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Since BdE updated the Spanish NIIP with data for 2012Q2 i ‘d like to update my analysis on the subject after the September Economic Bulletin comments:

Although the drop in the overall Net Investment Position is only a marginal 2.2% (-€960.3bn compared to a peak of -€982.1bn in 2011Q2) what is very impressive is the very large swing in the net position of BdE, from +€39.5bn to -€314.9bn, a change of €354.4bn since 2011Q1. This is basically matched by the corresponding changes in portfolio investment (€210bn, from -€672.4bn to -€462.5bn) and other investment (€146.1bn, from -€342.1bn to -€196bn) while FDI is unchanged.

As a result, the net position of BdE is now 1/3 of the negative NIIP of Spain. Since outflows in both portfolio and other investment are continuing, it is probable that by the end of the year both positions will have dropped even further and BdE will account for probably half of the Spanish NIIP. The consequences will be:

  1. Net costs on external net liabilities will be based on the ECB MRO rate (since Target2 liabilities pay the MRO rate to the ECB), limiting income outflows in the balance of payments.
  2. Net Spanish liabilities will be towards the official sector, especially if a Spanish bailout+OMT program goes through. In a sense, Spain will be firewalled while its interest and principal payments will be subject to political decisions in Euro summits and ECB governing councils.

In terms of foreign exposure, the Eurozone has managed to slowly move risks of PIIGS debt to the official sector even though the corresponding capital flows were enormous, a task that was made possible due to liquidity provided by the ECB. How governments will handle these risks is an open question.

Th BdE released its economic bulletin for September 2012. It includes various data on economic indicators as well as a very interesting coverage of deposit developments during the last 12 months.

Although i ‘m sure everyone will have their own ‘favorite’ indicators, i ‘d like to give more attention on some specific indicators that i personally consider important.

First, unemployment developments:


Although during 2010 and 2011 there were some movements of workers from permanent to temporary jobs, ever since 2011Q4 there are clear indicators of the economic situation worsening seriously with job losses increasing in both permanent and temporary contractors.

Furthermore, although less-than-one-year unemployment has been hovering around a narrow band ever since 2009, long-term unemployment is on a strong growth path, increasing from 5.13% in 2009 to 10.42% in 2011 and 12.87% in 2012Q2. Combined with the fact that the most seriously hurt are young and less qualified workers, this development increases the risk of serious social tensions in the short/medium-term future, especially since the economic situation seems to be getting worse. It’s rather naive to believe that a society can manage having a long-term unemployment rate of more than 13% for a long time.

Another indicator is state resources and uses:


Current and capital transfers are growing strongly in 2012, another indicator of the deteriorating economic situation. What is worrying is the path of interest payments (on government debt) which seem destined to reach more than €25bn in 2012, a level around 2.4-2.5% of GDP. Although the level is still low, it should be compared to around 1.6% in 2009, an increase of close to 1% of GDP. Interest payments are clearly on a path to reach at least 3% of GDP which will mean that the Spanish government will need to achieve a permanent primary surplus in order to be able to adhere to the 3% deficit rule.

What is very interesting is the breakdown of foreign trade into individual partners:


Spain has achieved a surplus with the Euro area since 2011, mainly as a result of more than tripling of the surplus with France (from €3bn in 2008 to over €10bn, compared to a deficit until 2007), while the deficit to Germany has been reduced considerably, from -€23.7bn in 2007 to -€8.9bn in 2011 and the trade balance with Italy is now positive. The UK is now a strong net importer of Spanish goods as well as the OECD (at least based on 2012 data so far) with deficits towards the US and Japan dropping to small numbers.

The main sources of deficits are basically China and the OPEC, volumes which are determined more by factors such as global oil prices and the Euro exchange rate, rather than Spanish competitiveness. Even the German surplus seems to be on the path of dropping to almost half what it was during 2011.

In my view, these data show that Spain has managed to reverse its trade deficits and close the competitiveness gap, supported by strong internal demand (import) destruction due to the local recession. Any deficits are with the Eurozone outliers (Germany) or due to oil and China. I think we ‘ve already reached the limits of a mercantelistic growth view for the periphery and genuine stimulus is required for growth to return.

One last point is about the Net International Investment Position:


Spain has managed to lower its portfolio and ‘other investment’ positions significantly since 2011Q1, with portfolio decreasing from -€672bn to -€525bn in 2012Q1 and ‘other investment’ from -€342bn to -€256bn. This was driven by a move of liabilities to the official sector through an increase in the (negative) NIIP of BdE which went from +€39.5bn in 2011Q1 to -€185bn in 2012Q1. As a result, the total NIIP was held steady at -€978bn with a capital flight of more than €230bn (more than 20%) not leading to a severe depression or a euro exit, something which would be nearly certain in a fixed exchange rate regime. This is the most important advantage of a monetary union compared to the latter regime in terms of capital outflows.

Bank of Spain released its balance sheet data for August:

Lending to credit institutions increased during August as well, by €9.47bn, using both MROs and LTROs. This lending was used to finance outflows since Target2 liabilities increased by €14bn to €428.62bn (more than 40% of GDP). The increase in external liabilities was also financed by a further drop in the deposit facility of €3.72bn, while government deposits grew somewhat to €6.42bn (+€1.1bn). All in all, although the growth rate in T2 liabilities clearly slowed, outflows continued, increasing financing difficulties for Spanish banks. It is no coincidence that BdE activated ELA financing on a limited basis. We ‘ll see if the recent OMT bull market resulted in net inflows in Spain during September.

BdE also released data on government debt based on the excessive deficit procedure. Government debt is now 75.9% of GDP (compared to 69.2% at the end of 2011). The increase is attributed to long-term loans which increased from €114.67bn to €148.78bn (+€34.11bn) in one quarter. These loans were taken mainly by ‘Other units classified as central government’ as is evident in the corresponding table. Debt will most probably register over 80% by the end of the year, while taking into account the €100bn EFSF loan and other debts (such as public enterprises and unpaid bills) it will be close to the 100% mark.

On a related development, home prices fell 3.3% on a quarterly basis and 14.4% from a year earlier.

Update: ftalphaville has a very nice analysis on Spanish deposit flight. Worth a read.

Along with aggregated Euro area monetary data, the ECB also released the per country MFI balance sheets for July. In the case of Italy developments were rather mute. Categories such as loans to non-financial corporations and households, holdings of securities, private sector deposits and debt securities issued were either stable or increased a bit.

In the case of Spain though, the figures released were more worrying. Deposits to other euro area residents posted a large drop of €74.2bn. After correcting for repos, the net drop is still €60bn, or close to 4% in one month. If retail depositors start moving funds outside the country then the banking system financial situation will worsen pretty quickly. Central government deposits were down to €38.5bn from €42bn in June. It’s another sign that (especially given the bailouts of regional governments) the government’s buffer is running low and will not be able to cover any shortfalls when €20bn of bonds mature in October.

Holdings of securities other than securites also dropped significantly by €32.3bn. Although most of the drop was in the ‘Other Euro area residents’ category, general government also saw a drop of €9.4bn, a negative development since holdings decreased to February 2012 levels.

Loans to Other euro area residents were down by €30bn (-1.7%), driven by lower lending to non-financial corporations and other lending to households (mortgage loans were actually stable).

My stance on Spain has been highly negative for quite some time, mainly due to negative growth prospects as a result of the austerity measures and the sovereign debt problems. Still, the large foreign debt holders retrenchment during the last 12 months and the way the ECB handled these outflows allow for an alternative view of the future.

First, here’s a detailed view of the available current account data (which stretch up to May 2012 for now):

The Spanish current account deficit has closed significantly, to -€16.9bn for Jan-May 2012. Given the ongoing deep recession, it is quite reasonable to assume that the annual deficit will not be more than €35bn, lower than 3.5% of GDP. Financing a deficit of roughly €3bn per month, even if it means borrowing from the BdE and increasing Target2 liabilities, should not be considered challenging given the balance sheet size of BdE and the available assets of Spanish MFIs.

What is crucial is to stop the outflows in the financial account, present both in portfolio investment (for both of general government and MFI assets) and other investment (mainly short-term loans of MFIs):

Unfortunately, ‘other investment’ (loans of MFIs) is the most difficult flow to stabilize. It will require the continued support of the ECB, probably through more LTROs (of at least 12-month duration) and it will lead to a large increase in the Target2 deficit. Current RoW deposits of credit institutions are €406bn, while loans to RoW are €267bn, a rough net position of €140bn, although Spanish banks also hold more than €150bn in portfolio assets abroad (securities and shares).

Let’s move to portfolio investment. According to Spanish Treasury data, foreign holders of government debt securities held (on a net basis) €208.6bn in September 2011 (38.5% of total tradable debt securities) which fell to €182.3bn in May 2012 or 31.7% of total. By now, foreign residents should hold less than €160-170bn (their registered holdings dropped by 9bn in June). A big problem is the fact that bonds and notes holdings by the RoW of MFIs and other resident sectors are as large as government securities holdings (€205.2bn and €221.7bn in 2012Q1) government securities and have also registered large outflows during 2012. These holdings pose the largest uncertainty for future outflows, especially since there’s no available buyer of last resort.

In the case of government securities, the RoW holdings most probably set the upper limit of a future ECB intervention in bond markets. A ‘hybrid’ bailout scheme involving the ESM and the ECB could be introduced in which:

  • The ESM buys government bonds in auctions. In order to minimize the necessary intervention the ESM could just state certain spreads compared to Euro interest rate swaps for every bond class and place competitive bids based on these spreads which will provide a carry trade opportunity for other participants (who would only need to place lower yield bids in order to acquire the bonds). All interest income above the ESM funding cost should eventually be returned to the Spanish Treasury, probably based on conditionality of program compliance.
  • The ECB supports the secondary market through bond purchases (at the short-end part of the curve based on its recent statements). Given that yields pressure will mostly come from non-residents short positions, ECB intervention will basically finance any portfolio outflows in RoW government securities holdings.

The ECB market effect of the SMP portfolio can be enhanced by managing it more like the Fed’s SOMA. In particular:

  1. The ECB should announce that it will roll-over its debt holdings as long as that is required by financial conditions. Any final discount profits should be remitted to the issuing country Treasury.
  2. The ECB can set a spread over its total SMP term deposit interest costs and immediately remit any profits to the issuing country Treasury on bond interest payment days (a simpler solution would be to just remit any profits over the ECB main refinancing rate although that will lower the available profits).

If it is carried out in this form, the ESM/ECB ‘hybrid’ intervention will probably not exceed €100bn (if the 2012 funding needs are covered) since a (recapitalized) domestic banking system will be able to participate in bond auctions. Current BdE Target2 liabilities are €415bn, net RoW ‘other investment’ stands at €140bn and portfolio investment excluding government securities is roughly €400bn while the annual current account deficit will be around €35bn. Assuming that outflows from other portfolio investment categories are reasonable, total outflows in a post-bailout environment should not exceed €10-20bn/month, a level that i consider manageable.

The fact that the BdE pays the ECB refinancing rate on its Target2 liabilities places a strong floor on the income deficit created by interest payments. Lending from the BdE in order to finance the outflow in portfolio/other investment does not change the ultimate Spanish net investment position but, as long as the corresponding collateral maintains its value, is cost-limited by the ECB rates (and not market rates). Even if Target2 liabilities were to reach €600bn, based on a 0.75% ECB rate, the total annual cost will be €4.5bn or less than 0.5% of GDP. As long as the ECB/ESM remit any profits to Spain, the same will apply to a possible bailout.

In this context, large BdE lending to the Spanish banking sector and a ‘soft-bailout’ can actually prove to be stabilizing factors by anchoring interest costs in the current account. The main risk continues to be the macro situation and the fact that a bailout will be conditioned on even harsher recessionary measures.  What the Eurozone lacks is a ‘growth mechanism’, one that will unconditionally and directly finance investment and employment in countries in recession.

To summarize:

  • ‘Other investment’ outflows mainly involve short-term bank loans. Net RoW lending of domestic credit institutions stands around €140bn. The outflows can probably be offset by BdE lending through the MRO and 3-month LTROs (since loans are short-term anyway).
  • Portfolio investment outflows are observed in all of the bonds and notes categories, mainly government securities, MFIs and other residents. Government securities outflows can be handled by ECB SMP purchases and ESM primary bond auction bids. Outflows in MFI debt will probably require easing in ECB collateral rules and long-term LTROs (12-month?). The ‘Other residents’ outflows are a problem not easily solvable. Each category is around €200bn or less.
  • ECB and ESM intervention if done correctly and remitted profits to the Spanish Treasury can provide support for the bond market, since foreign holdings of government securities are probably less than €160-170bn by now while residents are assumed to rollover their holdings. The size of the 2013 deficit is an open question since the Spanish government might need to also finance regional/local government debt.
  • The annual current account deficit stands at less than €35bn, a figure that can be financed relatively easy by domestic sources (by using BdE financing).
  • Retail deposits do not seem to be flowing out of the country. As long as there is not adverse shock in that category, the outflows can be contained. NPLs will be handled by the recapitalization loan of 100bn by the EFSF/ESM.
  • Regarding BdE financing of outflows (which create corresponding Target2 liabilities) they provide a ceiling on interest payments abroad (equal to the ECB refinancing rate). In contrast with a fixed exchange rate mechanism, the Eurosystem framework of the Eurozone provides for unlimited domestic financing of outflows (with very flexible collateral rules as evident by ELA financing in countries such as Greece) using the NCB refinancing operations, with the ultimate constraint on capital flight being interest payments rather than the actual flows.

In any case, the low RoW holdings of government securities limit any possible future Spanish debt restructuring to maturity extension/NPV haircuts rather than principal reduction, since the latter will entail further loans in order to support the domestic sector while lowering its actual net worth.

BdE released data on doubtful loans for June 2012. They posted a very large increase of €8.4bn to €164.4bn (9,42% of total loans). Total loans increased by about €3bn, driven by repos (+€7.2bn) and ‘Debts repayable on demand’ (+€7.55bn). Mortgage loans decreased significantly by €11.4bn (more than 1% of GDP) to €948.3bn while other fixed-term loans by about €1bn to €480.34bn. Deleveraging (especially in the housing sector) now appears to be going full speed with the results visible on bank balance sheets.

Taking a look at the equity side of credit institutions, we see that net profits were an impressive -€10.54bn in June, while impairment allowances increased by €21.68bn to €148.75bn. The ‘capital and endowment fund’ increased by €3.51bn to €59.24bn while reserves stayed roughly steady at €170.62bn. The troubled state of the Spanish banking sector is clearly visible and the path of the doubtful loans figures is worrying.

The central bank also provided statistics on bank deposits. Overall, they maintained their general level although there were some interesting developments. RoW continued its exodus with balances dropping €22.93bn to €406.59bn. The outflow was more than matched by domestic lending (‘Credit system’) which grew by €59.77bn to €614.67bn (balances were lower than €320bn up until November 2011 when RoW deposits were €508.6bn, an outflow of more than €100bn). The move to domestic financing of the banking sector (financed by BdE lending) is quite evident. ‘Securities other than shares’ decreased further by €13.2bn to €410.7bn, a path they ‘ve maintained throughout 2012.

What is worrying is the fact that government deposits dropped €11.5bn to €68.6bn. Coupled with the lower government deposit balance at the BdE, total government deposits were €75.9bn in June, a figure not seen since December 2011. Based on these figures i maintain my projection that the Spanish government will be able to cover its financing needs until the next round of large bond issuance in October. Nevertheless, the current financial position makes an official bailout more likely since the government is running low in liquid financial assets.

Today, Bank of Spain released its balance sheet data for July which point to continued growth in its lending to domestic credit institutions and target2 liabilities. More specifically:


MROs increased significantly, from €45bn to €69.34bn while LTROs also posted an increase of €12.8bn, from €320bn to €332.85bn. In total, lending to credit institutions is now €402.2bn.


The larger growth came from Target2 liabilities, which grew €42.81bn, to €414.62bn (more than 38.5% of GDP), pointing to a continued capital flight out of Spain with Target2 liabilities still being larger than total bank lending. Banknotes increased somewhat by €1.5bn to €71.6bn, while general government deposits decreased further to just €5.3bn, a figure that has not been registered during 2011-2012. The deposit facility decreased a bit in July as well to €26.64bn (a drop of €1.15bn) while the reserve accounts increased by only €0.5bn. The Spanish banks safety buffer is now only limited to the funds in the deposit facility. Net Other Assets kept their steady decline during 2012, registering at €79.84bn in July.

What is interesting is the fact that while the increase in Target2 liabilities was €42.8bn, new net lending from BdE was €37.2bn with entries such as government deposits and the deposit facility used to also fund the outflows. As stated before, this pattern of €40-50bn outflows per month is not sustainable and coupled with the difficult government financial situation points to some sort of development  in September.

BdE published its monthly bulletin for July. Although all of the tables are quite interesting, i will focus on the GDP and money market statistics.

The economic deterioration is quite clear. Fixed investment shows an accelerating decline while final consumption has now turned negative, although not at levels seen in 2009. Government consumption is declining strongly, making a significant negative contribution to growth, something which is certain to become stronger after the July austerity measures and the bailouts of regional governments (which require further cuts in regional budgets). Exports have been the main source of demand for the Spanish economy but even they show a clear pattern of decline (with growth in the Euro area turning negative), lowering the prospects for the general economy.

More detailed data show that the decline in investment is not confined to construction anymore but includes other sectors as well. The decline in exports growth can mainly be accounted by goods, although services are also showing signs of trouble.

BdE projections for Q2 are negative:

«On preliminary estimates, based on still-incomplete information, economic activity in Spain fell again in Q2. The pace of decline was estimated to be sharper than that of the two previous quarters, with a quarter-on-quarter rate of change of -0.4%. National demand fell off more markedly than in the previous quarter (-1.2% against -0.5%), since household spending and general government demand shrank at a quicker pace. As has been the case in recent years, net external demand softened the adverse impact of the decline in national demand on GDP, as it made a positive contribution of 0.8 pp, up on that of the previous quarter, thanks to a moderate pick-up in exports. In year-on-year terms GDP declined by 1%, set against -0.4% in Q1.»


The money market data show that conditions in Spain have worsened in May and June. Unsecured financing seems to only be available for terms up to one month while secured financing up to 3 months. Unsecured loans interest rates increased from 0.48% to 0.83% while repo rates from 0.20% to 0.32% for 1 month, 0.21% to 0.77% for 2 months and 0.45% to 0.93% for 3 months. It is clear that counterparty risk has increased heavily and lenders are anticipating troubles in the summer.

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Kostas Kalevras

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