Tag Archives: Spain

Recipe for a Spanish Comeback

Global Economy, On the cover, Sin categoría, Spain

(This article was published in The Wall Street Journal on June 26th, 2012 copyright WSJ)

The recent pullback in Spanish bond yields has been heralded locally as almost a victory. But if so, it’s probably a pyrrhic victory, as Spain’s 10-year sovereign bond yield still stands at 6.5%, and five-year credit default swaps remain at historic highs of 563 basis points. Meanwhile, the question in investors’ minds is the same: How will Spain repay its public debts, which have more than doubled since early 2008 to 72% of GDP as of the first quarter of 2012?
Before Spaniards elected the Rajoy government last year, the previous government had denied the crisis for years and failed to act swiftly upon it, leading foreign investors to avoid the country’s bonds. Spanish public debt owned by non-residents has fallen to 37.3% today from 54.5% in 2010. The real figure is even lower, as a significant portion of that 37.3% represents debt bought by the European Central Bank.
The slump in international demand has been mostly offset by bond buying by domestic institutions, including the Spanish social-security and public-pension funds, and mostly from Spanish banks. These Spanish banks now loading up on sovereign bonds are the same ones that have used €288 billion of the ECB’s discount-lending facility so far this year. This is a truly dangerous move, as the vicious circle of risk-contagion between bank balance sheets and sovereign risk affects every asset class. This has also created a credit crunch for the real economy, particularly unhelpful in a country in which small and medium-sized businesses generate 70% of value added and almost 80% of employment.

According to Spanish Finance Minister Luis de Guindos, investors are not taking Spain’s “growth potential” into account. There is truth in that assessment, but Spanish authorities seem resigned to the notion that they can do no more to actualize this “potential.” I believe there is a lot more they could do.Given its potential, Spain can do better, it can do more and it can do it now.

Spain has failed to restore investor confidence in its ability to repay its debts predominantly because the reforms pushed by the Rajoy government so far have focused mostly on revenues, namely tax increases, while the government’s bloated administration and massive subsidy culture remain in place. As such, the economy deteriorates and taxes go up, while debt continues to grow.
Spain seems stubbornly intent on restoring tax revenues that were the product of a giant real-estate bubble, and those will not return easily. Tax collections per capita increased almost 40% between 2003 and 2008 due to the housing bubble, driving a similar increase in government spending. Spain created a public sector perfectly suited for an economy that would grow 2% per year forever. It didn’t. Once the bubble burst, those revenues disappeared but the spending stayed. That funding gap, which took Spain to an 8.9% deficit in 2011 from a 2% surplus in 2007, can not be tackled through taxes, but only through cuts in spending.
When discussing possible cuts to Spanish public spending, one always hears that every reduction is only a drop in the ocean. True, but a million “drops” would add up quickly in a country with 17 regional administrations, thousands of loss-making public enterprises, tens of billions in subsidies, and a complex web of regional and national regulatory bodies.
The Spanish economy, centered on services, industry, tourism and construction, is strongly cyclical. As such, the burden of the state and the maximum debt it can sustain need to be smaller than its less cyclical peers. Spain could restore confidence and reduce its bond yields by achieving this through a four-step, zero-cost program focused on:
1. Structural public-administration reforms: Eliminating duplicative public administrations, chiefly in regional, island and county councils, could save up to €20 billion, according to Spain’s Circle of Entrepreneurs think-tank and the Conservative Party. Additionally, selling off Spain’s dozens of public television and radio networks, and ridding taxpayers of thousands of loss-making companies owned by regional governments, could save €10 billion.
2. Tax Reform: Increasing Spain’s standard value-added tax rate to 20% from 18%, while reducing the employer portion of social-security taxes by 3.5 percentage points, could boost GDP by between 1-1.3% without any decrease in government revenue, according to a recent study by domestic banks. Spain scores 69.1 out of 100 in the Heritage Foundation’s Index of Economic Freedom, significantly below its peers. It needs a long-term sustainable plan of tax incentives for new businesses, and a unified system of regulation instead of the current patchwork of rules, to allow small and medium-sized businesses to grow into large corporations.
3. Cut subsidies by half: Spain spends more than 2% of its GDP per year on corporate subsidies and grants (not including its aid to banks). So far these have only been lightly trimmed throughout the crisis. The subsidy culture keeps zombie businesses in place and puts up a barrier to the development of more productive enterprises. End it.
4. Attract capital: Spain’s private-equity funding of companies is below 0.1% of GDP, according to the national stock-exchange regulator. This is partly due to regulatory instability, along with its protectionist regulation of foreign capital, as any fund that has tried to open an office there knows. By opening its doors to foreign investment, Spain could erase the view that all major deals there must happen between friends and behind closed doors, thus improving its public image in financial markets.

Sovereign-bond investors are by definition the most risk-averse of the world’s financiers. Markets want clarity, sustainability and no surprises. Spain needs to prove to them that it can not only meet its current economic estimates, but beat them. The country has done it many times in the past, and it still possesses all that “potential” that Mr. de Guindos talked about. Spain can do better, it can do more and it can do it now.copyright The Wall Street Journal. Published with permission.

How to Save the Spanish Banking System

Global Economy, On the cover, Sin categoría, Spain
(This article was published in Cotizalia on June 23rd, 2012)

The big news of the week was the presentation of the independent assessment of capital needs of Spanish banks. It is interesting, but on Tuesday I was at a dinner with several managers and analysts of the financial sector, and all of them were spot on about the figure that would be published: A maximum of 60 billion euro.”A solvent banking system” read one of the local press headlines. The ones that have proven to be solvent are the usual suspects: Santander, BBVA, etc… And a positive surprise in Sabadell, which came off better than expected by the market. The savings banks have proven again to be the main problem, because a financial hole of tens billions is frightening.

What angers me is that this tremendously harmful process of “pretend and extend” the problem has led to cast doubt on the solvency of some banks that never should have been doubted. Not all the savings banks are a problem either. It should be noted that Caixabank, made the transition from savings bank to commercial bank and proved to be better-prepared within the national economic disaster.

It is worth to note that at least for the first time, the Government has sought to manage expectations. Hence, the chain of events: 1) The IMF says that the capital needs of banks are 40 billion euro. 2) The State requests a loan of 100 billion euro, and 3) independent consultants put capital needs between 15 and 62 billion, depending on macroeconomic conditions. All happy, instead of changing numbers every three months.

However, if we go into detail, this is another “stress test” I am afraid that leaves more questions than answers.

All prior stress tests have started from the premise that they were very conservative, but the market misses ​​a genuine exercise in “cleaning up the closet.” Let us not forget that all entities that have gone bankrupt – Dexia-, or have been intervened, passed the “stress tests” with flying colours. And do not forget that in 2006 one of the consultants, Oliver Wyman, said that Anglo Irish Bank was the best bank in the world . And it went bust.

Everyone can make mistakes, of course, but what is important to note is that these reports are neither aggressive nor conservative in their estimates. That is the premise from which we must start the analysis.

spanish banks I

The Positives:

Spain is the only country that has made ​​the exercise of bringing independent consultants. It is an important exercise in transparency.

. Now no one doubts that losses in the “adverse” scenario would reach about 250 billion euro, with recapitalization needs of 51-62 billion. And forget about the other scenarios. The independent reports themselves provide many clues and reasons to consider that the “base” scenario is the least relevant, starting with bank profits estimates, GDP growth and estimate of fall in home prices.

. If recapitalization needs remain in the medium scenario, the State would not use much of the 100 Billion loan granted by Europe, reducing the negative impact.

. Listed banks are saying they would not need to access the loan and provisions will be made ​​against their results. Let us see if I banks make the necessary capital increases, as Italian banks did.

. The Government itself, as part of the committee preparing the basis of the report, has allowed some macroeconomic estimates for the base and adverse scenarios that in many other countries would have not been allowed.

The criticisms:

– The consultants have not analysed corporate risk, liquidity, and sovereign risk. There is no review or analysis of the substantial portfolio of sovereign bonds, or the DTA (deferred tax assets), or industrial holdings losses, when latent losses are very important, estimated at 20 billion euros, according to Merrill Lynch. This is very important because in some cases more than 70% of the core capitalization ratio (CT1, Tier 1) is made of government bonds.

– The acceptable solvency ratios are calculated at very low levels: They use an acceptable ratio of core capital (CT1) of only 6% in the adverse scenario, while 9% is used in the base scenario. If the economy is going to deteriorate further, would financial institutions be allowed to reduce their capital ratio from 9 to 6%? This difference alone can enlarge the capital needs by 50 billion euros, according to BNP or Credit Suisse.

– The estimated “new profit generation ability” clearly seems benign for the banks, at approximately 64 billion of profits in the adverse scenario. It seems at least optimistic, since the entire sector generated 100

billion in the last three years. If the economy collapses it is very difficult to estimate this level of profits as “conservative.”

Spanish banks IIHow to save the system from another “stress test” in a year:

I have participated in the documentary, “Fraud.Why the great recession” , which outlines some of the essential measures to prevent further financial shocks from a liberal perspective. It is worth listening to some of these ideas and leave behind the old arguments of “that’s impossible” or “it has never been done” to find sustainable solutions.Using core capital ratios of 6% or 9% is simply putting patches. Banks cannot be so thinly capitalized and risk going bankrupt with any small change in the markets. Banks must be capitalized at least 25%, and ideally build a cash to deposits reserve ratio that gets as close as 100% as possible.

The risk spiral “sovereign debt-bank balance sheet” should be cut. They cannot keep gorging on Treasuries, because when bond yields rise it impacts the credit quality of the bank through the cumulative risk in the sovereign portfolio.

The spiral of corporate risk should be limited and provisioned at market prices. Industrial stakes, with millions in latent losses, should be reviewed and banks should get rid of those that are not profitable.

In the absence of wild credit to feed the bubble that created the Spanish network of industrial holdings, the cycle of “debt rises -> GDP falls -> stock market falls -> industrial stakes stocks fall -> quality of bank assets deteriorates -> bank stocks fall -> loans to the real economy fall -> debt rises -> GDP falls -> start again” is repeated over and over again.

Don’t bail out banks. The bail-in alternative we always mention is the logical one. Bailing out banks perpetuates the incentive to lend recklessly, to continue to take risk “suggested” by politicians and fail again. Use the EU loans to guarantee bank deposits and liquidate the insolvent ones or we will have another round of “bailouts” in a year.

Leave any intermediate solutions. There are no partial provisions for zombie loans. Provisioning “part” of Non Performing Loans does not cut the risk. It perpetuates it. And old school bankers know it.

Finally, conduct a continuing review of the loan portfolio by independent entities and increase international transactions.

If the entities base their risk analysis less on PowerPoint, and less on optimistic own research, banks will see the beginning of the solution and the return to a banking model that has made some of our institutions and managers global models. Do not forget that the solution is not so crazy, because we have it in the past.

Spain: The Mother Of All Bailouts And The Financial Hole

Global Economy, On the cover, Sin categoría
If there are three questions that investors ask me every day those are: why has Spain been so reluctant to ask for a bailout?, why doesn’t Europe act decisively on the Spanish problem? and why does no one really know the true figure of Spain’s banking hole?.

While the IMF has estimated the capital needs of banks at 40 billion euro and Spain has requested an EU credit lifeline of 100bn, I will try to give some ideas that can help answer those questions.Today’s Spanish banking system bailout poses more questions than answers. The financial assistance will be provided by the EFSF/ESM yet these entities are barely capitalized, so the debt of Europe will rise. Also following the proposal, which the Eurozone highlights is a maximum of 100bn, an assessment should be provided by the commission, in liaison with the ECB, EBA abd IMF, as well as the necessary “policy conditionality for the financial sector”. What will those conditions be?. What will this new line of credit –debt- do to Spain’s public debt and borrowing costs?, as investors will add this new line of credit to Spain’s debt pile even if the EU allows the country to account for it separately, and also how will the clean-up of the banks impact on credit to the real economy, which is likely to decrease further?.  

Why did Europe not act more decisively on the Spanish problem?

Basically because non-European bond investors, sovereign wealth funds and central banks, have no significant further ability to add Europe risk to their portfolios, because European countries cannot borrow much more and because the proposed solutions so far are nothing but solving a debt problem with more debt. Another exercise in kicking the ball forward without addressing the debt problem.

The week has given us interesting surprises added to the aforementioned report of the IMF, which highlighted that the core of the Spanish financial system is solid, but draws attention to persistent vulnerabilities in the system. A couple of things: 

  1. The President of the Chinese sovereign wealth fund, China Investment Corporation, Lou Jiwel said that they will not buy more European sovereign debt until the EU takes radical measures to solve its problems. I would highlight his comment “the risk is too high and the returns are too low.” This sentence, similar to that made by Russian officials, helps to provide an answer to a question I get from many readers “is there suddenly no money for Spain?”. Indeed, the availability of foreign investor money is limited after a decade of excess borrowing.
  2. In the UK the rumour is that the British government may not accept an unconditional bailout of Spanish banks with European funds, as it could require a change of the Brussels Treaty . Why? Because the UK spent 31% of its GDP rescuing its banks on its own. Being the second largest net contributor to the EU after Germany (12 billion euro), financing the bailout would almost double the UK contribution, after a 74% increase in 2010. Holland has also warned of the possible need to review, and approve, a new EU Treaty. Watch out for vetoes, which could be likely.
  3. The borrowing capacity of the European Stabilization Fund (EFSF) is increasingly questioned. Bond trading desks have mentioned that their investors no longer consider it in their benchmarks, given the systemic risk, according to Daily Telegraph.

If we add to the above issues the considerable difficulties of the European Central Bank and the International Monetary Fund, as we mentioned in this column in the past two weeks, the only real alternative for Spain seems to be the European Stabilization Mechanism (ESM), but, alas, the fund will not be operational until July, and funds are also limited. The funds that the press mentions over and over, 500 billion euro, will not be available until 2014. The ESM’s capital is less than 16 billion euro, which implies that its maximum leverage capacity is 107billion euro until October 2012.

Even if the ESM leverages its balance sheet its maximum capacity does not cover a third of the potential risks of Greece, Spain and Italy. That is if we ignore the small insignificance that all this means to try to solve a debt problem with more debt and with no meaningful access to non-European investors. In the end it seems it will be the indebted countries of Europe lending themselves money in a kind of circular pattern.

Why has Spain taken so long to ask for a bailout ransom?

That is the million dollar question. Well, at least a 40 to 100 billion question.

First, and this is obvious, to avoid the word “rescue” and the enormous negative political implications involved, and to try to force a combined solution combining private banks bail-ins and a European credit line. Basically to prevent a “Greek bailout” headline in favour of a “sweet and soft bailout” that does not affect sovereignty and only addresses banks liquidity needs.

Spain’s unwillingness to ask for a full bailout looks to prevent the negative consequences for the economy of a full-scale intervention, the famous fear of “the Men in Black” coming to impose massive cuts and tax increases. I personally think that the fear of technocrats is a bit of a memory of the past, from the intervention of Spain in the late 50s. And it might be unjustified as Italy and Spain’s own history shows that in many cases technocrats can be quite positive for the economy.

Too big to fail and too large for bail-out. 

Second, because Spain cannot be “rescued” the Greek way as it is the fourth largest economy in the EU and it would severely impact the entire Europe. In addition, Spain must and can solve its problems alone, as we have mentioned again and again. Spain can cut a large part of the 12 billion it gives in subsidies and its bloated public sector and it has big international quoted banks with a global presence. The IMF said in its report that “in the most unfavorable scenario (-4% GDP 2012), the largest banks would be sufficiently capitalized to withstand a further deterioration of the economy”.  This is why the solution of a 100bn credit line sought by the Spanish Government is much more logical. 

We must not forget that Spain also faces the need to calibrate very carefully the amount of help it needs, because, even if it is not accounted as public debt, the market will immediately add it to the country’s already huge external debt, and therefore its ability to reduce the deficit in the future. Most analysts fear that unless banks undertake the much needed capital increases quickly and efficiently, the burden of the new debt on the public accounts could be a real issue, deficit targets would be difficult to achieve and that borrowing costs will remain high.What we have seen with Spain and the EU is a negotiation to secure a compromise that is best suited to Spain knowing that if Spain falls, the entire EU collapses. A tense game of “poker”. The risk of these negotiations would be that if everyone plays to push the opponent to the edge, the entire table falls apart.

Why does no one really know the true figure of Spain’s banking hole?

The figures published in the press must give headaches to the average citizen. But we must understand that all this is the result of many years of hiding the problem. The “pretend and extend” era that I always write about.

Banks in Spain have a capitalization problem, not a liquidity issue. After the 23.5 billion euro requested by Bankia and the possible need of another 9 billion from Catalunya Caixa and Novagalicia, the estimated figures range between 40 and a 100 billion. The IMF estimates are in the 

bottom of the range, and supposedly enough to meet the timetable to transition to Basel III.
image003

The first thing that surprises analysts is the low figure of provisions made so far .Less than 20% of the toxic assets (which thankfully will be increased to 32% after the recent legislation approved in Spain) but less than 1.4% of “other loans”, ie the “non real estate” that amounts to almost 1 trillion euro. The market has trouble believing the famous sentence repeated over and over in Spain saying that banks have made excessive provisions, particularly given the huge number of businesses closed and the large unemployment level. Minister De Guindos seems to doubt it too, and that is why I believe with the new management at the Central Bank Of Spain we will see a more thorough clean-up process.

The reasons why it is not easy to quantify the magnitude of the banking hole are mainly the following:

  1. “My village is worth more than Detroit”. The inability to certify actual transaction values on land and housing loans. When there are no significant transactions since 2008, maybe loans are simply valued at the banks’ self assessment. Same with the empty ghost towns and homes built in areas without meaningful recent sales. The lack of transparency and real transactions makes the valuation process a “because I said so” problem, which is partially what led to the Bankia disaster, a conglomerate of savings banks overpricing their assets and underestimating the risk of their loan portfolio to improve their ratios in the merger.
  2. “You Never Give Me Your Money You Only Give Me Your Funny Papers”. One of the main issues is the sheer complexity of a giant web of loans that are considered “performing” but which are “lifeline” loans to avoid the bankruptcy of zombie companies. We are talking of massive loans to regional companies, government entities, developers and concessionaries which are technically bankrupt but are kept “alive” artificially.
  3. “I Call The Shots, I Say The Prize”. There is a huge amount of properties that are not sold because the owner says that “the price is the price” and never lowers it although there is no demand. But banks extend the owners their credits in order to avoid foreclosures which would increase the already large portfolio of unsold homes in the balance sheet of banks. Many of these loans remain in banks’ balance sheet valued at 80% of the “price”. But what is the real price of those homes when disposable income, wages and savings are falling in Spain?.
  4. “A Little Bit country, A Little Bit Rock n Roll”. The web of interests between banks, indebted firms and regions is a real issue. One of the reasons why the government has been forced to hire independent auditors is that there is a network of interests to keep asset values at high levels,  preventing actual losses from emerging. From desalinization plants that are woth a third of the invested capital, to uneconomical solar and wind projects and a web of cross-shareholding isn industrial stakes that are valued many times higher than market prices.

For example, if a region has requested a loan of 300 million to build a city for a circus –real case-to a savings bank, but the construction company has not been paid, and a bank has been forced to buy the saving bank, it now has both loans. Is there a vested interest among the three-saving bank, construction company and regional community-to defend that the project is still worth those 300 million?.

Today’s move from Spain finally asking for help for a figure -100bn- that addresses the top end of market estimates of the banks’ recapitalization needs is a step in the right direction. 

However, when you realize that of the potential $100 billion to spend, 22% of that has to be provided by Italy, and their lending to Spain is at 3% but Italy has to borrow at 6% the questions continue to arise. 

It is essential that the independent auditors put on the table a realistic figure of banks’ toxic assets, that Spain gets enough funding to support the recapitalization of the banks, but it is absolutely critical that banks finally behave responsibly and clean up the balance sheet so that there is no doubt about the strength of their accounts. Better to err from excess than to make the mistakes of the past. 

If Spain finally gets its act together there will be no need for  “men in black”.

The government in Spain seems to be determined to fix the financial hole created in the times when the country believed things like “we are the best and the world envies us”, “Spain has no subprime”, “we have the best financial system in the world and the best regulation”, “prices cannot fall”. The Irish clean up of its financial system cost them around 40% of GDP. Spain has to make that effort and finally emerge from the nightmare of its massive real estate bubble. Realistically, not with promises and prayers.My interview on Al Jazeera here

http://www.aljazeera.com/programmes/insidestory/2012/06/20126126534386935.html

This article was published in Cotizalia on June 9th 2012

Official Statement from the EU: The Eurogroup has been informed that the Spanish authorities will present a formal request shortly and is willing to respond favourably to such a request.
The financial assistance would be provided by the EFSF/ESM for recapitalisation of financial institutions. The loan will be scaled to provide an effective backstop covering for all possible capital requirements estimated by the diagnostic exercise which the Spanish authorities have commissioned to the external evaluators and the international auditors. The loan amount must cover estimated capital requirements with an additional safety margin, estimated as summing up to EUR 100 billion in total.
Following the formal request, an assessment should be provided by the Commission, in liaison with the ECB, EBA and the IMF, as well as a proposal for the necessary policy conditionality for the financial sector that shall accompany the assistance.
The Eurogroup considers that the Fund for Orderly Bank Restructuring (F.R.O.B.), acting as agent of the Spanish government, could receive the funds and channel them to the financial institutions concerned. The Spanish government will retain the full responsibility of the financial assistance and will sign the MoU.
Beyond the determined implementation of these commitments, the Eurogroup considers that the policy conditionality of the financial assistance should be focused on specific reforms targeting the financial sector, including restructuring plans in line with EU state-aid rules and horizontal structural reforms of the domestic financial sector.
We invite the IMF to support the implementation and monitoring of the financial assistance with regular reporting.

Spain: Exit The Euro? A Long and Painful Death

Global Economy, On the cover, Sin categoría
(This article was published in Cotizalia on May 19th 2012)
This week everyone is talking about the possible Greek exit from the euro and the apparently appealing idea of “why not Spain?”. Let’s press the Reset button and start over. We have discussed Greece in detail here (http://energyandmoney.blogspot.co.uk/2012/05/greek-drama.html).

The Greek state, which has more public employees than Spain with four times fewer inhabitants, wasted bailout after bailout and continues delaying reforms, saying that “they’ll come, be patient”. And now, some demand breaking the agreement-yes-after having accepted the money. One thing is to belong to the European club with its obligations and rights, and another is to demand to participate only for the party and not to collect the broken glasses … But it is their sovereign decision to shoot themselves in the foot.To read the arguments in favor of breaking the euro, I recommend the interesting and detailed analysis of Jonathan Tepper here. But I’ll give my opinion focusing on Spain. Leave the euro? No. And I think Spain should not, due to the dangerous implications for the country, its partners and the financial system . Why?

. Because Spain is not rich in oil, gas or natural resources as most countries that have made default and devaluation in the past decades, which allowed them to contain hyperinflation.

. Because even if Spain leaves the euro and enters into a default, it will not be freed to carry out the reforms, adjustments and severe cuts needed due to its structural primary deficit.

. Because Spain can ease its debt problem with reforms and budget control, continuing as a major country in the OECD without breaking the rules.

Leaving the euro, and re-structuring -default, bankruptcy, it’s all the same- to start again is like cheating at cards to try to continue in the casino without paying the debts, and as such you get thrown out. It would lead to a collapse of of 25-40% of GDP quite likely, according to UBS, with 45% unemployment, and hyperinflation.. and then, hopefully, grow.

The examples of devaluation and default in Spain are not encouraging.

Spain devalued the peseta seven times between 1959 and 1993. Inflation and unemployment overshot but what is most important is that by the end of the devaluation frenzy the economy was not stronger, unemployment remained stubbornly high and real inflation -not official- rose well above the expected targets. In the early 90s the so-called “devalue for growth” measures delivered no strong growth and just the obliteration of the middle class for years until the country recovered in 96, mostly due to a massive real estate bubble. Spain devalued in 1992 twice its currency by 6% and 5% and in 1993 by 8%. Unemployment reached 24% (3.5 million), public debt to GDP shot to 68% and public deficit soared to 7% of GDP.

To grow after the shock departure of the euro would require capital. Who would lend or invest in Spain after a blow of such caliber? Just look at the list of countries that have abandoned the reference currencies. Either rich in natural resources or examples of extreme poverty.

In the best case there would be a V effect on growth of GDP. A very doubtful effect that, if anything, would lead to the same starting point. Of the twelve countries that have made ​​mega-devaluations in the last 20 years, none generated a GDP growth remotely similar to the devaluation imposed. Average devaluation of 40% for an average increase in GDP over three years of 10%. Immediate poverty without increasing wealth. As U2 would say, ‘running to stand still’.

An exit of the euro would lead to a devaluation of 35% minimum, default on debt, and the contraction of GDP would be enormous, up to 20% but Spain would continue with a primary deficit problem, which is 3% to 4% currently. The primary deficit is the difference between revenue and expenditure without incorporating the financial burden of public debt.

Spain, as in the bad years pre-euro would have to finance this primary deficit… where? At what cost? In fact, in all cases in the past, the runaway deficit has been the first consequence of the departure of the reference currency . Thus, Spain would have make severe cuts in addition to the drop in investment and disposable income . Leaving the Euro does not free Spain from the much needed cuts and reforms.

At what cost would the Spanish State finance itself outside the euro? The 10 year bond at 6%, which today seems too high, would go to much higher levels. Spain’s financing rate soared to 13% in the devaluation frenzy of the 90s. And CDS in Argentina is 1,196 compared to Spain at 500. And what would happen to corporations? Half of the private debt of the country is held by 28 companies of the Ibex 35 Index. These would bankrupt with the subsequent massive impact on employment.

To think that a Spanish exit of the euro would have no contagion effect in Europe and Latin America, its financial and trading partners, with the subsequent effect on export capacity is also dangerous. Spain would create a domino effect of risk on some European banks, our lenders- as well as defaults on domestic ones, with the consequent spread to Latin America. But once done, Spain would become like Argentina or Ecuador … but without oil and gas, natural resources to keep inflation under control.

Do not forget that Spain is already a net importer of commodities, including agricultural ones. Hyperinflation in such products would lead to extreme poverty, and oe can not be re-orient a nation to autarchy and agriculture in a year.

I remember seeing staff at supermarkets in Argentina changing price tags every half an hour while the government repeated over and over that inflation was just 9%.

Those countries that abandoned reference currencies, made huge devaluations and defaults, kept prices of its domestic oil and gas artificially low to contain hyperinflation. And despite this, inflation shot up to levels of 9% -11%. And in Spain, the “high inflation vs hyperinflation” debate is irrelevant. With 24% unemployment already, 9-10% inflation is hyperinflation.

In Spain, hyperinflation would consume the economy again, as a net importer of raw materials. And the example of other devaluations shows that unemployment is not reduced substantially. Although Argentina doubled its number of civil servants after the de-dollarization, unemployment rose from 14% to to 22% three years later only to fall to an 8% “official” -11% real- rate today, more than 10 years later.

On the other hand, ‘default’ would have a financial domino effect . Given the huge exposure of the banking world to Spain and its private companies, it would create a credit ‘crunch’ at least in Europe if not global. If it happens now with the Greek risk, where we do not know if the impact is 400 billion or a trillion euro, imagine with Spain, which is three times larger than Greece.

But in addition, assuming that the international financial system recovers from the effect of “Spain is out of the euro”, which would take away a good part of the assets of our investors, the country would have very severe financing issues, as it happened in the previous seven devaluations. Because Spain has no natural resources, gold or technology sufficient to make us able to force an autarchy that doesn’t mean “poor for 100 years” . A country back to poor shepherds, farmers and tourism services as in 1960.

Spain is Spain, not Iceland

It seems obvious. The bankruptcy of Iceland, a widely used example, was a national agreement of mutual impoverishment in a country of 320,000 inhabitants. Fewer inhabitants than Bilbao. Spain has 47 million. The implications are devastating. Iceland, when broke, was not as relevant for the global economy as Spain is. In 2007, Iceland had a GDP of 8.5 billion compared with a trillion from Spain. The debt of Iceland, at 800% of the GDP was nothing, tiny, in the global financial world. Nevertheless, its default generated a ‘credit crunch’ that affected many countries. The impact of the debt of Spain, which is 3.5 times the GDP of the country is a major risk of an international financial meltdown.

The cost of leaving the Euro of Greece is estimated between 400 billion euros and 1 trillion euros. Spain would be around 2 to 3.5 trillion euros. With that cost, and an impact on financial markets and banks that could last years of provisions and losses, Spain would not see much of a dime of external financing, which would curtail its return-to-growth options.

A problem created in a decade is not solved in one day.

Spain and Europe suffer the hangover from over a decade of debt. And you don’t not cure a hangover from years of alcoholism in two months. Trying quick solutions has a monstrous side effect.

Spain has to lower its debt within the euro, slimming its wasteful spending (14 billion in subsidies, 100bn in duplicated political spending) to improve its creditworthiness and, therefore, make debt less expensive, while reducing total debt. Attract investors and make State with lower and more sustainable costs. Additionally, it must reorient its production model to high-productivity sectors, making an attractive environment for investors, for the entrepreneur. Not all civil works, infrastructure, useless subsidies and housing.

Devaluations and defaults destroy long-term capital investment because it becomes well known that the country will make more and more devaluations, as we did in the past, and defaults.

Spain needs a process of deleveraging in the private and public sector, which, on the other hand, the country can afford without breaking the rules. Another thing is that until today they have not wanted to do because it was easier to wait until more funds from the EU arrive.

In short, the deleveraging is healthy . Growth will not spectacular, but cleaning unproductive sectors unclogs the fundamental problem, that the country borrows to pay current expenses and interest charges. Spain, if it reduces useless expense and the culture of subsides, can reduce debt with modest growth of a mature economy, but with an affordable and sustainable cost and size, appropriate to the cyclical nature of its production model. Not running to stand still.

To watch my interview on Al Jazeera about the Bankia and Spain (Realplayer Quicktime or Oplayer needed): http://dl.dropbox.com/u/62659029/iv_daniel_lacalle_250512_0.mpg

Further read from Juan Rallo: http://www.iea.org.uk/blog/bringing-back-the-peseta-won%E2%80%99t-solve-spain%E2%80%99s-problems