SERIOUS MONEY:LAWRENCE PETER "Yogi" Berra, a man who earned the respect of American baseball fans first as player and then as manager, declared in the early 1960s: "This is like déjà vu all over again" as two of his players – Mickey Mantle and Roger Maris – made a habit of hitting home runs game after game. Berra's words would appear to be an apt description of the renewed stress in the euro zone.
The euro crisis seemed to ease following the large liquidity injection provided by the European Central Bank in two separate three-year refinancing operations, leading some commentators to conclude the turmoil had come to an end. Indeed, the yield on Spain’s 10-year sovereign debt dropped from a peak of almost 7 per cent at the end of November to below 5 per cent in early March, while the rate available on equivalent Italian debt securities declined by more than 250 basis points over the same period.
The notion that the crisis was over was to prove decidedly premature, however, as the siesta was brought to an abrupt end by mounting stress in Spain, an economy that is twice the size of the combined national outputs of Greece, Ireland and Portugal.
A deepening recession combined with fiscal slippage at the regional level pushed Spain back onto investors’ radar screens, and the resulting jump in 10-year yields close to the psychologically important 6 per cent level, has prompted onlookers to revisit the possibility it might eventually need a bailout.
In order to appreciate the extent of Spain’s economic malaise, it is important to investigate the large macroeconomic imbalances that accumulated during the country’s long boom – from the mid-1990s until crisis struck in 2007.
Spain benefited considerably from EMU membership. Economic growth outpaced the OECD average in nine of the 10 years before the crisis, with the annual rise in GDP exceeding the euro zone as a whole by one to 1½ percentage points over the period. However, the long boom was built on shaky foundations that would be badly exposed once economic turbulence struck.
The stellar performance was driven primarily by a housing bubble alongside an ill-advised construction boom, stimulated by the reduction in interest rates that accompanied greater European integration.
The reference rate on home loans dropped from almost 10 per cent in 1997 to just 3.3 per cent by 2007, and the resulting increase in housing demand led to a 115 per cent increase in house prices in real terms over the period.
The true extent of the overshoot in the housing market is demonstrated by the fact that price increases outpaced rental growth by about seven percentage points a year from the mid-90s until the bubble burst in 2007.
Strong housing demand enabled the construction market to flourish, and the resulting demand for unskilled labour contributed to a massive influx of immigrants in need of shelter, which perpetuated the cycle. Indeed, the sustained demand for unskilled labour saw the population expand from 40 to 45 million.
The construction boom was fuelled not only by Spanish demand for second homes and immigrants in need of shelter. Further impetus was provided through increased home purchases by other EU citizens. Indeed, net foreign investment in housing ranged from 0.5 and 1 per cent of Spanish GDP each year from 1999 to 2007. The supply-side response to strong housing demand was nothing short of phenomenal. The housing stock increased from 20.8 million in 2001 to 25.1 million, and the annual new supply regularly exceeded the new construction of France, Germany, Italy and the UK combined.
In fact, Spain added a new dwelling for each addition to the population over this period, such that the number of people to fill each home fell to 1.7.
The bubble years were accompanied by a credit boom that saw households and non-financial businesses leverage their balance sheets to dangerous levels. Household debt as a percentage of disposable income jumped from just 53 per cent earlier in 1997 to a peak of 132 per cent, while non-financial corporate sector debt jumped from less than 50 per cent of GDP to more than 130 per cent.
Importantly, a disturbingly large current account deficit meant the debt-fuelled boom became increasingly dependent upon external financing, which rendered the economy vulnerable to a “sudden stop” that duly arrived in 2007.
Investors’ concerns today are focused on fiscal slippage and the true level of government debt, which many believe to be more than 20 percentage points higher than the official public debt-to-GDP ratio of 68 per cent. However, investors should be equally troubled, if not more so, by the large private sector imbalances that have shown only marginal improvement since the crisis began.
Private sector debt remains unsustainably high, while house prices and the excesses in the construction sector will take several years to absorb. Investors will be aware that troubled private sector debt has a habit of becoming public debt via an ailing banking system. It’s déjà vu all over again in Spain.
