Saturday, September 01, 2012

A good explanation of the problem

This article from the BBC website explains the problem that Spain faces.

Worries are increasing that Spain may become the fourth eurozone country to require a full bailout.

It has already asked for help with its banks - its main problem - and will receive up to 100bn euros ($125bn; £80bn) to be targeted at its financial sector.

But with its economy in recession it is struggling to balance its books and further pressure is coming from its regional governments, who are starting to ask Madrid for financial help to deal with their own debt issues.

What went wrong with Spain?

Spain's story illustrates the fact that the eurozone's problems run far deeper than the issue of excessive borrowing by ill-disciplined governments.

Greece, Portugal and Italy all had way too much debt.

But the Spanish government's borrowing was under control - that is, it ran a balanced budget on average - every year until the eve of the 2008 financial crisis.

And as Spain's economy grew rapidly before 2008, its debt-to-GDP ratio was falling. Germany's, by contrast, continued to rise.

When Spain joined the euro the Spanish government resisted the lure of cheap loans, but most ordinary Spaniards and its banks did not.

The country experienced a long boom, underpinned by a housing bubble, as Spanish households took on bigger and bigger mortgages.

House prices rose 44% from 2004 to 2008, at the tail end of a housing boom, according to ministry of housing data. Since the bubble burst, they have fallen by 25%.

The economy, which grew 3.7% per year on average from 1999 to 2007, has shrunk at an annual rate of 1% since then.

So, although the Spanish government still had relatively low debts, it is now having to borrow like crazy to deal with the effects of the property collapse, the recession and the worst unemployment rate in the eurozone.

What has happened at the regional government level?

Spain's 17 regional governments collectively have large debts of their own.

They run and pay for most of their own services, including social services, health and education, with the central government in Madrid funding less than 20% of national spending.

In the boom years they spent lavishly on new infrastructure and big projects like airports and swimming pools.

Valencia, which built an airport at which not a single plane has landed, asked the central government in Madrid to help it. Neighbouring Murcia is likely to follow.

Others, including giant Catalonia and Andalucia, Castilla La Mancha, the Balearics and the Canary Islands are other possible candidates.

They are under pressure from the central government to cut spending, but local politicians are reluctant to take unpopular action.

The regions collectively need to refinance 36bn euros in debt this year.

Not all of them have large debts though, the coal-mining region of Asturias in the north of the country is relatively debt-free. The region of Madrid itself has said it has already covered all its refinancing needs for the year, while Navarra, Galicia, Cantabria, Aragon and the Basque Country all seem to be on a sounder financial footing.

What is the problem with the banks?

It's another tale of high-living in the boom years followed by an uncomfortable return to reality.

Before the credit crunch, the banks had been thriving thanks to the rapid expansion of the property sector.

But its collapse brought default from borrowers who were suddenly bust and a plunge in the value of the assets the loans were based on.

Since the onset of the recession, which is expected to continue throughout this year and next, losses on loans have continued to mount as borrowers struggle to make repayments.

The situation has been made worse by the fact that the banks borrowed the money on the international markets to lend to developers and homebuyers, a much riskier strategy than using the deposits they get from savers.

They are sitting on massive losses whose size is not yet fully known - some say it could be as much as 180bn euros.

Not all of the banks are in this situation, however. The International Monetary Fund said a large part of the banking sector, including Santander and BBVA, is well run and resilient.

What has been done to help troubled banks?

Spain has begun to restructure its banking sector.

Many of its smaller, weaker banks have had to merge or have been rescued by larger ones. The number of branches has been cut by 15%, and 11% of the jobs in the industry have gone.

Up to the end of April, the government had injected 34bn euros into its banks, according to the IMF.

That is not including the 19bn euros Bankia, Spain's fourth-largest bank, asked for shortly before it was nationalised.

Bankia itself was formed when several regional banks, or cajas, were brought together because they were too small to bear the knock from the economic downturn.

With the crisis of confidence in the markets about the state of the banking sector and its impact on government finances, it has become increasingly expensive for the government to borrow on the markets.

Like credit card companies, investors demand higher interest the riskier a prospect they think you are. As a result, Spain has had to turn to emergency funding from its eurozone partners.

How will the bank bailout work?

Spain will be able to borrow up to 100bn euros. But it isn't a bailout or rescue, it insists.

The help it gets will differ from the bailouts given to Greece, Portugal and Ireland in a number of ways.

The loans will come from eurozone funds set up to help members in financial distress: the European Financial Stability Facility and/or the European Stability Mechanism, which is supposed to come on stream in July.

In previous cases, money has come from the troika of international authorities - the European Union and the International Monetary Fund as well as the eurozone.

Also, the money will be targeted specifically at Spain's banks, rather than at the economy as a whole through central government.

Spain was desperate to avoid this, as the sovereign bailouts have previously come with demands to cut spending and raise taxes and close supervision of the countries' finances.

Prime Minister Mariano Rajoy has unveiled another set of austerity measures, including another 65bn euros of spending cuts and a rise in VAT from 18% to 21%.

At the meeting of eurozone finance ministers on 9 July, it was agreed that Spain could borrow an initial 30bn euros to support its banks.

The final figure of how much of the 100bn euros offered that Spain will want to borrow may not be known until September.

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