Austerity and Growth. Why It Works

(This article was published in El Confidencial and  Cotizalia on April 4/2012)

The great debate in modern macroeconomic analysis focuses on whether the processes of public spending cuts that are being carried out are consistent with fostering growth or whether spending cuts threaten economic development.

Many anti-austerity economists like Krugman, who calls for more spending but also massive wage cuts, or Stiglitz warn of austerity as a driver of deepening crisis.

I'd like to give a summary of the talk I gave a few months ago in Austin and Dallas called “Austerity Works” and why it is in Spain and Southern Europe where budget control is most needed.

The first thing worth to note is that Europe is not undertaking true austerity measures, but very modest cost savings. In fact, in most cases the cuts have only slowed down the speed of spending growth. As we explained here to reduce the "deficit" from 8.9% to 5 % is not austerity, it’s just fiscal prudence. It is not the same to aim for debt reduction than to reduce its increase.

The first argument often used by those who attack the austerity programs is to compare this process with what happened in the 30's, that is, a worsening of the crisis. But these arguments tend to forget the differences between both periods.

* In the thirties there was a combination of austerity with protectionism , a lethal combination that our rulers should avoid. In a globalized world it is very difficult that we can see the wild U.S. protectionism of the 30s. Unfortunately, this is where Europe can err seriously, since political intervention and protectionism is growing, but not alarmingly.

* In the thirties interest rates were extremely high and the financial capacity of the systems was very limited. That is not the case today. The role of central banks and the globalization of the financial systems has changed this risk dramatically.

* In the thirties quantitative easing was not used as a tool to mitigate the risk of deflation and stagnation. But there is a huge problem to solve. The QE (quantitative easing) that the U.S. Fed makes floods the system with money directly, skipping the banks as an intermediary. In Europe, the monetary policies have been directed solely at banks, which hold on to the funds, buying sovereign debt, without extending credit to the real economy.

The current problem is that the increased liquidity provided by the ECB fails to reach businesses and families. As the chief executive of a large Spanish company said to me "credit crunch here is affecting the small and efficient businesses, not the inefficient overgeared large companies."

The reasons why I believe that more spending is equivalent to a shot in the foot is as follows:

* Spending more did not work, repeating it is suicidal . Spain increased public spending by 67.2 billion euros between 2007 and 2011, 6.4% of GDP, to generate a GDP decline of 3.3% and a fall of industrial output of 12.7%, with an increase in unemployment to 24%. That increased spending also meant a cost of additional debt equivalent to 0.3% of GDP. Spain SA not only did not stop the crisis spending, but rather deepened it. The figures in Spain are devastating, but the U.S., UK and the Eurozone demonstrate the same principle, that increased spending has not produced a real positive impact on GDP.

I always speak about the debt saturation model. When an additional unit of debt does not generate additional GDP, but negative . We have saturated the dubious benefit of spending. A clear example of this aspect is the infamous Plan E of the Spanish government, 13 billion euros, only generated debt, job losses and lower GDP.




As we have seen in the past years, "lack of austerity" is expensive, but indiscriminate spending is even worse. I always say that if Krugman was able to read the details of expenditure items in many European general budgets he would join the Austrian school in a minute. We are not just talking about tens of billions dumped in phantom cities, unused airports, useless infrastructure and outright subsidies and grants. The problem is that all these expenses are not supported by an equivalent income (no ROIC, Return on Invested Capital) thus leaving behind them not just a non-existent value, but an unpayable debt that must be covered with higher taxes destroying other activities and productive sectors.

Useless infrastructures and subsidies are not only wasteful, but the debt they leave behind is also crowding out and taxing the profitable and productive sectors. The subsidy and uneconomical public spend culture also becomes a private "investment deterrent" . No one dares to put a penny in an economy in which taxes generated by productive sectors will be used to cover liabilities of unproductive wasted capital.

Why does austerity work:

* It frees financial resources from unproductive to productive activities. Today, almost 70% of financial resources available are used to purchase public debt and finance government expenditure. It is the crowding out effect of a State that accounts for more than 50% of Europe's economy. If the State stops monopolizing the majority of credit availability, and also stops spending on unproductive activities, private investment activity and high productivity activities return. It is no coincidence that the states that have cut public spending are the ones that create more jobs.

* It accelerates the transformation to a more productive economy. It is no coincidence that productivity falls with increasing public spending. Most public spending stimulus plans are directed to subsidies and to rescue declining industries (mining, automobile) and very low productivity activities (construction, civil engineering), and it monopolizes scarce financial resources which precludes private investment in high productivity areas. If countries rescue the inefficient by taking from the efficient one’s pocket, investors fly away from the country and moves to more attractive places.

* It helps create real jobs, not subsidized labour. When the State spends on pointless companies and investments with no return, it does not create employment, it subsidizes it by borrowing. And that cost comes from taxpayers until the State runs out of other people’s money and the pyramid collapses. Europe has seen the destruction of more than 80,000 small and medium enterprises annually while governments subsidize spending that also destroys public jobs in the medium term, when money runs out.

* The increase in interest expenses from more government debt hinders recovery and generates tax increases that discourage consumption and investment as well as repel capital. If Europe stopped issuing new debt to pay interests on old debt it would start to solve its problems.

It is relatively easy, austerity would help: Not only stop paying unnecessary subsidies and reduce billions of euros of cost of additional debt, but austerity attracts capital and reduces the loss of tax revenue by bringing new investors. And instead of removing 0.3% of GDP increasing debt, GDP would be up reducing the financial burden.

The well-intentioned recipes of Krugman and Stiglitz start from incorrect assumptions:

. That most European governments would spend taxpayers' money more efficiently and wisely than private investors.

. Even worse, they assume that those European governments would base their investment criteria in a capitalist, return-driven, open-market, Anglo-Saxon way.

. And much, much worse, they assume that the investment decisions of most European governments are compatible with private investment, when often they aren't.

Most of these "growth plans" have proven to crowd-out private investment, prevent competition, unfairly defend unproductive and declining sectors, and aim at safeguarding inefficient low productivity oligopolies. As such, in many cases European government spending has proven to be in most cases more damaging than helpful for economic recovery, and it widens the funding hole.

We need to escape the spiral of spending, of favors owed, protectionism and subsidies, we need to stop rescuing the unproductive and, through lower taxes and lower spending, foster investment private capital, innovation and growth.



Further read:

My article in The Wall Street Journal:
http://online.wsj.com/article/SB10001424052702304782404577488283442408896.html?mod=WSJEUROPE_hpp_sections_opinion

also here:

http://energyandmoney.blogspot.co.uk/2012/06/recipe-for-spanish-comeback.html#frameId=uWidget20a9e6e60130f5c6a6f0&height=131

The Myth Of European Austerity

http://energyandmoney.blogspot.co.uk/2012/05/myth-of-european-austerity-in-five.html# 

What If Germany Turns Off The Funding Tap?

http://energyandmoney.blogspot.co.uk/2012/05/what-if-germany-turns-off-funding-tap.html#

The European House Of Cards

http://energyandmoney.blogspot.co.uk/2012/06/euro-house-of-cards-and-greek-temporary.html

Real Austerity Does Work

http://pompeunomics.com/2012/07/09/real-austerity-does-work/

Recipe for a Spanish Comeback

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

http://online.wsj.com/article/SB10001424052702304782404577488283442408896.html#articleTabs%3Darticle

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.

Diez cosas que España hace en futbol y no en economía:

. El entrenador no subvenciona a los jugadores perdedores para que sigan en el equipo

. El Estado no interviene ni en composición de equipo ni en estrategia.

. Aprender del contrario que gana, no imitar al que pierde.

. Celebrar la diversidad cuando gana el equipo, no usarla para perder.

. Usar al entrenador que gana, no al que pierde y promete cambiar.

. Adaptar su estrategia a sus recursos, en vez de pedir más recursos.

. Incentivar el liderazgo para el bien del equipo.

. Ajustarse a la formula que siempre ha funcionado y no variar a medio partido.

. Reducir impuestos para incentivar éxito.

. Premiar y felicitar al ganador, en vez de criticar y marginarlo.

How to Save the Spanish Banking System

(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.

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."

How 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.

You can't get Blood from a Stone

In the hope that someone in the EU reads it:

I: Inflation is a tax. Create inflation when salaries are stale and spending will collapse

II: Printing money is stealing funds from savings and from efficient companies to give it to inefficient and indebted governments.

III: Trying to increase tax revenues to bubble-period figures is impossible. Those revenues disappear when the bubble bursts. You have to bring spending to pre-bubble levels.

IV: Increasing spending and debt means passing the bill or the consequences of a default to our children.

V: Offsetting private investments with government spending assumes that politicians are better managers and investors than private entrepreneurs.

VI: More taxes, less growth, less revenues. Same spending, more deficit. More debt, bigger hole.

VII: Increasing debt today is to assume that we deserve to spend today the expected productivity and efficiencies of the future.

VIII: If our policy is that countries don't have to worry about debt because governments don't need to pay it we shouldn't be surprised with increased cost of borrowing.

IX: Increasing public spending today assumes that the same governments that made spending mistakes in the past will now change their way and do it well.

X: If a country's debt is "low" and its cost "manageable" yet demand for its bonds is collapsing and costs soaring, the debt is neither low nor manageable.

The Euro House of Cards and the Greek Temporary Relief

After a week of maximum tension in Europe driven by the Greek elections, Spanish and Italian bond yields, and Cyprus, another one that needs a bailout, things seem to be stabilizing. As suspected, New Democracy -the conservatives- have won in Greece but they will need to form a coalition in the next 3 days. Germany have already suggested this may allow some loosening of program terms but Eurozone bond yields remain at historical highs and the challenges remain. Yet Greece solves nothing. At the close of this post (Monday 18th) Spain 10 year soared to 7.00%, a spread to the Bund of 553bps.

The solution to the debt crisis in Europe is evident. No more reckless spending, reduce debt and avoid forcing monetary expansion measures. After consuming billions of dollars in expansionary policies without success, Europe should stop and think that the damage is greater than the benefit. All these mechanisms have proven ineffective . We have seen five consecutive years of stimulus plans in Europe, a total of $2.63 trillion, with no evidence of success. Providing liquidity and financial relief must be temporary measures, not structural. To demand half a trillion in new stimulus each year is madness.

The solution is fiscal prudence, halting the spiral of political spending, cleaning banks' balance sheets-preferably paid by shareholders and bondholders-, attracting capital and eliminating unproductive subsidies.

The European House of Cards

The European crisis continues and this page " The European Super Highway of Debt " shows visually the size of the house of cards. More debt is not going to help.

In the European credit market we have seen this week a few interesting things:

. Despite the austerity measures, Spanish public debt has grown 5.39% in the first quarter to 774.5 billion euros, 72.1% of GDP. Reforms must continue, but much faster.

. The Spanish risk premium to the Bund stands at 553 basis points . Why? Because debt and financing costs would soar if the country was to use the loan of 100 billion to recapitalize the troubled banks, making it more difficult to repay that debt. The key issue to tackle is that international investors are selling government bonds, leading to the Spanish banks having to buy more public debt. Almost 67% of the country's debt is now in national hands.

. The credit default swaps (CDS) in France and Germany are up almost 12% in a month, showing that the crisis is still spreading. All CDS, including Germany's, have risen on the risk of another stimulus plan/shot of debt. This is what happens when one breaks the principle of responsibility of creditors. Structurally rescuing banks and countries endangers the whole system.

. The International Monetary Fund on Friday urged Europe to help Ireland refinance its crippling bank bailout and consider taking equity in state-owned banks to help Dublin return to bond markets and avoid a second bailout next year.

. We are told again and again that the ECB and Germany do not support peripherals . However, the numbers say otherwise. The Bundesbank has lent to the periphery of Europe 699 billion euro since January within the Target scheme II, equivalent to almost 25% of the GDP of Germany. Spanish banks have asked the ECB for a further 7.4 billion euros, making a total of 288 billion so far.



. While Europe, the ECB, EFSF or ESM, provides support, the countries contributing funds to these institutions are almost all highly indebted and are funded in many cases at much higher rates. Il Corriere della Sera echoed the irony that Italy will contribute 19 billion euro to the 100bn loan to Spain, lending it at a 3.3% rate when Italy has to borrow in the markets at 6%.

Look at the chart below. Over 85% of the money that is contributed to the European stability fund is provided by heavily indebted countries and their contribution is not capital. It is debt.



The Greek Relief

In all this week heading into the Greek elections we have read comments that central banks "maybe" "may" "study" the "possibility" of a concerted action to support the economy. Failed before? Try and try again.

Greece shows us the fragility of Europe's policy of "debt with more debt." Greece is not the problem, it is part of it, but it can cause a big financial turmoil given the web of cross-country loans.

For starters, Greece will need a new additional injection of 15 billion within weeks. Remember in April 2010 when former Spanish president said that the country would gain about 110 million euros a year -yes, a year-with the loan to Greece? Now, neither loan nor gain. A donation.

To put it simply:

. New Democracy winning, with a coalition of pro-Europe parties, solves nothing. It is ironic to see the markets rejoice at the fact that the same party that lied about the countries' finances is now winning. Greece will probably renegotiate the terms of the bailout, yet require a package of "growth"- ie debt- for infrastructure projects financed by the EIB. Funded is probably too big a word, because it is highly unlikely that the loan will be repaid. The "cost" of this option is estimated at 50 to 60 billion Euro in a period of 18 months. JP Morgan estimates only €15bn of €410bn total “aid” to Greece went into economy – rest to creditors, yet the financial hole of lending to Greece has only grown.

The reality is that no matter who ends in government, in Greece what has won is the scheme of a hypertrophied state, political spending and cronyism between government and financial institutions. And that additional debt will be funded by a Euro-zone with fewer resources and increasingly isolated from international markets.

The giant financial web, the house of cards of the Euro-zone, is the reason why every time there is an announcement of intervention the placebo effect lasts a few hours an bond yields explode higher. The  house of cards of debt is the root of the problem and only tackling it would be the beginning of the solution

At the close of this article, there is speculation again with the possibility of a massive shot of liquidity (LTRO) from the European Central Bank, but this has a considerable risk. Banks use most of that liquidity to buy sovereign debt, creating a vicious circle. On the one hand, liquidity does not reach the real economy, lending to households and businesses continues to fall, and on the other hand, it doubles the risk. The bank balance sheet risk and the public debt risk together. This is because banks have ​​it more difficult to attract funding as their sovereign bond portfolio gets larger and riskier, impairing financial entities' balance sheets.

The stubbornness of the European Union to solve a debt problem with more debt only increases the fragility of this house of cards. Fortunately, now there is no turning back because the creditworthiness and the credibility damage is already done. Now, the entire European Union must address the shortcomings of its foundation and find a real fiscal union and implement credible fiscal prudence. Only then, and not before, will Europe see international capital returning and see sustainable economic growth.

You can watch my interview in Al Jazeera on the Spanish crisis here
http://www.aljazeera.com/programmes/insidestory/2012/06/20126126534386935.html

Europe In Eight Quotes

1. “Spain is not Greece.”
Elena Salgado, Spanish Finance minister, Feb. 2010

2. “Portugal is not Greece.”
The Economist, 22nd April 2010.

3. “Ireland is not in ‘Greek Territory.’”
Irish Finance Minister Brian Lenihan.

4. “Greece is not Ireland.”
George Papaconstantinou, Greek Finance minister, 8th November, 2010.

5. “Spain is neither Ireland nor Portugal.”
Elena Salgado, Spanish Finance minister, 16 November 2010.

6. “Neither Spain nor Portugal are like Ireland.”
Angel Gurria, Secretary-general OECD, 18th November, 2010.

7. "Spain is not Uganda"
Rajoy to Guindos according to El Mundo

8. "Italy is not Spain"
Ed Parker, Fitch MD, 12 June 2012

Anthology of Shocking Market Quotes

In this crazy market there are moments to cherish. The recent collapse has generated memorable quotes from conversations with brokers and analysts. Here are my top 10:

1 "No one owns this stock" (Me: "it is 100% owned every day") Him: "you know what I mean" (Me: "No I don't")

2 "The company has to take a $4bn write-off, which would be very positive for returns"

3 "Why would you think that a State Owned Company will not increase tariffs by 20%?"

4 "If you forget the sovereign and macro concerns, it is very cheap" (tied with ""We leave that to the strategists" and "On an absolute basis, the stock is cheap"  )

5 "Stock overhang should not matter because it gives opportunity to buy cheaper"

6 "Seven percent yield is very attractive" (Me: "But sovereign is at 6.5%") Him: "Why would sovereign matter?"

7 "Earnings downgrades are not relevant, although consensus will have to go down 20%"

8 "Semi-State Owned Enterprises have less risk because they will be allowed to earn medium profits"

9 "I don't use P/E for valuation, I don't believe their accounting methods or find them relevant"

10 "I don't look at EV, I'm recommending an equity, not debt"

Of course, these are added to the classics "everything is discounted" and "my estimates are very conservative" etc... 

And, as always, never forget the Top Three Sentences to Identify a Great Short when you read a broker report:

a) Fundamentals Haven't Changed

b) It's A Good Company

c) Dividend Yield Is Supportive

From meetings with companies, here are my Top 10:

1 "It's not a profit warning, it's a revision of estimates" (tied with ""this is an opportunity for longer term investors")

2 "Management ownership of stock is low because if we owned a lot of stock it could compromise our long term perspective"

3 "This acquisition has not destroyed value. Depends what you define as value creation"

4 "Paying the dividend in shares proves our commitment to maintaining shareholder remuneration in difficult times".

5 "A convertible bond is not dilutive because shares will go up more in the long term"

6 "Of course we have kept our targets, we are just rebasing them"

7 "Our plan has not changed, it has just been postponed"

8 "Leverage doesn't impact fundamentals"

9 "In the long term we will be proven right"

10 "You cannot judge the valuation of the company on earnings and balance sheet"

yes... Top eleven...

11. Deservedly... My all time favorite: "We are committed to having the highest dividend yield of our sector"

And from Buyside, the mother of all... "The market is wrong", "It's only a correction", "catalysts abound" or "why is X stock down/up?" ... culminating in "My friend has told me that this is going up".

Daniel Lacalle, June 12, 2012

Spain: The Mother Of All Bailouts And The Financial Hole

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: 

. 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.

. 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.

. 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.

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:

. “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.

. “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.

. “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?.

. “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.

Close To The Edge Or The End Of The Tunnel

(This article was published in Cotizalia on June 2nd, 2012)


Let me start from the end. We are arriving, slowly and with enormous difficulties, at the end of the tunnel. We simply don't know it because the light at the end of the tunnel is not "back to 2007". The end of the tunnel does not mean growing at 3% per annum, more debt, the stock market back at highs and holidays in Marbella. I expect a tough decade of adjustments and depressed valuations, because the world is slowing its growth. But it is a very healthy sign to see that Europe is finally exposing the skeletons of the closet, the need for recapitalization of the banking system and adopting the adjustments that the economy has demanded for years.

While the stock market plummets, driven by the weak data coming from the US, China and Europe, I would like to remind of what I always say. This market is a bad investment, but a good bet.

A few comments:

* Despite the fall of the Ibex in Spain, the valuations of most of its companies have not changed significantly relative to their European and global peers in debt adjusted relative multiples. It's just that most are barely less expensive than they were a few years ago, when Spain traded at "high growth" premiums to peers. Look at the valuations of Russian, Chinese, Brazilian, French and American stocks that collapse every day... And debt is an important factor to curb expectations-hopes-prayers of takeovers. Because predators post-2008, after the value destruction of accumulated losses in corporate transactions, rarely seek to buy more indebted companies.  Remember that over 78% of all corporate transactions in Europe between 2005 and 2011 have been value-destroying, according to Morgan Stanley. The only way in which the Eurostoxx or the Ibex will go up will be when companies show growth cutting off debt.

* In May the bond and stock markets in Europe and emerging markets saw more than 30 billion euro in outflows. We can complain as much as we want about short positions, but what we have here is pure and simple selling. Especially from Long-Only funds.

* 2011 and 2012 so far have been the years with the lowest percentage of share repurchases by companies and executives since 1998 (source: Goldman). It is almost ironic that those who complain about the price of their shares are not buying.

* The greatest mistake of investors in these months has been to remain positioned in risky assets waiting for an elusive ECB, Fed or China stimulus. As a friend always tells me, the only ones who now demand a stimulus plan do so not because of the state of the economy, but to see stock markets rise. And of course, we forget the chart below (courtesy David Einhorn). More stimulus means more debt and fail again.



Spain. Rescue? What Rescue?

This week the successive set of global economic figures, almost all negative, has driven markets to panic mode. But with all due respect to the poor U.S. data, the slowdown in China and the debt crisis, what I find really surprising is to read that 57% of citizens in Spain support a rescue package from the IMF or ECB, because it shows that much of the population supports more stringent austerity measures and the budgets cuts that would be imposed with a rescue package, as we have seen in Portugal. Let's not forget that any bailout will be done to strengthen the creditworthiness of the country and that means cutting the large expense items -pensions, unemployment support, public sector. In fact, the largest additional effort that will be demanded by the EU, IMF and anyone that's going to pay for the rescue will be a meaningful reduction in the public sector.

The world is aware that the 5.3% deficit target for 2012 is unachievable, since the estimates of revenues looks too optimistic. More taxes have proven to generate limited or negative revenue growth. The Laffer curve shown in all its glory again. So what will be critical will be to focus on reducing overheads (ministries, councils, subsidies, etc..), liberalize some sectors and cut energy costs.

But what surprises me most is to see how little liquidity is available in the global system to put out financial fres when they become as large as Spain. Last week we talked in this column about the huge debt that the Fed and the ECB hold, and their problems. But the IMF now has just 330 billion dollars of funds available, from a total of $560 billion, almost all of it debt-financed in New Arrangement to Borrow (NAB) , and the veto of both the UK, Canada, United States and China, who refuse to provide more funds, given their own specific domestic debt issues.

A lifeline to Spain of $300bn would consume most IMF funds, and make it impossible to prepare for a solution for Italy, for example. This does not mean that the IMF with the ECB could not provide an appropriate credit line, but a full rescue package seems unaffordable. 

Incidentally, it is striking that in the orgy of debt of the OECD, the IMF has gone from providing support packages of 20 to 30 billion dollars to now talking about figures that are ten times higher to historic ones.

How to solve a problem called Spanish banks?


All this intense support that the Spanish government is negotiating is to finally make an attempt to clean up the financial system after years of denial saying stubbornly that it was the best and most effectively regulated banking sector in the world, with no sub-prime. A final attempt to limit and clean the real estate exposure, therefore trying to stop the current effect of "contagion and collapse". Contagion of bad non-performing loans on the rest of the portfolio of credit of banks and collapse of new credit to the real economy.

The announcement by Bankia of its capital needs 23.5 billion euros, has revealed two things:

1) When it comes to provisions, the term that the ordinary citizen sees is "revealing losses". If, as Draghi said on Thursday, banks subject the country to a steady increase of the amount needed for provisions, it creates uncertainty, lack of credibility and suspicion. A slow drip of bad news does not reduce risk, it multiplies the confidence problem . Markets sell the shares and there is a risk of an outflow of deposits. It is better to err by excess of prudence than to wait for markets to forget the  previously published figure of real estate losses and see if it works.

2) The need to recapitalize Spanish banks probably reaches 70-80 billion euro, according to Nomura and Morgan Stanley. As always, Goldman Sachs, optimistic as they are, see only an estimated 17 billion euro of capitalization needs. Anyway you see it, an enormous figure that makes Spain "impossible to bail-out". And even Goldman warns that banks may be spending up to 6% of Spain's GDP annually to finish building houses and homes to avoid having to make higher provisions (if properties are finished the provisions required by law are substantially lower).



Therefore, Spain can not afford a Swedish solution, public money to bail out all banks and remove their toxic assets, given the monstrous amount of exposure to real estate of banks, and given the current level of government debt. Issuing public debt to fill the capitalization gap of banks could prove to be extremely damaging to Spain's already high cost of borrowing. 

A possible solution comes from a Bail-In with limited public cost. Forcing a conversion of debt into shares, even though banks dislike this measure due to the massive dilution that would result for their shareholders. The Instituto Juan de Mariana points precisely to that solution , which I also commented on twitter and in this column. Debt To Equity Swaps. An internal recapitalization, forced conversion of debt into equity, which affects only the bank's shareholders, not the taxpayer, rather than a public bailout, which would be unaffordable and extremely costly. 

A bail-in has the advantage that the bank loses the perverse incentive to return to making lending "mistakes", "knowing" that it can be rescued with public money. As the bail-in affects its shareholders the most, they will be the first ones to force the bank management to behave appropriately in future lending.

The solution is difficult and slow, but once Spain has finally imposed severe recapitalization measures the light at the end of the tunnel will be evident, as seen in other countries.

Confidence and credibility

In a country that has withdrawn billions of deposits from their banks in the first quarter according to the Bank of Spain, Spanish mainstream media (chiefly La Razon, Publico and ABC) still has the audacity to blame the international press, the Anglo-Saxon evil papers, and "speculators" for the decline in its stock market and the rise in bond yields. Blaming the wicked investors who Spain so desperately needs to buy its debt, or the foreign press, by the way, the same press that criticizes openly and aggressively Obama, Bush, JP Morgan, Goldman or Cameron. Yet the headlines "Spain under attack from speculators" and "the attack of anglosaxon press to our banks" is repeated like a mantra in different forms.

The beginning of the solution to Spain's problem is foreign capital and we must attract it. When I hear atrocities about "scavengers" (on Spain's public TV) referred to international investors I think that Spain's media -unwillingly- is at risk of sabotaging the government efforts to seek funding and solutions.

The truth is that I have never seen any business / country prosper and be sustainable on the strategy of telling their clients / investors that they are ignorant and publicly blaming clients for the slowdown in sales. Nor have I ever seen a market that values ​in a positive way a constant change of targets, or missing them, even by a few decimals. Investors can not make acts of faith, because they are not allow by their own customers. If there is no trust, there is no investment. And if the country is not well understood, is it not our fault for not explaining ourselves clearly?

I live in London. Spain is a country valued for its solid corporations and professionals. Hard workers, serious and humble. This media concept of "they do not understand us" or "they attack us" parts of two very dangerous vices that were not typical of Spain. Arrogance and ignorance. The arrogance of thinking that we deserve the attention, forgiveness and eternal capital of investors, no questions asked, and ignorance of what happens globally, which is that almost all OECD countries are in trouble and that the money available is reduced by a deleveraging world.  

Spain should not settle on being "one of many bad countries" but we have, precisely because of our current difficulties, to do our homework faster and better . Because we do not judge ourselves. We tend to see ourselves more beautiful, slimmer and with more hair than it is real. We are judged by the world.
Investor confidence can not be recovered in five months. We can not demand that speed. Trust will be recovered with hard figures, not of a quarter, but those of 18-24 months. I'm sure Spain can do it.

Originally published in Cotizalia.

To watch my interview in Al Jazeera about the Spanish banking issues go: (Quicktime or Oplayer required) http://dl.dropbox.com/u/62659029/iv_daniel_lacalle_250512_0.mpg

And my interview on Spain's bailout

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

Further reading:

Eurobonds? No Thanks. Debt Isn't Solved With More Debt: http://energyandmoney.blogspot.co.uk/2011/11/eurobonds-no-thanks-debt-isnt-solved.html#

What happened to put Spain on the verge of intervention?: http://energyandmoney.blogspot.co.uk/2012/04/what-happened-to-put-spain-on-verge-of.html
Why Italian and Spanish CDS can rise 40%... and Greece is not to blame:

http://energyandmoney.blogspot.co.uk/2011/11/why-peripheral-cds-can-rise-40-and.html#


The Spanish Banking reform
http://energyandmoney.blogspot.co.uk/2012/05/spanish-banking-reform-and-devils.html