidity crunch back home in recent months, as the price of oil has dropped and lack of investment by the Russian oil majors means that field depletion is leading to ever lower levels of domestic output. Indeed the price of Urals crude, which is Russia's principal export blend, was down 68 percent from the July peak last week, hitting the "bargain basement" level of $44.80 a barrel.

Lukoil, which already owns refineries in Bulgaria and Romania, agreed in June to pay 1.35 billion euros to buy into an Italian refinery with partner ERG SpA. Lukoil, which has $1.9 billion in debt and loans scheduled to mature this year (although obligations will drop to $609 million in 2009 and $525 million in 2010) had only $1.66 billion in available cash at the end of June. So what is going on here?

Well, as I have said, Russia is facing its own credit crunch and construction slump, and as a result Vladimir Putin did recently introduce his own $180 billion dollar bank-bailout and loan guarantee scheme. Could it be that Lukoil want, in some shape and form or another, to take advantage of this potential funding to acquire the Repsol stake? Well, there are reasons for imagining that there might be a very strong incentive we haven't yet touched on for them to do just this. The principal reason among such reasons (or the bitter and compelling inner logic of the issue) was basically put under the spotlight by the recent announcement (and large gaffe) made by central bank Chairman Sergey Ignatief when he said that Russia's currency (aka the ruble) had a "certain tendency toward weakening'' . Since the ruble normally trades in a tighly controlled trading band this widely interpreted as meaning that the ruble is about to be devalued, and while estimates of the extent of the devaluation vary, something in the 15% to 20% range would be a good guess, I think.

Viewed in this light, a loan of some 6 or 7 billion euros (denominated in rubles) under the Putin bank bailout and credit guarantee scheme wouldn't look to be too bad a proposition, especially if it was subsequently to be repaid in rubles following a substantial devaluation. (I mean I don't think I will get here into any rather Machiavellian type of speculation about how a hypothetical demand for 7 billion euros from the central bank foreign exchange reserves - which are of course under considerable pressure right now - would effectively constitute a very large "devaluation put", and offer us all the hallmarks of being a self-fulling declaration of intent). And don't start imagining that such an idea is very far fetched, since IMF Managing Director Michel Camdessus effectively had to resign at the end of the 1990s following continuing scandals about IMF support loans being diverted into currency speculation. And that such activity is not entirely dead in today's Russia was confirmed by last week's threat by First Deputy Prime Minister Igor Shuvalov that Russian banks who convert government aid into foreign currency rather than lending to troubled companies would risk losing access to state funding .

Obviously, in addition to any incidental gains they may make in the forex markets, Lukoil would also gain access to Repsol's extensive refining capacity - 1.23 million barrels a day according to their website - which includes five refineries in Spain, three in Argentina and one in Peru. Repsol also has holdings in another refinery in Argentina and two more in Brazil. And indeed the deal has a certain logic from the Repsol point of view, since the tie-in with Lukoil would give access to Russian supplies while the company currently relies on South America for about 95 percent of its present oil reserves. But then, as is normally the case, nothing in life ever comes free, and in this case the strings attached are important ones, very important ones.

Spain's Builders Up To Their Eyes In Debts

Obviously Sacyr is far from being alone in its current "tight fix". Acciona SA, is another Spanish builder struggling under the weight of a growing mountain of debt. Acciona came to international prominence when it bought joint control of power company Endesa SA last year together with Italy's Enel SpA. Well, the Madrid-based builder said July 30 that first-half net income fell 15 percent to 314 million euros as the takeover had increased debt costs, with Acciona net debt rising to 17 billion euros in Q2, up from 10 billion euros a year earlier. Acciona has recently stated it is in talks with creditors in an attempt to refinance the debt it contracted to make the purchase of the Endesa stake, but strongly denied that it has already committed to selling the stake in 2010. This denial followed a report on Spanish financial website El Confidencial that Acciona has assured its creditors that it will exercise an option it has to sell the 25 percent stake in Endesa to Italian partner Enel in 2010.

Despite the denial the decision to sell would be a logical one, and appears as if it may well form part of an agreement Acciona have reached with a group of banks lead by Banco Santander not to link Endesa's share price to the collateral required for the 7.1 billion euro in loans it received for the stake buy, as previously agreed. The 2 loans were due to have expired on 31 December 2012, but Acciona was obviously anxious to get the conditions changed.

"Acciona has not committed to exercising the March 27, 2010 put option but that
does not mean that the company will not exercise it on that date or at a later
date," the Spanish builder said in a statement to the stock market regulator.

Under the previous contract Acciona needed to give additional guarantees in the case that Endesa stock fell below 25 euro per share and this had been the case since October 6. Such guarantees -or margin calls - disappeared under the new contract. In exchange the new contract increased interest rates on the entire sum of the debt - doubling the premium when compared with the previous rate of 60 basis points over Euribor. Thus we find ourselves in exactly the same position vis-a-vis margin calls as Sacyr has with Repsol. The 21 syndicated banks behind the principal Acciona loan include Santander, ING, La Caixa, RBS, Caja Madrid, Calyon and Natixis, and the loan effectively financed the original 25 percent stake that Acciona took in Endesa following a 42.5 billion euro bidding contest in alliance with Italy's Enel which currently owns some 70 percent of Endesa. At the time Enel and Acciona came out in front of competing bids from Germany's E.ON EONG.DE and Catalonia-based Gas Natural.

Back in July the Italian newspaper Corriere della Sera reported that Enel was in talks to buy out Acciona for 10 billion euros, adding the point that any such deal would needs the approval of Spanish prime minister Jose Luis Zapatero - so Zpt is going to be busy, since he has already flown to St Petersburg. Corriere also suggested that Endesa's development was currently being paralysed by an ongoing dispute between the two principal shareholders. The paper stated that there was an urgent need to find a solution to overcome the repeated obstacles raised over Endesa board decisions by Jose Manuel Entrecanales, who is chairman of both Acciona and Endesa. Enel has plans to expand Endesa outside of Spain, while Acciona is simply looking to sell its stake to pay down some of its 18 billion euros of debt, according to the paper.

Valuation of Acciona's stake in Endesa depends on valuation of Endesa's wind power generating plants, which Acciona would like to acquire. Any finally agreed exit price for Acciona would also need to take account of the put option it holds to sell the Endesa stake by October 2010 to Enel at a price of 10 billion to 12 billion euros.

Meantime another Spanish building dynosaur - Ferrovial - labours on with its heroic attempt to try to sell its Stanstead airport holding in the UK - but at least in this case the asset being disposed of does not form part of Spanish national patrimony. The Spanish builder that spent $20 billion buying the British Airports Authority is taking longer than anticipated to sell London's Gatwick airport because of the global financial crisis, according to its Chief Financial Officer Nicolas Villen.

``It's difficult to say where we are in this crisis,'' Villen said in an
interview in New York late on Nov. 14. ``In this financial crisis it will always
be more difficult for potential bidders of this asset to obtain financing. So I
think it's going to be a lengthier process than usual.''

BAA currently provides poor service and has failed to plan for extra capacity, according to a recent report from the U.K. Competition Commission, adding a recommendation that the company be stripped of the capital's Gatwick and Stansted airports and either Glasgow or Edinburgh in Scotland. Both Heathrow and Gatwick had a drop in traffic of about 0.5 percent in the first nine months of the year, described by Villen as a "moderate decline" when compared with earlier economic crises, when traffic fell by 3 percent or more.

Ferrovial had a third- quarter loss of 17 million euros, which compared with a year earlier profit of 49.6 million euros. The company's total debt fell 5.4 percent from a year earlier to 28.6 billion euros in September.

Fomento de Construcciones y Contratas (or FCC) - Spain's third largest builder - on the other hand had net debt of 8.51 billion euros at the end of the first quarter, 54 percent more than a year earlier, and up from 7.97 billion at the end of 2007.

And It's The Same Picture Among Property Developers

Spanish property group Tremon last week became the first major property developer to follow in the footsteps of Martinsa Fadesa, and file for administration after failing to meet debt payments, causing a fall in the shares of those banks which have total exposure of around 1 billion euros to the company. Tremon is thus the second large Spanish property group to seek
administration this year following the July decision of Martinsa Fadesa. Among Tremon's biggest creditors are Banco Popular, which has an exposure of around 200 million euros exposure, unlisted savings bank Bancaja with 100 million and Banco Pastor which has 95 million.

"Our debt is up to 1 billion euros, and more than 90 percent is held by a
pool of 16 banks. Administration was filed last thing on Friday," said
lawyer Angel Romero, who is acting as Tremon's spokesman.

Other Spanish property companies with large debts are Metrovacesa (6.991 billion euros), Colonial (10.086 billion euros) Realia (2.26 billion euros) and Reyal Urbis (4.672 billion euros)

Spanish property firm Metrovacesa recently stated they expect to meet the terms of a 3.2 billion euro syndicated loan by the end of the year. At the end of September, Metrovacesa's core earnings were 2.13 times its financial costs, below the minimum limit of 2.25 times the company is obliged by creditors to meet by the end of 2008. Among other conditions attached to Metrovacesa's 3.2 billion euro loan is that the company maintain its 6.9 billion euros of debt at no more than 55 percent of asset value. The company said its debt stood at 54.4 percent of assets on Sept. 30 when it published its third-quarter results. If Metrovacesa does not comply with the conditions of the syndicated loan, the banking syndicate can order its immediate repayment and order the company to talk to its creditors.

Spanish stock market regulator CNMV last week requested Metrovacesa to provide it with details on where it stands with repaying the syndicated loan, as well as with refinancing 810 million pounds worth of borrowing with HSBC, the money was used to buy the bank's London offices. Metrovacesa stated in reply that the company was still in talks with several financial entities over refinancing the HSBC debt, which falls due at the end of November, but had yet to reach a deal.

Real estate company Reyal Urbis also recently reached a deal with creditors to refinance debt of 3.006 billion euros. In a statement to the Madrid stock exchange regulator, Real Urbis stated it had obtained two new credit lines which gave it "the necessary liquidity for its operative management". The new deal refinances two syndicated loans signed in 2005 and 2006 in addition to other loans and debt issues. Under the new financing terms, the company has been able to postpone the next payment on its debt until October 2011 and signed up to twice-yearly payments after that date until 2015. Thus it seems there is a tendency to postpone into the future - to 2011 at least - and then perhaps at that point a critical moment will be reached in all this, assuming that is that it doesn't come before, which if we look at the very dramatic state of the contraction in the Spanish economy is a possibility which certainly can't be excluded.

In 2015 - should we get that far - the company will then have to pay off the remaining 40 percent of the debt. One of Spain's largest developers, formed through the merger of Urbis and Reyal in 2007, Reyal Urbis said it had net debt of 5.5 billion euros when it reported its first-half results.

Another Spanish real estate company, Colonial, recently reported a nine-month net loss of 2.475 billion euros after taking charges for plunging asset values. The loss compared to a profit of 356.9 million euros for the same period last year. Group sales for the nine months to end-September dived 23.7 percent to 472.8 million euros, but still the "walking dead" real estate firm managed to put through a debt restructuring in September. Funding banks had previously taken partial control of Colonial earlier this year when some of its shareholders failed to meet obligations. Residential land sales fell by over a half in the fisrt nine months of 2008 and Colonial's net debt stood at 8.975 billion euros as of the end of September.

And As Spain's Government Sells Bonds......

Spain's government still effectively seems to be in denial about where all of this more or less inevitably leads, and is still trying to keep alive the ailing builders and property developers on an emergency life support ("reanimator") system by selling government debt to guarantee the ever more risky private variant. Thus last Thursday (20 November) the (previously-postposed) first special "reverse auction" was held and the Spanish government bought 2.115 billion euros of bank assets out of a maximum possible of 5 billion euros. Spain's Economy Ministry said a total of 4.562 billion euros of assets had been offered. Spain's Fund for Acquiring Financial Assets (FAAF) held the reverse repo auction for investment grade, 2 year asset-backed-debt issued after Aug 1 2007. It plans to purchase up to a further 5 billion in 3-year mortgage-backed debt in December.

The government has said it plans to buy up to 50 billion euros in bank assets in 2008 and 2009 to provide a market for longer-term bank debt which institutions cannot sell to investors or the European Central Bank. The head of the State Credit Institute (ICO) Aurelio Martinez argued after the auction that some banks may have felt inhibited from participating due to fear of being stigmatised. FAAF received 70 bids worth 4.56 billion euros from 28 banks. Of those, 51 bids from 23 different banks were accepted, the rest were rejected after failing to meet criteria ranging from their size and interest rate to the participation of the bank in lending markets. Questions are being raised by analysts about the effectiveness of the fund given the limits on how much banks can sell, the stigma attached to sales, and the comparative ease of borrowing more anonymously from the European Central Bank.

The other side of this particular coin is however the little question of just how all this bank funding is going to be paid for. To some extent this became clearer this week since the day before the auctions the Spanish government previously paid its first visit to debt markets for funds in connection with the programme, and the first programme-specific auction was duly held on Wednesday 19th November. Remarkably the sale generated quite strong demand and even revealed comparatively stable spreads. Indeed demand was such that the Spanish treasury was able to issue 200,000 euros more in debt than initially anticipated in the special 4.4 billion euro sale to cover bank asset acquisitions.

That outcome is especially surprising as it compared with a disappointing demand in a sale of new 10-year German bunds held the same day, and which met fewer bids than the sum issued. Amazingly even the spreads remained stable. Investor appetite may be cautious in view of the high levels of uncertainty surrounding sovereign issues and debt levels over the next few years, and may be showing a preference over debt with a somewhat shorter maturity horizon. Anecdotal evidence (as encountered by the author of the present post) also suggests that many Spanish people may be seeing treasuries as a "safe haven" against a banking system where lack of reliable information makes them nervous about using deposit accounts.

Spain has said it plans to issue issue up to the full 50 billion euros earmarked for this kind of bank support in public debt (thus raising around 5% of GDP in new debt) over the next two years. Spain's deepening economic problems has caused the spread between 10-year Spanish bonds and the benchmark German bund to widen to 60 basis points in October from 8 bps a year earlier.

The much smaller yield differential on shorter term debt was reflected in a yield of 2.7 percent on the Spanish two-year debt sold on Wednesday which compared favourably with a rate of 2.71 percent in the secondary market the previous day. This paper traded in a band of 2.503/687 on Thursday in the secondary market and its spread against comparative German debt remained steady at 25 basis points.

Spain is to hold further auctions December and January to sell bonds and bills. Of course it is not clear who exactly is buying this paper. If it is the Spanish themselves then it will be of little avail (as per the above external financing argument), but Industry Minister Miguel Sebastian did tell Reuters on October 20 that Spain was appealing to Arab sovereign wealth funds to buy the bonds. With what success we have no idea.

........The Government Deficit Rises Sharply

As a result of all this selling Spain's budget numbers are deteriorating fast and could hit the EU 3 percent fiscal deficit limit as early as by the end of this year, according to a statement from central bank governor Miguel Angel Fernandez Ordoñez before the Spanish Senate last week. The limit itself is only a technicality at this point in time, but it is astonishing to learn that in the space of less than one year Spain will have gone from a budget surplus equal to 2 percent of GDP to a deficit of 3 percent. This is a shift of 5 percentage points in a year, and of course, if this continues into 2009 and 2010, then the debt to GDP levels will start to shoot up rapidly.

Fernandez Ordoñez may well not tell you (as I say here) the whole truth, but he normally does tell you the truth and nothing but the truth, andn he is thus fast becoming one of the main sources of reliable information in what is now a worm-infested Spanish communications system (just as another piece of anecdotal evidence here, I was to have travelled to the Basque Country tomorrow to appear on a regional TV programme about the merger between local cajas Kutxa and BBK, but the programme was cancelled - for the second time now - for the simple reason that the production team could find absolutely no one apart from me who was willing to talk in front of the cameras about this kind of topic. Thus hundred of Tertulias, thousands of empty words, and little in the way of cool clear light on the subject. The wheels of metaphysics turn round and round, but I see no motion in the drive shaft...). Anyway, Fernandez Ordoñez has been quick to pick up on the fact that the government's present forecast of 1 percent growth next year — unveiled just weeks ago in the 2009 budget — is already well out of date and the budget provisions need to be revised accordingly, and on the basis of much more realistic economic forecasts. If they don't start to do this, then the spreads will inevitably only start to rise further and faster as investors get more and more paniky about the actual underlying debt dynamics in the absence of any kind of realistic information.

"We must make a downward revision of prospects for economic growth in the next
few quarters," Fernandez Ordoñez said.

I think everyone now accepts what Prime Minister Jose Luis Rodriguez Zapatero explicitly said last Thursday: namely that Spain will inevitably exceed the European Union budget deficit limit as it tries to spend its way out of recession. EU budget rules specifically allow for countries to breach the deficit limit of 3 percent during exceptional circumstances, and Zapatero rightly said such conditions existed in Spain, where the economic contraction is about to become much sharper than elsewhere in Europe.

"Whether it (the deficit) goes to 3.5 or 4 or 4.2, we will have to wait to seehow the economy develops," Zapatero said during a press conference. "The Spanish government is not going to resign itself to recession, we're going to try to grow and provide jobs,' he said. "We're going to use the public deficit to keep social promises"

Of course, Zapatero is right here, Spain does need to use its fiscal leverage - Spain's debt to GDP ratio was around 20 percentage points below the EU average at the start of 2008 - to address the probelms. But just one more time Bank of Spain Governor Miguel Angel Fernandez Ordonez is also right in urging Zapatero to show some sort of fiscal prudence and hold back some public funds in case (I would say for when) conditions get even worse. Ordonez is explicitly expressing his fears that a focus on short-term, emergency measures, without a total restructuring plan, may rule out deeper structural labour and service market overhaulswhich will be needed in the future to raise competitiveness and promote long-term growth.

I will be even more explict. As I have argued here, and in numerous other posts, the present Spanish depression is being caused by deep-seated structural problems, and not by transitory cyclical ones. Thus, using fiscal policy as if this was simply a classical problem of the business cycle is a big mistake, on my view, and is needlessly using up vital ammunition which will be badly needed to take us through the battlefields which lie ahead.

We are now facing an economic slump of unprecendented proportions in Spain, and more than likely an ongoing problem of outright price deflation. To fight this combination using the traditional fiscal and monetary policy tools simply will not work - they are likely trying to drain an ocean with a teaspoon. We need new tools, fresh thinking, and a complete change of course. And the sooner we get them the better.

Well, this has been a very lengthy post. If anyone else has actually arrived this far, I can simply thank you for your patience and your perseverence. You are undoubtedly the kind of enduring person the new Spain is going to badly need. I hope you have learnt as much in reading this as I have learnt in the doing the background research which was necessary for writing it.

Friday, November 21, 2008

Some Random Thoughts On The Deflation Problem

Today it is precisely one month since yours truly first reported that he was starting to feel swamped. Well he still is, but even though your author is still struggling to meet the quantitative demands of neo-classical graduate economics (especially, the statistical vintage) he still thinks that now might be as good a time as ever to jump back into the saddle and practice some economic punditry. After all, this is something he, much unlike graduate econ math, is quite familiar with.Needless to say, it is difficult to know where to start but since I am only now returning from an extended pause it might a good idea to pick up one of the themes I laid out just before the anvil of quantitative science hit me. Consequently, one thing that I have been persistently noting in my ongoing analysis of the global economy has been the risk of deflation in key economies due to the dramatic decline in domestic demand and credit momentum.

Specifically, I have been warning that when it comes to the old economies of the world (measured by median age) the risk of a deflationary backdrop is particularly large. The argument here is really quite straight forward in terms of economic dynamics and basically hinges on the idea that relatively old economies do not have sufficiently dynamic internal demand conditions to prevent their economies from falling into deflation. Obviously, the risk of deflation can hardly be confined to these economies at this point and what we are facing now is a potential scenario of global deflation both in terms of core and headline prices as well as of course asset prices. At least I would say without sounding too doomist that this is now a real threat.

Deflation Coming to a CPI Near You?

A couple of months back I sketched my thoughts on the topic as I asked the simple question of whether deflation would be the next macro story. As the carnage in global finance continues and as the effect on the real economy is increasingly making itself felt I am sure most analysts and observers feel a bit shell shocked. I know that I do. Consider consequently the recent news that consumer prices in the US fell a whopping 1% on a monthly basis which more than suggests how the threat of deflation is mounting.

Of course, the monthly decline in consumer prices masks a healthy y-o-y growth rate of some 3.7% (2.2 in core prices) which does not exactly spell deflation in any sense of the word. However, the negative momentum must be considered here and in particular the fact that the global economy has gone from a situation of liquidity disruptions confined to the wholesale banking market, over to a severe credit crunch in terms of firms operational finance and on to what must now be considered a complete freeze of lending to all agents. On the back of the recent barage of execrable news from the US, JPMorgan rolls out the inevitable prediction that the Fed and Bernanke may even introduce some form of ZIRP to counter the recession.

And speaking of ZIRP we learned yesterday from Japan how exports sank the fastest pace in seven years which also prompted analysts from Barclays to suggest that Japan would return to deflation and that the BOJ would have to re-introduce ZIRP accordingly.

I don't know whether the good lads at Barclays had to dig deep to come up with this call; needless to say that deflation in Japan is now a foregone conclusion as we venture towards 2009 and the previous sharp dose of cost push inflation tapers off. At the BOJ, rates were kept at the odd 0.3% yesterday and while there may be an strong inclination not to cut rates to 0% for simple reasons of credibility I do think that they will have to bite the bullet as we move forward into this slump. In a general global context, I think it is important to recognise the massive negative shock we are seeing on demand conditions in those nations who have hitherto been living high on credit and since the credit channels are now firmly broken, so will those macroeconomic credit providers (read: exporters) also suffer .The epitomy of this must clearly be Japan but also Germany comes immediately to mind.

And now that I am talking about Europe, the deflation ghost is also here hovering like a dark shadow over the economic edifice. Of course, and as a hell of a lot more than the proverbial Rome is burning I am not sure what the ECB will do here? It is true that it seems that European policy are content with flexing their fiscal muscles while Trichet et al. remains in the ivory tower where the M3 presumably is still growing above target and where only a definitive drop in consumer prices below 2% would seem to allow the ECB, in a postmortem perspective, to really act along the lines of its other CB peers. At this point I will give the ECB the benefit of the doubt in the sense that we have indeed observed a real change of strategy, but given other CBs' response the ECB seems still, to be the odd man out.

That may change quickly though. The Spanish representation at the ECB roundtable certainly seems to be predicting a dire potential outcome which, given the state of things on the Iberian peninsula, it is difficult to second guess.

European Central Bank council member Miguel Angel Fernandez Ordonez forecast an ``enormous'' drop in euro-region inflation. Bank of Spain forecasts for the 15-nation euro area ``show an enormous moderation in price gains, but they do show price gains,'' Ordonez, who is also governor of the Spanish central bank, told reporters in Madrid today. The forecasts ``don't show deflation,'' he said.

As in the US we are far from an actual state of deflation, but given my argument as I laid it out (see link above) the negative momentum we are observing suggests that what comes next on the macroeconomic front may be quite "unexpected" as those ever incoming stream of Bloomberg headlines are so fond of noting. If we look at the evolution of data the interpretation is quite clear. As can be seen from the graphs below, the decrease in inflation is currently being produced solely as a function of declining headline inflation (this is the same picture as the one emanating from the US and Japan).

More generally, it is hard not to think back to the days when Trichet was playing tough on inflation, when CEE central banks revalued as there was no tomorrow, and where moral hazard (or traitor?) was pinned on all those who had the temerity (I positively love that word!) to argue that something had to be done. Clearly, we are past that now and to steal again the analogy conjured by my colleague Edward Hugh; what is the point in having your throat slit alongside your enemy's just to see who can run the fastest before bleeding out? Clearly, not the most productive of endeavors I would say.

Meanwhile and returning to the graphs one last time it seems as if, once again, one of Macro Man's metaphors will be useful; more specifically I am talking about the one in which Trichet does the humpty dance (now, there is a party I would attend!). Do you see a hump sir? I do.

Obviously it is never so simple. First of all there is the good old sticky price phenomenon which is also present in the graphs where headline (cost-push) inflation is coming down rapidly but where core inflation naturally will need more time before adjusting to the economic fundamentals. In this way, and if we pull out the oldie but goldie dichotomy between the Anglo-Saxon and Continental European economies conventional wisdom would have it that prices (and wages) adjust more more slowly in the latter. In some ways this would merit the divergence between the Fed and the ECB in tackling this mess. However, I am not sure such MD/SAS analyses apply in this case. More specifically, what I am looking for in particular is what will happen in the transition as many economies now will need to depend more on external demand to achieve growth. Remember here that all those rescue packages need to be paid for and domestic demand in itself will hardly do it. For the US et al. a reduction of external imbalances will be of material importance.

Thus, I am also sure that we have the whole rebalancing/global imbalances discourse knocking around somewhere in the background. Yet, I am just not sure that the ECB can "help" the US by keeping interest rates up and by derivative "offering" the Eurozone as a shoulder on which the global economy can lean for demand. Add to this of course that the market has already discounted the incoming recession through the absolute slaughter of the EUR/USD.

In this sense the ECB may get double pinched since if they lower rates further (and one has to assume that they will) it COULD take the Euro to a level where the objectives of policy would be in conflict in the sense that rates would have to be kept higher than otherwise to avoid the Euro to fall in the .9-.8 region. In some ways, this is would square well with the likely growth path of the "future" Eurozone as an economy driven less by domestic demand than has hitherto been the case. And yes, you heard me right, there will be much less domestic demand to go around in the Eurozone and indeed the entire EU 27 once the corrections in Spain and Eastern Europe becomes clear for everybody.

And thus we end up at one of my favorite hobby horses (I have several). In a world where governments are presiding over ageing populations and faced with a major overhang of debt in the context of fighting this behemoth of a financial crisis, the incentive to try to burn up the debt through inflation (and for all things in the world, to avoid deflation) and thus by derivative export your way out of trouble is massive. I would hold this to be true even without the particularity of the current situation in the sense that as the world ages so does the number of economies dependent on external demand grow. In fact, it is precisely this "incentive" to be export driven I think it is so crucial to pin down in both a practical and theoretical sense, but that will have to wait for another day.

Thursday, November 20, 2008

As The Federal Reserve Readies-Up Quantitative Easing, The Bank of Spain Sees Little Prospect Of Deflation

While we are likely to see a "substantial'' drop in euro-region inflation, Bank of Spain forecasts for the 15-nation euro area do not show price drops. That is they "show an enormous moderation in price gains, but they do show price gains,'' according to the latest statements by Miquel Angel Fernandez Ordoñez, ECB Council member and Governor of the Bank of Spain. Bank of Spain eurozone forecasts "don't show deflation" he told reporters in Madrid yesterday (Wednesday).

The reason for this swift and adroit response to the question of the day in Spain was that EU Economy and Finance Commissioner Joaquin Almunia (not exactly your garden-variety world authority on macroeconomic topics) had earier said that the Europe's economies were "facing the prospect of deflation" amidst the worst financial crisis since the 1930s. In fact Fernandez Ordoñez is right, as is his want - right on a technicality. The Eurozone as a whole is almost certainly not heading straight into deflation (yet), but this begs the question which he could have been answering: what about poor little Spain?

As I reported last week, Spain's consumer price index has now been dropping since June (see chart below), and it is very possible (I would say probable) that the index will move in negative territory throughout 2009 (and possibly by between 1 and 3 percent). True a significant part of the drop at this point is due to the drop in energy costs, but even the core-core index (excluding energy and fresh vegetables) was only up around 0.4% in October (HICP) over June, or an annual 1.2% rate, and it is my very very strong opinion that we will start to see "downwards pass through" as the recession deepens, profits melt (rather than just being squeezed) and everyone struggles hard to try and find a bottom.

According to data from the National Statistics Institute earlier this week, Spanish household spending contracted 1 percent in the third quarter of 2008 over the previous quarter, while investment contracted by 1.9%. We can only realistically expect this process to continue during 2009 and unemployment to continue to rise, creating a considerable capacity overhang which will exert a downward pressure on wages and prices (remember around one third of new employment contracts in Spain are temporary, making salary reductions comparatively straightforward, at least for one part of the labour force).

The Federal Reserve - On The Other Hand - Readies Its Plans

Meantime in the United States the Federal Reserve has been busy stressing that it will do whatever it has to do to ensure the US does not fall into a deflation trap. This view was reinforced by statements from vice-chairman Dohn Kohn yesterday (Wednesday), as US stocks fell below 8,000 on the Dow Jones Index (their lowest level so far in this financial crisis) and consumer prices fell 1% in October when compared with November. That was the largest monthly drop in at least 61 years (since the current index only goes back to 1947). Even core consumer prices, which exclude food and energy, fell by 0.1 percent month on month, and this was the first monthly drop in core prices in more than a quarter of a century.

Don Kohn stressed he did not believe deflation was the most likely outcome for the US economy, but he did say he thought it was a “less remote” possibility than he previously thought.

“Some people have argued that we should save our ammunition, that interest rate cuts aren’t effective,’’ Mr Kohn said. “I think that were we to see this possibility, that we should be very aggressive with our monetary policy, as aggressive as we can be.”

The lions share of the fall in headline inflation, of course, came from energy prices dropping 8.6 per cent. Yesterday crude oil fell to a $53.30 a barrel, its lowest since January 2007.

Treasury inflation-protected securities now indicate that investors anticpate deflation in the US, though Fed officials stressed in interpreting the data that prices were being distorted by a lack of liquidity. The five-year break-even rate, which provides an expectation of future inflation, currently suggests that investors expect annualised inflation at a minus 0.70% rate over the next five years.

It is also worth noting that it is getting much more difficult to read Fed policy intentions, at least as far as movements in the key policy rate go. Massive injections of liquidity have now driven the interbank overnight lending rate to less than half the current 1% Fed FOMC rate. The presence of this gap seems to be now shifting investors' focus toward the amount of money in the banking system as a better gauge of Fed intentions than possible movements in the policy rate. Kohn in fact stressed that the US central bank is simultaneously reducing interest rates and expanding its balance sheet (in a process known as quantitative easing) and explicitly avoiding reliance on one strategy "in favor of another".

Analysts point to the surplus cash that banks keep on deposit at the Fed as an important gauge of the Fed's true monetary-policy stance. These so-called excess reserves have ballooned to $363.6 billion from $2 billion in August as the Fed has added one measure to another in its emergency lending program package. Excess reserves are now bigger than the overnight lending market between banks (aka the federal funds market), but it is in this market thatthe Fed sets its key rate target. As a result of the large volume of excess liquidity it is becoming more and more difficult for Bernanke to control the federal funds rate (he recently described it to the House Financial Services Committee. as an issue he was "working on") - and the effective federal funds rate was 0.38 percent Novber 18, and has averaged 0.29 percent since the Federal Open Market Committee cut the rate to 1 percent on October 29.

Former St. Louis Fed President William Poole has described this as a move to quantitative easing, a process which forces a large volume of reserves into the banking system with the expectation that banks will start to trade them for a higher-yielding asset. Such quantitative easing in fact formed the backbone of the Bank of Japan anti-deflation stance between 2001 and 2006 (as in the case of the Fed, it was this easing rather than the more headline catching ZIRP - zero interest rate policy - which was doing the bulk of the donkey-work), but it is worth noting that while this policy stabilised Japan's situation temporarily, the Japanese economy never actually came out of deflation (at least as far as the core core index goes) and now once more under the grip of recession it seems almost certain to fall back even further into negative price territory. The basic problem is that the banks themselves may well fail to freely lend the excess reserves to businesses and consumers, in the process prolonging the credit freeze. That is basically the underlying story of what actually happened in Japan.

Normally, when central banks launch explicit quantitative easing strategies they abandon the interest-rate target and start purchasing assets in order to boost the money supply. This is what Bernanke calls "expanding the Fed's balance sheet". Typically, such activities can have two effects on an economy.

In the first place banks can decide to earn more than the nominal rate they earn at the central bank and start to lend aggressively. We have seen no signs of this happening as of yet, and measures of bank reserves are growing faster than most money supply measures. Secondly, the central bank can target some assets that are thought to have a broad impact on the economy, such as Treasuries or mortgage-backed bonds. The US Federal Reserve has already taken a half-step in that direction by purchasing the commercial paper of U.S. corporations at predefined rates. The central bank's Commercial Paper Funding Facility held $256.1 billion as of November 12.

Basically returning to the issue at the start of this post concerning Miquel Angel Fernandez Ordoñez's statement on deflation, we should not take everything here at face value. Communicational techniques are different between one side of the Atlantic and the other, and we might note that even Don Kohn says that he doesn't consider deflation a "likely" outcome (he couldn't very well say so, could he, as saying it was likely would be like saying in advance that it wasn't very probable the Fed's preferred policy option would work, and this he isn't going to say, even if he has serious concerns about effectiveness).

By the same token all Fernandez Ordoñez has really told us is that the Bank of Spain forceast isn't currently showing price falls in 2009 (and I am sure it isn't) but only a pack of fools would draw the conclusion from that that they should have no "plan B" for deflation just in case, and while I may think many things about the current Governing Council at the ECB, a pack of fools I do not think they are. It is also worth remembering that with the present occupant of the Bank of Spain governorship it is very important that you read the fine print in what he says, since while he definitely tells the truth, and nothing but the truth, he doesn't always tell "the whole" truth, as when he said that Spanish banks had no exposure to off-balance-sheet SIV-type securitisation (which it didn't), which is not the same thing as saying Spanish banks have no exposure to potentially toxic instruments, since as we are now seeing they do, and I'm sure he was aware of that at the time. Prudently, he was simply keeping his fingers crossed, and saying what he had to say.

Like Chalk and Cheese, Definitely Not Two Of A Kind

So we should be aware that Señor Ordoñez is a very astute customer, which Joaquin Almunia evidently isn't, and the difference between the two is apparent in the way the former has to rapidly jump up out of his foxhole in an attempt to undo the damage potentially done by the latter's rather eyebrow raising "faux-pas".

And just to ram the matter home, I will leave you with an earlier effort on the part of our much beloved Economy and Finance Commissioner to win for himself the acollade of economic illiterate of the year.

The European Union's Economic and Monetary Affairs Commissioner Joaquin Almunia said on Monday (27 October) that while lower financing costs were needed interest rates should not fall to negative levels in real terms.

"At this moment, it would be good for the cost of financing to go down," Almunia told a live Internet chat with readers of Spanish newspaper El Pais (www.elpais.com), adding: "We shouldn't go back to a situation in which real interest rates are negative, as we know from experience that this leads to excess indebtedness, low perception of risk and new bubbles which always end by blowing up in our faces." Almunia said it was hard to say how long the present bout of financial turbulence would last but he thought the uncertainty plaguing markets should have cleared with a year.

Essentially two things are being confused here. Negative interest rates (such as those Spain had between 2002 and 2006, you know, the ones that lead to the current crisis) are highly undesireable during the upswing in a business cycle, since you are simply giving more stimulus to economies which are already stretched to capacity - and negative rates may thus produce "bubbles", as they obviously did in both Ireland and Spain - but they are of course highly desireable during a downturn, and especially during recessions, since they can stimulate slumping economies. And of course, we are all currently heading into one of the most important recessions since WWII, or hadn't our "machine-reader" commissioner noticed?

I mean, as I say, basically the man is a total economic illiterate, and indeed his policy pronouncements more often than not lead me to feel what the Spanish would call "verguenza ajena" for any club of economists who would entertain him as a member, or indeed group of Commissioners who get stuck with him fielding the economics portfolio. And what better proof of all of this could there be? Well, take a sneak peak at the above chart, and you will see that Spain once more had negative interest rates after the end of 2007 - ie at just the time when Almunia was speaking - as, of course, the textbook recommends it should. As I said, a complete pack of fools is something the ECB Governing Council aren't. But, and here we come full circle, as inflation is falling interest rates get near to turning positive again (once more giving Spain a dose of "restrictive" monetary policy) and the problem is going to be how we maintain negative rates as Spain enters deflation. We had all better join Fernandez Ordoñez in keeping our fingers crossed and hope that our ECB Council Members prove to be just as inventive as Messrs Benanke and Kohn at the Federal Reserve, and equally astute as those Honourable Gentlemen over at the Bank of Japan.

Monday, November 17, 2008

Unicredit Has NOT Made Losses On The Russian Interbank Market

Well it must come as something of a relief for any Italian readers I have to learn that UniCredit SpA, Italy's biggest bank by assets, has definitely NOT incurred losses on the Russian interbank market. Although perhaps I should rephrase that by adding just one extra word: yet. UniCredit has definitely NOT YET incurred (significant) losses on the Russian interbank market. This important piece of information is what we can glean from today's statement from Unicredit spokesman Marcello Berni to the effect that "We have no losses on the interbank market....The rumors come from a misinterpretation of news that came out today"

The "misinterpretation" - that lead to a 15 cents, or 7.3 percent, drop to 1.85 euros of Unicredit shares in trading today in Milan - was the result of a report from Moscow-based Interfax to the effect that UniCredit was about to sign an agreement with Russia's central bank to get compensation for losses on interbank operations. The source for the Interfax story was UniCredit Russia Chief Executive Officer Mikhail Alekseyev. But as Marcello Berni points out Alekseyev was referring to possible support the Russian central bank has offered to financial institutions in case of losses on the interbank market, and it should not be read as meaning that such losses had already been incurred, only that Unicredit have hat-tipped the central bank to be readying the money up just in case they do.

The real roots of this problem are to be found in the fact that Unicredit has very substantial exposure to losses in a number of key Central and East European countries, and the Italian government, which already has a debt to GDP ratio of over 100%, is in no position - especially with an economy which looks set to shrink all the way through from here to 2011 - to offer much in the way of cash to support the bank. As I point out in this post, Austria (which is a much smaller country than Italy, but which has similar East European exposure) has already lined up an initial 100 billion euros to support its banks, while the Italian government has remained hesitant to be specific about anything, but seems to be talking about support which only amounts to something like 20 billion euros. So we are left with the rather undignifying spectacle of the leaders of the eurozone's third largest economy having to rely on Muammar Abu Minyar al-Gaddafi and Vladimir Putin for vital support to keep one of Italy's leading banks alive.

Unicredit used to also be Italy's leading bank by market value, but since their stock has now declined by 59 percent in the last six months, and the company's market value stands at 24.7 billion euros ($31.3 billion), it now lies behind Italian rival Intesa Sanpaolo SpA. I repeat, as far as I can see Unicredit currently constitutes the greatest systemic risk to the eurozone banking system, and people somewhere ought to be thinking very carefully about just what the plan 'B' is going to be if all this goes horribly wrong.

Saturday, November 15, 2008

The Spanish Crisis In A Nutshell

This will be a relatively short post, since I think the facts here speak for themselves. Basically the roots of the Spanish "problem" are undoubtedly many and complex, but there is one underlying ingredient in the present dynamic which more or less governs everything else: the dependence on external financing due to the ongoing current account deficit, and the difficulties the banks have had raising this external financing since the outbreak of the "financial turmoil" (aka as the US sub prime crisis) in August 2007. Following the difficulties which arose in the global wholesale money markets in the wake of the "August troubles" two countries - Spain and Kazakhstan - found themselves in a virtually unique (and unenviable) situation: the doors of the global money markets were slammed tight shut in their faces. Since September 2007 both of these countries have, each in its own particular way, struggled to handle the aftermath of what effectively amounted to "financial armageddon".

Astonishingly, after mountains of words have been written, and hours and hours of radio and TV talk shows and "turtullias" have been held, this simple detail about the Spanish situation remains obscure to the the majority of the Spanish people (and indeed, equally incredibly, the majority of Spaniards still don't have the faintest idea what cédulas hipotecarias actually are).

So at the heart of the current problem in Spain lies, not the fact that 12 month euribor interest rates went up somewhat, which they did, and which was (of course) an aggravating factor, no, the real reason that Spain now has around one million empty properties waiting to be sold (apart from the fact that there seems to be no switch here to "shut off" the construction industry when it produces products for which there is no market) is that the Spanish banks have been unable to raise sufficient money to provide the mortgages that are needed to enable people to buy them (or better said they are unable to raise the money at prices which make the mortgage business a profitable one for them).

And what better example of this than what happened in August 2008.

Sudden Stop In Bank Lending In August

According to the latest (provisional) data from the Bank of Spain, Spanish banks lent 33 million euros LESS to Spanish households in August than they did in July. After years when the banks were lending between 8,000 and 10,000 million euros a month, this situation, I think, counts as what people in the technical jargon of the trade call a "sudden stop". The whole Spanish financial system seems to have seized up in August. Even lending to non-financial corporates - which had been increasing during the boom at the same rate as to households - virtually dried up, with only 523 million in additional lending.

Of course, such lending has been slowing steadily since August 2007 (see charts below).

This is not the first time bank lending to households has ground to a halt during the current crisis, back in December 2007 new lending was only 561 million (see chart below), but this time the situation looks much more serious, and even definitive, since in the intervening period the economy has simply deteriorated and deteriorated.

Spain's Current Account Deficit Reducing Slightly

The principal reason why Spanish banks are so short of money to lend is the size of Spain's external current account deficit. Running at around 10% per annum, the deficit means that Spain needs to find roughly 7,000 - 8,000 million euros (7 to 8 billion) a month to settle the account. Unless external lenders step in and provide funding (by buying cedulas, or Spanish government debt, for example), the Spanish banking system keeps gasping for air, it suffers from a chronic lack oxygen in the bloodstream (and each month things simply get worse) in the form of new money to lend to oil the transactions flow. This is what having a "financial crisis" means when you come down to the nitty gritty of things. Actually the size of the deficit has come down since the early months of this year, when the monthly deficit was more like 11,000 million euros, but this "improvement" has been due more to a reduction in the value of imports (due to collapsing internal demand and lower oil prices) than to an increase in exports (both goods and services exports were effectively stationary in August year on year, and as the global economy enters recession this is hardly likely to improve).

Another factor which it is very important to bear in mind is that the deficit on the income item in the monthly current account (basically the difference between what Spanish residents receive from money lent abroad and what Spanish residents pay to external lenders) has been rising notably of late, as both the volume of debt and the cost of serving it, ie interest rates, have risen.

The financial account has also deteriorated recently, with the "other investment" heading (basically the balance between loans people outside Spain make to Spain as compared with loans people in Spain make to the rest of the world) turning strongly negative in July and August after very robust performances in February and March. So, effectively, the whole system is now folding in on itself, and the consequences are not hard to see. GDP slows and then contracts, more than likely in a pretty violent fashion in the not too distant future.

Well, I said this would be a relatively brief post (although I hope there is a lot of meat here to chew on). I think this is the core of the Spanish crisis in a nutshell. To better understand how it all works out in practice across the real economy you will need to dig around in my earlier posts, and to understand the implications of what all this will mean as we now move forward, well, naturally that will form the substance of the posts which are now to come.

Friday, November 14, 2008

As Italy Enters It's Fourth Recession Since 2000, Who Will Bail-Out Unicredit?

Italy, which is still the eurozone's third biggest economy, slipped into a recession in the third quarter. The Italian economy fell into what is now its fourth recession in less than a decade as gross domestic product shrank 0.5 percent from its level in the second quarter, when it contracted a revised 0.4 percent, the national statistics office said today. This is already Italy's worst recession since 1992, and there is evidently more and worse to come.

Italy effectively followed Germany, Europe's largest economy, in posting two consecutive quarters of contraction -- the technical definition of a recession. Spain contracted on the quarter, while France narrowly avoided recession by posting a slender 0.1% expansion after contracting in the second quarter.

From the third quarter of 2007 the economy contracted 0.9 percent, and this was the sharpest year on year quarterly decline in more than 15 years. ISTAT will provide a detailed breakdown of the GDP figures when it releases its final report on Dec. 12.

The IMF recently forecast that the Italian economy will shrink 0.1 percent this year and 0.2 percent next year, while Italy's employers organisation Confindustria are forecasting a 0.2 percent contraction this year. Making a rough, back of the envelope, calculation, if the economy once more contracts by 0.5 percent in the last quarter, we could be looking at a 0.4 percent contraction this year over 2007, and a year on year drop of around 0.9% again in the last quarter.

The real problem being raised here is not so much the recession itself, but the long term trend growth of the Italian economy in the light of the need to sustain a sovereign debt in the region of 104% of GDP and financing a rapidly ageing population. As can be seen in the long term growth chart below, Italy's growth rate has been steadily dwindling for some time now, and it is clear that this tendency is not going to be reversed any time in the near future.

Very Slender Bank Support Programme

Just how delicate all of this now is is highlighted by Italy's programme to help the banking system cope with the consequences of the global financial crisis, and deal with the impact of the economic unwinding which is currently taking place in Eastern Europe, which was finally approved by the European Commission earlier today (Friday).

The Commission said in a statement that the plan to offer guarantees for new banking debt and other aid was needed to remedy serious disturbances in the Italian economy.

"The Italian guarantee and swap scheme is an effective instrument for boosting market confidence and the commitments we have secured from the Italian authorities ensure that distortions of competition are kept to a minimum," EU Competition Commissioner Neelie Kroes said in a statement.

The Italian government says its conservative banking system has been hit less hard than others by the crisis, but even so the government has offered to swap up to 10 billion euros ($12.5 billion) in government bonds in temporary exchange for other forms of debt held by banks, and in any event it is by no means clear that the Italian banks will not be hit hard by what is now to come in the East of Europe.

This sum the Italian government has set aside compares with the Austrian government's 100 billion euro ($129 billion) banking package. Despite being a small country, Austria has a fairly large exposure to the East European banking system (equivalent on some estimates to 100% of Austrian GDP), but the exposure of Italian banks (and in particular Unicredit) is hardly negligible.

In reality, most of the capital that is being "readied up" in Austria is destined for use in underpining lending in CEE countries including Romania, Hungary, Bulgaria, Poland and the Baltics. As the Eastern Euopean euro-pegs break or the currencies slide, domestic households will have to be "eased of" CHF and euro denominated loans, and the subsidiaries of Austrian, Belgian, Swedish and Italian banks look set to have to eat large loses as a consequence.

"That this is about providing credit to Austrian companies is just a pretense," said Matthias Siller, who manages emerging market funds at Baring Asset Management. "This move is a clear commitment to eastern Europe......But this has nothing to do with charity. Those (Austrian) banks are system-relevant banks in central and Eastern Europe, and if they had to withdraw capital from there, this would set off a landslide," he said.

By tapping their home governments, those banks who have significant CEE exposure effectively lean on taxpayers in their home countries for refinancing countries with large current account imbalances, and large forex household debts. In other words Italian taxpayers are going to have to fund the losses Unicredit and other Italian banks will accumulate on their CEE lending just as the US Treasury is having to fund United States sub-prime loses. The difficulty is, however, that Italian taxpayers are already "in hock" up to their eyeballs, and if people aren't careful Italians could end up paying for some of the CEE loses with part of their future pension entitlements.

This is why this is no simple and ordinary "technical recession" and why the issue of where the money is going to come from to refloat Unicredit should the worst come to the worst, is the NUMBER ONE question facing the European bank bail out at this point in my humble opinion.

Thursday, November 13, 2008

Germany's Recession Becomes Official

The German economy contracted more than most analysts expected in the third quarter, entering what now appears to be its worst recession in at least 12 years as both exports and domestic spending continue to fall. German gross domestic product dropped by a seasonally adjusted 0.5 percent from the second quarter, when it fell by a revised 0.4 percent, according to data from the Federal Statistics Office earlier today (Thursday). The Germany economy last had a two quarter contracted of this magnitude back in 1996.

And all the signs are that the fourth quarter will be worse than the third one, so the situation may even surpass the 1996 recession.

``The headwinds of the financial crisis and the global economic slowdown are
blowing right in the face of the German economy,'' said Carsten Brzeski, an
economist at ING Group in Brussels. ``Even more worrying, the full impact of the
financial crisis still has to unfold. Anecdotal evidence and leading indicators
are scary.''

And the 2009 outlook promises to be even worse. Only last week, the International Monetary Fund forecast economic contractions for the U.S., Japan and the euro region next year, with Germany's economy expected to shrink by 0.8 percent. The European Commission accepted last week that the entire 15-nation euro region is probably already in a recession. Just over 40 percent of German exports go to other euro-area nations. Eurostat, the European Union's statistics arm, will publish third-quarter growth data for the eurozone tomorrow.

Quarter-on-quarter positive side of the GDP growth balance sheet came from a slight increase in the final household consumption and government expenditure of households as well as an increase inventories. Imports were up significantly (largely due to the rise in oil prices - oil peaked around $147 a barrel in July, while exports dropped, thus movements in the net trade balance had a negative impact on final GDP.

The German economy did, however, continue to create jobs, and third quarter employment - at 40.5 million persons - was up by 582,000 persons (or 1.5%) on a year earlier.

Looking forward a little into Q4, the signs, as I said, are for deterioration rather than improvement, as can be seen from the fact that (according to the PMI) German services contracted for the first time since January in October.

While the manufacturing contraction which started in August really began to pick up speed.

Wednesday, November 12, 2008

Inflation Is Dead In Spain, Fasten Up Your Seat Belts For A Sharp Dose Of Deflation

As Barcelona-based property consultants Aguirre Newman publish a report that suggests Spanish property prices may need to fall by at least 23% for the market to return to any kind of normality, we learn today that Spain's annual inflation dropped almost a full percentage point to 3.6 percent in October, according to data from the Spanish National Statistics Office. This was the lowest level in a year as energy and food costs fell and the real economy slowed dramatically. October's figure, in line with estimates, was down from 4.5 percent a month before, but this piece of information obscures more of Spain's current inflation dynamic than it actually reveals.

The slowdown in inflation over the last few months is evident in the chart below.

"Headline figures reflect energy and food price falls. The most interesting thing is the substantial drop in core inflation, which is a very clear sign of a more fundamental slowdown in the overall economy," said Daniel Antonucci, economist at Merrill Lynch.

But this slowdown in annual inflation isn't the important point, the big news, and the part most analysts seem to be missing, is that the price index peaked in June (as can be seen in the chart below, and whether you measure on the Spain general index or the EU HICP), since which time it has been falling, and from now on (barring the slight possibly of a minor "blip") it looks like it is going to be downhill all the way. From all the indications we have at present we should be ready for quite a sharp fall in Spanish prices in 2009 (possibly 2-3 percentage points).

The reasons why we should expect a fall are evident, we are heading for a global recession in 2009, energy and commodity prices will all be y-o-y negative, house prices, rents, factory gate prices etc etc, all look set to fall as profits get squeezed, and wage and salary earnings - if not direct base salaries - also fall. As the headline in newspaper the woman sitting opposite me in the metro this morning was reading said "Rebajas Hasta El Pan" (The "sales discounts" even reach bread).

GDP is about to start shrinking fast:

While unemployment is rising at this point almost exponentially:

I would say that the practical economics of this situation are now obvious, but for some more general theoretical explanation of why we should now expect to see deflation raising its ugly head across one economy after another see Claus Vistesen's "The Global Economy – Is Deflation the Next Macro Story?" post. And for more details on the current macro economic background you could try my Spain's Services PMI Contracts At Record Rate In October