Spain Takes the Spotlight From Greece in Europe's Debt Crisis

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SpainFirst came Greece, which threatened Europe's economy with its staggering 130% debt-to-GDP ratio. Now comes Spain, which also seems to be contributing to the debt crisis in Europe.

Unlike Greece, Spain has a low debt-to-GDP ratio. The country's problem is its banks' large real estate debt, fears about Spain's economy, and the fact that its sovereign debt is largely financed abroad. If foreign investors walk away from Spanish bonds, it could cause a sovereign debt crisis for Madrid that could spread to the rest of Europe.

Spain May Experience Japan's Deflation

World stock markets shuddered on Monday and Tuesday after the Bank of Spain, the country's central bank, seized a small savings bank called Cajasur and replaced its directors after it failed to merge with a larger savings bank, Unicaja. This was followed on Monday by the announcement that four small savings banks were being merged into the country's fifth-largest bank, with assets of 125 billion euros ($152 billion), causing fears of market instability to spread across the continent.

"Spain could easily be like Japan," says Jonathan Tepper, a partner at Variant Perception, an independent macro economics research firm based in London, referring to Tokyo's 15 years of price deflation and stagnating economy. "In terms of a long, protracted period in which property prices go down on a sustained basis and banks have to recapitalize themselves, I think the problems are far ahead."

Unlike Greece, Spain's debt-to-GDP ratio is among the lowest in Europe, about 55% of GDP. Japan's debt is approaching 200% of GDP, but thanks to a high savings rate, it finances 95% of the debt internally. Spain's problem, along with the rest of Europe's periphery, is that it must finance its debts abroad. Some 45% of Spanish debt is held by foreigners -- the amount climbed to 55% in the last year.

"If people don't show up for your bond auctions, it can be a big problem," says Tepper. "There was a problem with one of the Spanish bond auctions last Wednesday where they didn't raise the full amount they wanted and had to do it at a higher price. People are focusing on the wrong thing -- it's not so much the absolute level of debt, it's more how the debt is funded."

Skittish Foreign Creditors

What's the problem with foreign creditors? They tend to be more nervous than domestic lenders and often flee at the first sign of trouble. That forces up interest rates, which could cause interest payments to balloon.

Santiago Lopez Diaz, a bank analyst for Credit Suisse, says the Bank of Spain's intervention in Cajasur "may raise concerns for the financial system, for the sovereign risk profile and for the economy in general," though he added that he didn't think the system was at risk.

Diaz, in a note to investors, says he thinks banks' cost of funding is likely to go up due to higher sovereign risk, an increase in deposit costs and restructuring of the financial system. He said he expects earnings to decline by an average of 4% over the next three years at Spanish domestic banks.

Real Estate Debt a Drag

"The risk for the debt outlook lies, in our opinion, in the looming bank restructuring," Diaz said. While the Spanish financial system had virtually no exposure to toxic assets like U.S. subprime bonds in 2007 and 2008, it's exposed to the highly leveraged domestic real estate sector. Outstanding loans to developers now stand at around 325 billion euros ($397 billion), or about 31% of GDP.

One big problem, according to Tepper, is that Spanish savings banks have a huge amount of undeveloped land on their books. This property is held at relatively high values as urban land available for development. But with 1 million unsold homes in the country, it's unlikely that anyone is going to build new residences anytime soon, meaning the undeveloped land is worth a lot less now than it's being valued at on the bank's books.

"A lot of this land should be marked down," Tepper says. "The long-term solution is being more aggressive about writing down loans and recognizing losses."

Tepper adds that the Bank of Spain's approach is to hope that eventually these losses will be recognized, but it doesn't want to do anything now to upset the stability of the financial system. "If that's the case, you just have a grossly long period of stagnation where credit isn't available because it's tied up in illiquid assets," he says.

Getting Worse Before It Gets Better

The International Monetary Fund concluded a visit to Spain this week with a downbeat assessment of the country's economy. "Spain's economy needs far-reaching and comprehensive reforms," the IMF report said. "The challenges are severe: A dysfunctional labor market, the deflating property bubble, a large fiscal deficit, heavy private sector and external indebtedness, anemic productivity growth, weak competitiveness, and a banking sector with pockets of weakness."

The usual antidote to an economic slump is to devalue the currency and pump government funds into the economy to create jobs. But Spain is part of the eurozone and thus can't adjust the currency to its needs. And the IMF and the European Union are forcing Spain to make cuts to its government budget, reducing civil-service pay and public-sector pensions, at the precise moment it needs to increase spending to boost the economy.

This could have a drastic impact for years on economic growth in Spain and the rest of the European Union. "The bad news for investors is that due to the reforms, markets will turn more negative before they will improve," says Philip Gisdakis, a strategist at Unicredit, a large European bank, adding: "Harsh austerity measures and a reform of the banking system in the midst of a deflating property bubble is definitely not supporting growth."

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