Is Spain the Next Lehman?
June 4, 2012

The European debt crisis may be entering a dangerous new phase with Greece’s problems boiling over and an evolving crisis in Spain—a country too big to fail and too big to bail. Stock and commodity investors have been taking it on the chin lately as Europe’s problems threaten to derail the fragile global recovery. The Dow Jones Industrial Average tumbled into the red on Friday and commodities have slumped as global growth appears to be decelerating.

Eurozone economic data released last week showed a fresh decline in manufacturing and the highest number of unemployed in the region's history. Spanish manufacturing activity fell to a three–year low, while unemployment increased to nearly 25%, both statistics more dire than in problem-plagued Greece. Spanish 10-year bond yields are around 6.5%, levels considered unsustainable as worries swirl about the country's banking system and highly indebted regions persist. Nervous investors have piled into the perceived safety of German bunds and U.S. Treasuries, driving yields to levels once thought impossible.

Prices for U.S. government debt have soared lately with the yield on the benchmark 10-year note tumbling to a record low of 1.467%. The German 10-year fell to 1.171%, while the yield on the country's two-year debt briefly turned negative last week, with investors prepared to pay up just to protect their capital. German unemployment fell to 5.4% in April from 5.5% in March, while Austrian unemployment was just 3.9%. The latest figures out of Europe highlight the gaping divide between Europe’s prosperous north and debt-ravaged and moribund south.

Spain veered off the course of economic sobriety not because of runaway government spending but rather out-of-control consumption coupled with an industrial sector that under-exported relative to the rest of the Eurozone. Weak exports drove Spain to rack-up high current account deficits that were financed by borrowing from overseas. This reliance on borrowing from abroad has left Spain vulnerable to financial instability should the country's creditors decide to pull the plug.

Massive consumerism was exacerbated by a ten year housing boom that has gone bust, with house prices tumbling more than 30% from the peak and with experts calling for a further 20% decline.

To return Spain to economic health, the economy must be rebalanced toward export growth and away from domestic consumption. But left without a currency the country can debase and with Europe in the grips of recession, Spain will need years of high unemployment to depress wages back to pre-boom levels.

Belt-tightening has proven difficult in Greece and no less so in Spain, where austerity measures have only served to trim 0.4% from the country’s 2011 deficit/GDP ratio as economic growth slowed to a trickle. The government's stated target of a further 3.5% of GDP improvement for 2012, looks like wishful thinking as Spain tumbles deeper into recession.

High external debts, most of which have been accumulated by Spain's financial institutions coupled with a recession, a real estate crisis and massive regional debts have forced the Spanish government into an escalating spiral of bailouts and guarantees of bank debt. With interest rates on regional government debt now topping 10% and the cost of guaranteeing ballooning bank debt escalating during a worsening real estate bust, Spain may be forced into a Eurozone bailout in the same way that Ireland was. The situation is likely to get worse rather than better over time as real estate values continue to tumble and the recession grinds on. The Bank of Spain has estimated the capital shortfall within the banking sector at €75 billion, however, private estimates have come in at €150 to €250 billion—a staggering amount.

With Portugal and Ireland both likely candidates for a second bailout particularly if borrowing costs continue to soar and European leaders creating policy on the fly, the very real prospect exists that when Spain needs the vans of cash, the IMF and ESM lending facilities will be entirely drained. And while Europe can afford to bail out Spanish banks, it cannot possibly afford to bailout the entire country.

With more austerity ahead, no growth in sight and a real estate crisis that is getting worse, Spain possesses the potential to be the catalyst that will drag the world back into recession if its borrowing costs continue to soar and Europe’s leaders continue to dither. While another round of LTRO from the ECB and possible QE from the Fed appear more likely, neither program will have the necessary impact to dull the growing problems from the Eurozone.

Investors should adopt a policy of being safe, rather than sorry and should raise sufficient cash levels to weather the approaching storm. Germany’s banks are very exposed to Spanish banks, providing a conduit for Spanish banking woes to infect the global banking sector, should the problems in Spain escalate dramatically.

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