With Ireland's financial woes exposed, Spain's similarities warrant inspection.
Contagion has taken hold of Spain, with respect to both the sovereign and the banking system, in the wake of Ireland's financial troubles and bailout application. In contrast with Greece, where the key vulnerabilities are in the public sector, both Spain and Ireland have run up large private sector imbalances following real estate booms and busts. In "Comparing Spain With Ireland and Other PIIGS: Better in Some Ways, More at Risk in Others," available exclusively to clients, we shed light on Spain's balance sheet vulnerabilities to assess liquidity and solvency risks in comparison with Ireland and the other PIIGS (Italy, Greece and Portugal).
Spain shares some of Ireland's key vulnerabilities, including a housing bubble more pronounced than that in the U.S. and large nonperforming loan overhang in the banking sector. Though Spain's housing bubble is less severe than Ireland's, and though the Spanish banks' commendable loan-loss provisioning system is providing a buffer, a comparison of price-to-rent ratios shows that the bulk of the housing price correction and loss recognition has not yet come. Thus, the pressure on the banking system is bound to increase going forward.
Plus, unlike Ireland, Spain's economy is subject to structural rigidities that prevent a fast return to growth and a quick competitiveness adjustment through internal devaluation. While this year's fiscal performance is largely on track, the 2011 fiscal target of 6% will be more challenging amid fiscal austerity. In some dimensions Spain's macro and financial fundamentals (for example, national savings and public debt levels) are better than those of other periphery countries. But in many dimensions, fundamentals are worse and financial vulnerabilities more severe (for example, unemployment and financing needs).
As the flow of excess savings from abroad has receded after the investment bust, Spain's private losses are being socialized, with dire consequences for the public sector balance sheet--although not to the same extent as in Ireland. Ireland's outsized banking sector in comparison to GDP and its decision to stand behind banks that are too big for it alone to save have accelerated the unsustainable debt dynamics. But one must ask: Is Spain in a fundamentally different situation? Investors seemed willing to give Spain the benefit of the doubt, but market dynamics since Ireland's application for external support show that a reassessment is taking place.
If the current liquidity pressures don't abate and Spain, alongside Ireland and possibly Portugal, is forced to turn to the E.U. funding mechanism, the 500 billion euros of E.U. resources (in addition to the not-yet-committed 250 billion euros in potential IMF funds) would be strained. With Spain too big to fail but also effectively too big to save, a bailout request would open the door to speculation against the cohesion of the eurozone. Indeed, German Bundesbank President Axel Weber's comment that the 500 billion euro bailout fund could be increased if necessary to prevent a breakup of the currency union shows that this concern is shared among even the most vocal bailout skeptics.
The alternative to a bailout is a bail-in of private investors. The inclusion of collective action clauses on new debt issues starting in mid-2013, as part of the new European Stabilization Mechanism, is meant to facilitate this process in those cases where insolvency has been established. While useful, such legal technology is not necessary to achieve an orderly restructuring of sovereign debt--previous instances illustrate that market-based restructurings via exchange offers are sufficient.
Elisa Parisi-Capone is a senior analyst for finance, banking and Western Europe with Roubini Global Economics, Christian Menegatti is the head of global research and Nouriel Roubini is the chairman.
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