Watching developments in Spain since the beginning of April has been a source of non-stop déjà vu for anyone who watched events unfold in Ireland in 2010. There are a number of striking similarities between the position in which the Spanish government now finds itself and the Irish government’s situation just before it was forced into an EU/IMF bailout program in November 2010. Based on Ireland’s experience, a bailout for Spain seems inevitable.
The trifecta of problems
In the pre-crisis years, both Ireland and Spain allowed their public finances to become reliant on property bubbles that had also seen the countries’ banks over-extend themselves and their construction sectors grow unsustainably large. When the property bubbles burst, this house of cards fell in on itself.
Banks in the two countries faced massive losses and in some cases were pushed to insolvency, while in the real economy unemployment spiked and construction activity ground to a halt. The Irish and Spanish governments were left to pick up the tab, just as government revenues started to slump.
With debt and deficit levels soaring, the Spanish and Irish governments were forced to retrench, adding yet more pressure to their economies. What started out as a property bubble underpinned by cheap cross-border credit quickly turned into a trifecta of problems in both Ireland and Spain: banks needing government recapitalization, ever-greater demands for austerity to bring the public finances back under control, and the drag of austerity on economic growth.
This trifecta brought Ireland to its knees in late November 2010 when it was forced into an EU/IMF bailout program. Eye-watering losses on banks’ commercial property loans were crystallized over the course of 2010 as they were transferred to NAMA, the bad bank for Ireland’s worst non-performing loans. To prevent these losses collapsing Ireland’s banking sector and undermining the wider eurozone financial system, the Irish government was forced into a series of recapitalizations.
Spain’s residential property market has only collapsed around 22 percent from its peak in 2007 to the end of 2011 – compared with over 50 percent in Ireland – and will probably fall an additional 15-20 percent. The more gradual fall in Spanish property prices means Spain’s bank recapitalization costs have been smaller as a percentage of GDP than those in Ireland. Spain’s bank recapitalization has also been smaller because Spain’s bank resolution institution, FROB, does not force banks to crystallize bank losses up front.
This unfortunately does not mean Spanish banks are any healthier today than Irish banks were back in late 2010. As Spanish property prices fall further and unemployment continues to soar, mortgage defaults will rise. Spanish banks will almost certainly require further recapitalization from the government.
As was the case in Ireland, it is extremely difficult to estimate the size of the hole in the Spanish banking sector, and this uncertainty is deeply corrosive of investor confidence. As long as the health of Spain’s banks remains a huge source of doubt, investors will shun Spanish sovereign debt and borrowing costs for Spain will remain elevated.
Austerity vs. growth
In order to rein in its budget deficit – a key requirement of the EU/IMF bailout agreement – the Irish government introduced a steady stream of draconian austerity measures in successive budgets. With the government retrenching just as banks, companies and households were forced to rebuild their balance sheets, Ireland was pushed into a depression.
Spain’s budget deficit ballooned to 8.5 percent of GDP in 2011, and the Spanish government has agreed with the European Commission to reduce its budget deficit to 5.3 percent of GDP this year and 3 percent of GDP in 2013. We have already witnessed in Ireland what happens to GDP when the government is forced to retrench alongside every other level of society. There is no reason to expect a different result in Spain, which slipped back into recession in the second half of 2011.
The government can’t win
In late 2010, Ireland had reached a point at which it could no longer shift market sentiment in its favor. A small fiscal adjustment by the Irish government would have been perceived as a lack of seriousness about the need for fiscal sustainability. A big fiscal adjustment, on the other hand, would raise concerns about the impact of retrenchment on growth.
The government opted for the latter strategy, bond yields rose further and within weeks Ireland was forced to enter its bailout program.
Spain’s current trajectory looks eerily similar. In early April, Spanish bond yields started to creep upwards to unsustainable levels once again. In an effort to reassure investors, the Spanish government announced an additional €10 billion in savings. But the news of a bigger Spanish fiscal adjustment only served to unnerve investors, who fretted about the implications for economic growth. Consequently Spanish government bond yields edged upwards even further.
If the Spanish government cannot regain market confidence, it will be forced to request access to official funding. This may initially come in the form of support for Spanish banks, but recapitalizing the banks only addresses one piece of the puzzle. In the absence of economic growth, the Spanish sovereign will need a bailout too.
Given the similarities between the Irish and Spanish cases so far, is the success of the Irish bailout program a sneak preview of things to come in Spain?
Let’s hope not.
Ireland has been hailed as a success story by the European Commission, the ECB and the IMF. This is true in a relative sense – Ireland’s bailout program has gone better than those in Greece and Portugal. But Ireland dipped back into recession in the second half of 2011, and with domestic demand set to contract further and foreign demand weakening, it is unlikely the country will find sustainable growth in the next few years. Consequently, Ireland will almost certainly require a second bailout when its first program expires.
This highlights a crucial difference between the Irish and Spanish cases: size.
Ireland is small enough for a second round of EU/IMF funding to be affordable if it is needed. Spain is not.
There is only enough money in the EU/IMF arsenal to bailout Spain once. If Spain were to fail to find sustainable growth during the course of a first bailout, it would get no second roll of the dice. Instead, we would face a debt restructuring in one of the eurozone’s largest economies, with detrimental effects on global growth.