Eurozone Crisis - France & Spain

- Keyur Vinchhi - Raghav Pandey

Eurozone Debt Crisis: Spain

Overview
The Spanish financial crisis is the result of a real estate market crash, a significant increase in unemployment rates and unsustainable current account deficits.

Real Estate Market Crash

The residential real estate bubble in Spain saw real estate prices rise 201% from 1985 to 2007. House ownership in Spain is above 80%, in part due to tax regulations which encourage home owning. At its peak, construction activities accounted for 13% of the Spanish GDP. However, coinciding with the global financial crisis in 2008, prices began to fell and the speculative bubble burst. According to Eurostat, over the June 2007 to June 2008 period, Spain was the European country with the sharpest plunge in construction rates. Actual sales over the July 2007-June 2008 period were down an average 25.3%. As a direct result, Spain is now saddled with a consumer base weighed down by huge mortgage debts. In 2010, the central bank had forced the merger of 28 banks and reducing the number of cajas (savings banks) from 45 to 17. Amid concern about the impact of bad loans to building developers may have on the country's financial sector and to calm market jitters about an Irish-style sovereign debt crisis, the Spanish government has planned the nationalisation its weakest savings banks. Estimates of the cost of recapitalising the savings banks range from 17bn to 120bn, with consensus falling in the 25bn to 50bn range. It is believed Spain could afford this level of rescue without seeking outside aid from the Eurozone Financial Stability Facility.

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Labour Issues: Unemployment, Rising Wages and Falling Productivity

The cause of growing Spanish unemployment in 2008 to 2010 is related to the collapse of the domestic building boom and the wider global recession. In 2006, Spain enjoyed low interest rates and therefore cheap loans, this allowed developers to build new apartment blocks, houses and commercial buildings with a relatively low cost of borrowing. Spanish people could afford mortgages at low interest rates and therefore purchased houses contributing to the building boom. However, when the flow of cheap money ran out in mid 2008, the building boom stopped and the flow on effects of spending dried up. Falling tourism receipts and less foreign investment have also exacerbated the issue leading to unemployment doubling between 2008 and 2010. Another problem plaguing the Spanish economy is inflexible labour laws. Despite a deep recession and zero inflation, pay growth averaged 3% last year, according to the OECD. However, rigid wage-setting alone does not account for Spains poor productivity growth. In the euros first ten years, output per worker rose by an average of 0.2% a year. In some years it fell even as wages grew quickly, which chipped away at Spains cost competitiveness. Part of the blame lies with Spains two-tier jobs market. In the top tier around two-thirds of the workforce is comprised of permanent employees who are costly to fire. When firms cannot shed workers easily, they become reluctant to hire them at all, which pushes up unemployment.

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Unsustainable Current Account Deficits

Spains current account deficit reached a record high of 10% of GDP in December 2007. Spains main trading partners are the two economic giants of the Eurozone, Germany and France. Spain has been unable to maintain cost competitiveness with these countries due to ballooning labour costs and inflation. During the 10 year period from 1999-2009, prices in Germany rose the least in the Eurozone, by roughly 19%, whereas in Spain, it rose by 35%.

Economics
Budget Deficit

Spains budget deficit reached a high of 11.10% in 2009. After a round of strict cuts and austerity measures, the government was able to reduce it to 9.2% in 2010. According to the Spanish finance minister, Elena Salgado, the government has targeted an overall public-sector deficit of 6% of GDP in 2011 and plans to achieve the European Union target of 3% by 2013.

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Further cuts will be harder to achieve though. Most of the deficit reduction so far has stemmed from central-government cuts. The regional governments, which control a significant proportion of the spending, have so far made little progress amid fears of public agitation.

Rising Borrowing Costs

Spanish yields have soared in the first half of 2011, threatening to lock the country out of financing markets and marking a major escalation in the 18-month-old debt crisis. The yield on Spains benchmark 10-year bond reached a 6.3% Euro-era high on 18th July. In August 2011, the European Central Bank (ECB) bought Spanish Bonds in order to restore investor confidence after it was rattled by the downgrade of US credit rating by S&P. As a result, yields of Spanish 10Y government bonds have fell approximately 80 basis points to 5.3% So far in the year, Spain has only been to attract investors for its 10 year bonds for interest rates ranging from 5-5.5%.

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Outlook
Spain has undertaken several rounds of austerity measures such as departmental spending cuts of 16% and government worker salary cuts of 5% in order to achieve an overall spending cut of 7.7%. The government plans to increase receipts by increasing VAT and tax rates for the high income sections.

Business and investor confidence are low amid concerns that there is little for growth. A poor economic outlook and concerns about the banking sector have led Moodys to downgrade Spanish Debt to Aa2.

Bailout?

A bailout of Spain is not in the offing even if it becomes necessary. The European Union and IMF are not in a position to provide measures similar to the loans that Greece and Ireland received to the Eurozones 4th largest economy. The consequences of a Spanish default are the direst for Germany, as its banks are the ones most exposed to Spanish debt.

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Eurozone Debt Crisis: France

Overview and Problems
Over the short run, both the EU and the United States are attempting to resolve the financial crisis while stimulating domestic demand to stem the economic downturn. These efforts have born little progress so far as the economic recession and the financial crisis have become reinforcing events, causing EU governments to forge policy responses to both crises. Throughout the euro debt crisis, there has been criticism of an apparent lack of political leadership. Critics are especially targeting the German-French engine of European integration. But that engine has broken down. One of the reasons is that France cannot play the role of an anchor of stability. The country has its own problems and is in worse economic shape than when President Nicolas Sarkozy took power in 2007. Growth is now faltering in both Germany and France, which together account for half of euro-zone GDP. Germanys quarterly economic growth slowed in the second quarter of 2011 to 0.1% of GDP. France failed to grow at all.

Of the six AAA-rated countries in the euro zone, France looks the shakiest (see chart). Spreadsthe premium that investors demand to hold French debt over benchmark German bondshave widened since July, but are way off Spanish or Italian levels. French public debt is expected to reach 85% of GDP this year, according to European Commission forecasts: slightly more than in Germany (82%), but less than in Italy (120%) or the United States (98%). The budget deficit, forecast at 5.8% of GDP in

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2011, is closer to Greeces (9.5%) than to Germanys (2%), but it has been steadily falling. Mr Sarkozy has promised to squeeze it to 3% by 2013. French consumer spending, the motor of expansion over the past decade, is faltering. Sluggish growth in Germany, Frances biggest trading partner, and the rest of the euro zone is taking its toll. And France is sorely exposed to the euro zones troubled debtors.

Investors concerns about France have been showing up in the bond market where it is costing France more to borrow money and in the credit market, where the cost of insuring against the possibility of Paris defaulting on its debts has risen. The richest segment of French society are pledging another three per cent of their annual incomes to help the country battle its deepening debt crisis. The situation is explosive and France could be next to witness riots like those in Britain. Money used to repay interest on Frances debt this year has overtaken education and defense expenditures. The countrys huge debt burden has led to chronic underinvestment in schools and hospitals. The equipment is outdated and there is not enough of it.

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The biggest short-term worry for France is the effects of the euro zone crisis on its banks as further countries fall prey to contagion. French banks exposure to Italy stood at around 270 billion euros at the end of December, according to the Bank for International Settlements. That is on top of their exposure to Greece and Portugal.

Outlook/Measures
Slow growth has, made it harder for France to meet its deficit targets. There is talk of yet more pruning of tax exemptions, and possibly a new tax on extravagant incomes though not, lamentably, of reversing a daft reduction in value-added tax for restaurants that costs the state 2.4 billion ($3.5 billion) a year. Last month the IMF warned France that its growth forecasts were over-optimistic and that it would need further measures, particularly spending cuts, to stay on track. It is believed that they may need to be worth 20 billion over the next two years. Mr Sarkozys tinkeringnot replacing one in two retiring civil servants; trimming tax exemptionshas allowed him to keep his deficit-reduction promises, so far. Yet besides last years lifting of the minimum retirement age from 60 years to 62, he has done little to reform public spending structurally. As a share of GDP, the French state now spends more than Sweden. This is not only the result of recession: Frances national auditor calculates that crisis-related measures accounted for less than half of last years deficit. Moreover, the countrys long-term track record is dismal. No French government has balanced a budget since the early 1970s. Governments of all stripes have let debt pile up for future generations, preferring to blame speculators and ratings agencies for problems of their own making. To add to the uncertainty, France faces a presidential election next spring. With his poll numbers at last beginning to rise from record lows, Mr Sarkozy is in no mood to make unpopular spending cuts. But the prospect of a Socialist victory is hardly reassuring, given the partys pledges to reverse Mr Sarkozys rise in the retirement age and to create a mass youth public-employment scheme. In addition France will also have to bear the burden of further financial assistance to Greece, which needs a second multi-billions bailout package, and potentially others like Portugal and Ireland.

Recent News
Moody's ratings agency downgraded two top French banks highlighting the risk of a eurozone domino effect amid warnings the crisis could destroy the European Union. Moody's cut the rating for Credit Agricole bank, one of the biggest in Europe, from Aa1 to Aa2 and Societe Generale's from Aa2 to Aa3 because of fears over their exposure to Greek sovereign debt. The rating agency left French banking major BNP Paribas on negative watch.

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