A basic problem in the eurozone's periphery is that it is experiencing a commonplace emerging market-style crisis--yet its policymakers are oblivious to that fact. This recent observation, from an old hand in emerging markets at the International Monetary Fund, is perhaps nowhere truer than in Spain, where a virtual sudden stop in foreign bank lending has forced the country to become highly dependent on European Central Bank borrowing to stay afloat.
On Wall Street trading desks, the joke used to be that the longest river in the emerging markets was De-Nile. Yet in a manner disturbingly all too reminiscent of Greece earlier this year, the Spanish authorities appear to have deluded themselves into believing that the Spanish economy is about to rebound and that Spain can muddle through without an IMF-European Union bail-out package.
Denial is also all too much in evidence with respect to the Spanish banks. The Spanish authorities keep up the pretence that their banking system is sound and they engage in shameless loan-loss forbearance to paper over the system's difficulties. Sadly, in this endeavour they now seem to be being aided and abetted by the recently released results of the stress test for eurozone banks. By confining itself to singling out five relatively small Spanish saving and loan banks as unsound, that test gives the overall Spanish banking system a virtual clean bill of health. And it does so despite the system's patent overexposure to the very troubled construction sector.
The Spanish authorities justifiably take great pride in how well they managed the country's public finances prior to the 2008-2009 Great Recession. They point to the small budget surpluses Spain recorded prior to the crisis as well as to Spain's relatively low ratio of public debt to gross domestic product.
In stressing these positives, however, the Spanish authorities happily gloss over the fact that Spain experienced a massive housing boom in the past decade, which saw a trebling in Spanish home prices and an increase in the construction sector to a staggering 18 per cent of the economy. The Spanish authorities also prefer to ignore how Spain managed to lose about 20 per cent in international competitiveness*. That loss in competitiveness contributed to a ballooning in Spain's external current account deficit and to an increase in its gross external debt to around 135 per cent of GDP.
Since September 2008, the bursting of the Spanish housing bubble together with the onset of the Great Recession has revealed the weak underbelly of the Spanish economy. As housing-related tax revenue collections plummeted, Spain's budget position dramatically swung from a small surplus to an 11½ per cent of GDP deficit by 2009. At the same time, in large measure due to structural rigidities in the labour market, unemployment surged from less than 10 per cent prior to the crisis to more than 20 per cent at present.
More disturbing still, the incipient housing market bust has drawn market attention to the fact that the Spanish banks in general, and the cajas in particular, are overly exposed to Spain's crumbling housing sector. Construction loans made by the Spanish banking system are estimated to be the equivalent of 45 per cent of the country's GDP. Unsettled by this large exposure, foreign banks have virtually stopped lending to Spanish banks and companies. This has forced the ECB to have to rediscount about €125bn ($162bn, £104bn) in Spanish bank loans to forestall a full-blown Spanish funding crisis.
Spain now finds itself in a similar conceptual predicament to that faced by Greece. It is forced to engage in severe budget-cutting to bring its budget deficit down to a more sustainable level without the benefit of a cheaper currency to boost exports so as to cushion the economic blow of budget retrenchment. Similarly, Spain is forced to go down the painful path of price deflation to restore international competitiveness even though that path will compound the country's public and private debt problems.
Further complicating Spain's policy challenges is the fact that Spain will have to engage in serious budget tightening at a time when unemployment is already at about 20 per cent and when the domestic housing bust still has a long way to go. After having run up threefold, Spanish home prices have only declined by about 15 per cent to date.
Trying to talk up the markets is the right thing for the Spanish authorities to do provided they do not fall into the trap of believing their own rhetoric. It would be very much more constructive were Spanish policymakers to recognise the huge policy challenges that lie ahead and were they to go soon to the IMF for much needed financial support. It would also help if they took serious measures to recapitalise their savings and loan banks.
As the Greek authorities painfully learnt earlier this year, it is better to get ahead of the policy curve than to wait for the markets to force a country to have to approach the IMF in the midst of a full-blown financing crisis.
*From OECD figures for real effective exchange rates based on relative unit labour cost movements
Desmond Lachman is a resident fellow at AEI.