Hsbc Spanish Decoupling

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abcGlobal Research

Spain is differentiating itself from the

peripherybut growth remains key for continued

successAs jitters surrounding the Eurozone periphery refuse to go

away, the key question is whether Spain will continue to

differentiate itself from other peripheral countries.

So far, Spain does seem to be distinguishing itself. In terms

of the fiscal metrics, it not only starts from a position of

relative strength but has also delivered on tough austerity

targets in 2010. But the most important difference is that the

Spanish economy has started to grow again despite

continued de-leveraging across domestic sectors.

We believe that concerns that this recovery could be derailed

by ECB monetary tightening are overdone. A gradual

tightening cycle by the ECB can be absorbed by the Spanish

economy, especially since growth is driven by the global

trade cycle.

However, the recovery is still fragile and both the domestic

housing and labour markets remain weak. Markets are nervous

about contagion risks and the possibility of Spanish banking

sector woes resulting in fiscal stress, as was seen in Ireland.

We, however, believe that there has been progress on

banking sector reforms and even taking into consideration

known risks such as contingent liabilities, Spain is better

placed than Ireland on the banking side.

We feel that a more pressing concern is the credibility of

consolidation targets especially at the regional government

level in Spain. Regional governments have progressively

been given greater control over both expenditure and

revenue distribution. But their revenue structures are very

pro-cyclical while expenditures are determined by long-term

considerations which complicate the achievement of fiscal

targets. Furthermore, regional government elections are

scheduled for 22 May, and bring with them risks of fiscal

slippage against stringent targets. The lack of transparency

surrounding the regional governments fiscal position onlyadds to our concerns.

Economics

Spain

Spanish decoupling

ECB rate rises are not the risk

16 May 2011

Madhur Jha

Economist

HSBC Bank plc

+44 20 7991 6755 [email protected]

View HSBC Global Research at: http://www.research.hsbc.com

Issuer of report: HSBC Bank plc

Disclaimer & DisclosuresThis report must be read with thedisclosures and the analyst certificationsin the Disclosure appendix, and with theDisclaimer, which forms part of it
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Has it or hasnt it?

Senior officials at the IMF suggest that Spain is

different from the bailout-seeking peripheral

countries of Greece, Ireland and Portugal becauseof the progress made on reforms and restructuring

of cajas. But markets cant seem to decide on

whether Spain has decoupled or not.

The initial request for aid from Portugal in April

saw spreads of Spanish bond yields over bunds

compressing and five-year sovereign CDS spreads

coming down as well. However, concerns about a

possible restructuring of Greek sovereign debt

since then seem to have placed fresh strain on

sentiment towards Spanish debt.

A number of questions surrounding Spain still

persist: could monetary tightening by the ECB

derail economic recovery? Could the Spanish

banking sector go the way of the Irish one?

Finally, are increasingly challenging austerity

measures achievable given the existing fiscal

structure in Spain? Is Spain truly different?

All the questions really boil down to this: how

sustainable is Spanish debt compared to that of

the three countries that has already sought bail-

outs? In other words, is the size of the debt

manageable and what is the ability of the country

to repay that debt?

1. Spanish bond spreads over bunds have widened recently

0

2

4

6

8

10

12

14

08 09 10 11

0

2

4

6

8

10

12

14

Greece Spain Ireland Portugal

10-yr government bond spreads over German Bunds %%

Source: Bloomberg and HSBC

Starting from a position ofstrength

So far, Spain certainly has differentiated itself in

terms of the level of debt. Lets look at some

facts. First, fiscal consolidation during the boom

years saw Spain start from a position of relative

strength during the crisis. At the same time,

Spains debt ratios have risen less than those of

other peripheral countries, allowing Spain to have

Spanish de-coupling

Fears about ECB tightening hurting Spanish recovery are likely

overdone

with the achievability of fiscal consolidation targets at the

regional level a bigger concern

Growth remains key for continued Spanish de-coupling from the

periphery


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comparatively better debt metrics than the rest of

the periphery.

2. Spain's debt metrics look comparatively better than forother peripherals

020406080

100120140160

Spain Portugal Greece Ireland

020406080100120140160

Change in gross debt 2007-2010

Change in gross debt 2007-2012f

2010 gross debt

% GDP% GDP

Source: European Commission, HSBC

As a proportion of total GDP, Spains gross

expenditure on interest payments on government

debt is also much lower than that of the periphery

countries or even the Eurozone as a whole.

3. Gross interest spending is the lowest for Spain amongstthe peripheral countries

Gross spending by Government on interest

payments

0

2

4

6

8

00 01 02 03 04 05 06 07 08 09 10 11 12

0

2

4

6

8

Spain Italy IrelandPortugal Greece

Forecast

% GDP % GDP

Source: OECD, IMF, Thomson Reuters DataStream

The first year of the austerity programme has also

proven a success, with the target for budget deficit

reduction being met; predominantly through tax

increases but also some spending cuts. This

contrasts favourably with a country like Portugal

where the targets were missed, adding to the

pressure on the government refinancing programme.

4. Spain has had a successful first year of austerity

0

5

10

15

20

25

30

35

Spain Greece Ireland Portugal

0

5

10

15

20

25

30

35

40

2009 2010 (Actua l) 2010 target ( from 2011 budget)

% GDP% GDP Budget deficit

Source: Respective National Ministry of Finance and HSBC

The risks of becoming another Ireland

The starting point for debt sustainability then is

good. But the real fear is that this could well turn

out to be a repeat of the Irish story. The debt

position of Ireland were even better before the

crisis (gross debt at 25% of GDP in 2007) but

banking sector troubles wholly undermined

sovereign debt sustainability. As the crisis

unfolded in Ireland, it became increasingly

impossible to distinguish the banking sector

problems from sovereign solvency concerns.

5. Spanish bank's exposure to the real estate sectorballooned during the construction boom

40

45

50

55

60

65

00 01 02 03 04 05 06 07 08 09 10

40

45

50

55

60

65

Real estate loans/total loans

%%

Source: Band of Spain, HSBC


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6. Banking sector concerns and sovereign risks are tightlyinterlinked

Spain

Ireland

Greece

Portugal

France

Germany

-200

0

200

400

600

800

1000

0 200 400 600 800 1000

Sovereign CDS (5y Sen)

FinancialsCDS(5ySen)

Source: Thomson Reuters DataStream

Certainly, the similarity in economic

developments between Spain and Ireland is

striking. Before the crisis, both economies were

seen as having benefitted largely from joining the

Eurozone and deregulation that allowed for a

massive rise in construction activity fuelled by a

credit boom. Construction accounted for around

14% of GDP and 12.9% of total employment in

Ireland at the height of the credit boom, similar to

the 9.4% and 13% for Spain. In both cases, the

crisis began with the bursting of the bubble in the

real estate sector that ultimately forced a

restructuring of the banking sector.

Not only did Ireland start from a position of relative

strength in terms of fiscal metrics, but it also

implemented very severe austerity measures (fiveconsolidation packages) that had a net deficit

reducing impact of 9% of GDP between 2008 and

2010. This prompted ECB President Trichet to hail

Ireland as a model to be emulated in terms of

consolidation progress. Despite all that, it was a

series of unanticipated events in the banking sector

(see Box 1 in appendix for more details) that saw

Irelands fiscal soundness absolutely crumble.

It is the fear of a repeat of these known/unknown

unknowns that set off alarm bells across markets

and make it difficult to say with absolute

conviction that such a process will not be repeated

in Spain. (For a more in-depth discussion see

Eurozone periphery, Austerity, rescues and

politicsby Janet Henry published on 26

November 2010)

But given all the information that we do have, we

believe that Spain is different from Ireland. First

the exposure of the banking sector to problematic

real estate assets even at the height of the real

estate boom was lower, with outstanding lendingrelated to real estate (including mortgage loans) at

60% of total lending as compared to 70% for

Ireland. More importantly, the size of the banking

sector in Spain (relative to GDP) is much smaller

than in Ireland, which makes the economys

vulnerability to exposure to these real estate assets

much smaller than in Irelands case. Of course, as

the size of the Spanish economy is larger, the

absolute size of real estate related loans is nearly

the same.

Even in terms of the known contingent liabilities1,

these are smaller for Spain (European

Commission estimated this at EUR60bn in 2010

compared to the still massive EUR193bn for

Ireland, (which has declined from around

EUR352bn in 2008).______________________________________1 Contingent liabilities include guarantees granted by the general

government to non-government units, securities issues by special

liquidity schemes and special purpose entities, such as the NAMA.

7. Spanish banking sector remains small compared to theIrish banking sector as a proportion of GDP

0

400

800

1200

IRE ESP POR GRK0

400

800

1200

Size of MFI sector

% GDP % GDP

Source: National central banks and HSBC
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In addition, the Irish banking system remains fully

shut out from the wholesale funding market. This

has meant that it has had to de-lever sharply

(reduce loans/deposits ratio) while its dependence

on ECB funding is also very high.

Spanish banks, on the other hand, have been in a

position to reduce leverage in a more orderly

manner but are still able to tap the wholesale

funding market, with data from our bank equity

team (see Spanish banks, Deposit war easing butdomestic challenges persistpublished on 8 March

2011) also showing that the major Spanish

commercial banks there have been able to extend

the maturity profile of their outstanding debt,

reducing rollover risks.

In addition, Spanish sovereign debt has been

acceptable at LCH.Clearnet as collateral as of

August 2010. Consequently, the dependence of

the banking sector upon ECB funding has

fallen sharply.

8. Spanish dependence on ECB funding has fallen sharply asit is able to tap the wholesale funding market

0

40

80

120

160

05 06 07 08 09 10 110

40

80

120

160

Spain Ireland

EUR bnEUR bnOutstanding loans from central bank to

country's banking system

Source: Central Banks and HSBC

If we were to assume that the entire EUR60bn of

contingent liabilities turned bad and had to be

brought onto the Spanish sovereigns balance

sheet (as has happened to a large extent in

Ireland), this would add another 5.4ppts to the

Spanish debt/GDP ratio, which would still be wellbelow the debt/GDP ratios seen for Ireland,

Portugal and Greece.

There is progress at a more structural level as well.

Just as the rest of the private sector in Spain is de-

leveraging; so is the Spanish banking sector. The

banking sector has reduced the loan/deposit ratio

both by attracting deposits as well as by actually

cutting the total number of loans being given. The

total balance sheet of the MFIs in Spain has begun to

shrink as a result (see charts in appendix).

Spanish authorities have also taken measures to

restructure the banking sector even though theEurope-wide stress tests carried out in July 2010

were not particularly alarming for Spanish banks

(additional capitalisation of just

EUR1.8bn required).

9. Spanish banks are reducing leverage

0.5

1.0

1.5

2.0

2.5

99 00 01 02 03 04 05 06 07 08 09 10 11

0.5

1.0

1.5

2.0

2.5

Ireland PortugalSpain Greece

Loan-to-deposit ratios

Source: Central Banks, CEIC and HSBC

Bank of Spain (BoS) has pushed ahead with

regulations aimed at consolidating and

streamlining the banking sector, in particular the

unlisted savings banks (cajas). As a result, the

number of cajas is now down to 17 from 45.

New regulation by the Bank of Spain also requires

the remaining cajas to take steps to improve their

capitalisation levels by raising the core Tier I

ratios to 10% in case they are unable to list

(whether these banks get listings or not depends

upon wholesale funding the ratio is 8%).

According to the BoS, this would require

additional capital of around EUR14bn. The

process of improving capitalisation could be done

by one of two methods 1) raising private capital
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either through direct receipt of funds from thirds

parties or market floatation (IPOs etc) or both; 2)

requesting a fund injection from the Fund for

Orderly Bank Restructuring (FROB) which was

set up in 2009 to assist the restructuring process.

The deadline for implementation of

recapitalisation plans is 30 September 2011, with

some extension until March 2012 possible in

certain cases. Our bank equity team expects that

around half of the EUR14bn would be obtainedthrough the raising of private capital.

However, most market participants expect that

further losses on the real-estate portfolios could

see the actual recapitalisation amount rise over the

coming months. Our bank equity team expects the

final recapitalisation amount for the cajas to total

EUR45.5bn (See Spanish banks, estimated

EUR45.5bn capital needed for the cajas sector

published on 26 January 2011), which would add

4.1% to the debt/GDP ratio.

At present, even the most pessimistic scenario for

capital requirements envisages a EUR120bn

increase (according to rating agency Moodys

calculations) which would add another 10.9ppts to

the debt numbers, keeping the Spanish debt/GDP

ratio well below 100% and much below the

problematic levels seen in the rest of the bailout-

seeking periphery countries.

The importance of growth

Expectations of economic recovery also improve

the prospects of debt sustainability in Spain.

Weaker-than-expected growth was one of the

primary reasons that Portugal failed to meet its

fiscal consolidation objectives over 2010, despite

undertaking some drastic austerity measures.

The Spanish economy is witnessing a recovery in

growth, albeit still fragile. In fact, Spain is the

only country within the periphery expected to

grow over 2011 (consensus expectations). While

the official growth forecasts for 2011 and 2012

appear slightly optimistic, they are not too far

from our own and consensus growth forecasts that

look for a modest rise in economic output over the

next two years.

10. The Spanish economy is expected to start growing in2011

-8

-4

0

4

8

-8

-4

0

4

8

08 09 10 11 12

Ireland Greece Spain Portugal

% Yr% Yr Anuual GDP growth

Consensusf'cast

Source: Consensus forecasts, HSBC

The importance of growth for continued progress

on the fiscal front cannot be overemphasised. The

chart below shows the impact of different growth

profiles on the deficit and debt projections.

Weaker growth makes it progressively more

difficult to improve the fiscal position as it lowers

tax revenues and makes it more difficult to

politically justify spending cuts.

11. Lower growth can hamper attempts to reduce debt

45

50

55

60

65

09 10 11 12

45

50

55

60

65

Base-line Very weak growth Weak growth

% GDP% GDP Gross debt

Source: European Commission and HSBC calculations

Note: Nominal growth at 3.7% and 2.8% for 2011 and 2012 in baseline scenario; 1%

and 0% in weak growth scenarios and -3% and -1% in very weak growth scenarios

For Spain, a recovery in growth is also essential

for continued stabilisation of the two weak spots

in the economy, namely the labour market and the
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housing market (more discussion on this in

the Appendix).

ECB rate tightening will not derail

recovery

The big concern facing markets now is whether

the start of the ECB tightening cycle could derail

Spains still fragile economic recovery.

We believe that these concerns are overdone.

Undoubtedly, domestic demand is likely to remain

anaemic as not only the government but also the

private sector is cutting back on debt levels.

12. Not only government, but the private sector is cuttingback on debt in Spain as well

200

210

220

230

08 09 10 11

200

210

220

230

Spain Portugal

% GDP% GDP Private sect or indebtedness

Source: Central Banks and HSBC

But growth is being driven by net exports that relate

more to the global trade cycle. It is encouraging that

in an environment where almost all developed

countries want to re-balance the composition of

growth away from domestic demand towards trade,

Spain has actually managed to benefit from the re-

acceleration in the world trade cycle. The share of

exports in GDP has been rising and now accounts

for a little over 30% of Spanish GDP (though this is

lower than the 40% average for Eurozone as a

whole) and Spain has witnessed a strong export

recovery over 2010.

13. Spanish trade recovery has been encouraging

80

85

90

95

100

105

110

115

07 08 09 10 11

80

85

90

95

100

105

110

115

Spain Ireland Portugal Greece

Ex ports of goods & servicesIndex 2007=100 Index 2007=100

Source: Eurostat and HSBC

14. Spanish export growth has been very well diversified

-5

0

5

10

Food &

animals

Bevs. &

Tobacco

Crude

materials,ex. fuel

Mineral

fuels, lubric.etc

Animal fats,

oils etc

Chemicals

etc.

Manuf.

Goods.

Mach. &

trans. Equip.

Misc. manuf.

materials

Other

-5

0

5

10

Spain Ireland

Contribution to total export growth %pts%pts



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More importantly, a look at the composition of

exports also shows that growth has been quite

broad-based across product categories for Spain,

with the manufactured goods and machinery and

equipment sectors growing rapidly. With a large

part of its exports being intermediate goods, Spain

has entrenched itself well into the global and in

particular the European (led by Germany) supply

chain. Export performance has been patchier in

Ireland and Greece (see charts in appendix) where

growth has been driven by a few sectors even as

others have performed relatively poorly. Among

the periphery Eurozone countries, only Portugal

has shown a similarly strong performance.

Spain has managed to maintain just under 2% share

in world exports throughout the crisis. What really

explains this performance? This can be attributed to

the diversification of Spanish exports, with the fast-

growing emerging markets forming a much larger

proportion of total exports for Spain (19.1% of total

exports) as compared to Ireland (10.0%) and

Portugal (10.4%). In addition, both the US and

Germany, which are also witnessing a healthy

recovery in growth together account for around

16% of Spanish exports.

16. Spain exports more to the faster growing regions of theworld

0

4

8

12

16

20

Spain Portugal

0

4

8

12

16

20

Eastern Europe China India

Other Asia LatAm Middle East

% total% to tal Merchand ise export dest ination


In our view, this greater exposure to emerging

market exports also makes Spains export-led

growth story more durable. Emerging markets do

not have to deal with the problems of high debt

and de-leveraging like western economies and

with tight labour markets and incomes rising

sharply, growth in these economies remains on a

firmer footing when compared to that indeveloped economies.

In addition, we believe that emerging markets are

likely to better withstand the inflationary impact

of higher international commodity prices. (See

Global impact of higher oil prices, its not a

happy ending, published on 25 February 2011).

Strengthening growth in core Europe and in

emerging markets is also beginning to benefit

Spains tourism sector, which could provide some

welcome support to Spanish growth over the

coming quarters.

There are also concerns that interest rate hikes

could de-rail the fragile stabilisation process in the

Spanish housing market, which might ultimately

impact the banking sector. In particular,

households ability to meet higher repayment

obligations is being questioned, and with it the

health of the Spanish banks balance sheets.Floating rate loans form over 80% of all new

housing loans in Spain and in the past changes in

15. Spains exports by destination

France

21%

LatAm

6%

Other Asia

4%

US

4%

Japan

1%

CEE

6%

Oth.

Western

Europe

11%

Germany

12%

Oth. EMU

30%

ME 5%

France

21%

LatAm

6%

Other Asia

4%

US

4%

Japan

1%

CEE

6%

Oth.

Western

Europe

11%

Germany

12%

Oth. EMU

30%

ME 5%

Source: Eurostat.
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the policy rate and euribor have fed through much

more quickly into Spanish mortgage interest

payments than in other parts of the Eurozone.

17. Spanish household mortgage rates likely to rise onlymoderately with the ECB rate tightening

0

12

3

4

5

6

03 04 05 06 07 08 09 10 11

0

12

3

4

5

6

Spain 3mth EURIBOR

%% Interest rates: outstanding housing loans to HHs

Source: BoS, HSBC

We believe that the impact of ECB tightening on

mortgage delinquencies will be limited.

To begin with, there is anecdotal evidence to

suggest that domestic Spanish banks are beingmore lenient in terms of repayment of loans;

allowing for soft extensions of repayment dates as

well as lowering interest repayments. As a result,

we do not expect banks to be fully able to pass on

the rise in euribor rates into mortgage rates.

While the three-month euribor rate fell below

1.0% in late 2009, mortgage rates failed to do so,

leading to a widening in the spread between the

mortgage rate and the three-month euribor rate.

The rise in euribor rates now then is more likely

to see this margin beginning to fall.

Our own and consensus expectation is for ECB to

tighten only moderately over the next two years.

This together with only partial pass-through of

interest rate rises should help keep debt servicing

costs low in Spain. Furthermore, according to the

Bank of Spain, debt servicing costs are now lower

(chart 18) as is the annual theoretical effort for

households, (ATE)2

have fallen dramatically from

around 53% at end-2008 to 33% as of end-2010,

making it easier to service household debt.

In addition, around 70% of housing in Spain is

owner-occupied and has a much higher equityinvestment by households (mortgages in Spain

has a typical LTV ratio of around 58%). We

would expect Spanish households to continue to

try to meet these mortgage payments, using their

high savings rates if required. (Spanish

households savings are around 14% of

households disposable income).

In our view, a modest ECB tightening cycle then

is unlikely to have a really big impact on Spanish

recovery, with markets possibly being overly

concerned about the detrimental impact of rate

hikes. Instead we are more concerned about the

achievability of fiscal consolidation plans by the

Spanish government over the coming year.

18. Spanish debt servicing costs have fallen

0.0

4.0

8.0

12.0

16.0

20.0

Mar-00

Mar-01

Mar-02

Mar-03

Mar-04

Mar-05

Mar-06

Mar-07

Mar-08

Mar-09

Mar-10

0

4

8

12

16

20

Total debt burden3-month Euribor rate (RHS)Interest burden

% GDI %

Source: BDE

______________________________________2 ATE is defined as gross amount of instalments payable by an average

household during the first year following the purchase of a standard

dwelling financed with a standard loan for 80% of the value of the

dwelling, as a percentage of the households annual disposable income.


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The blind spotThe perils of fiscal federalism

Both the UK and Spain embarked on austerity

measures around the same time, but questions

about Spains ability to meet its targets have

persisted, while UKs austerity plans are

questioned much less.

A healthier banking sector in the UK is certainly

part of the explanation, but an equally if not more

important difference has been the centralisation of

fiscal decisions in the UK. Spain, on the other

hand, has a system of fiscal federalism that

include besides the central government, 17

autonomous Communities and 2 autonomous

cities at the regional level and 50 provinces and

over 8000 municipalities at the local level.

In 2010, these autonomous regions failed to meet

austerity targets and general government targets

were only reached as the Spanish central

government overachieved on its deficit reduction

target. However, there are clear reasons to worry

that the central government might not be able to

repeat this feat in 2011, when the deficit reduction

is expected to come through the more tricky

expenditure cutting rather than revenue raisingmeasures. In addition, historically autonomous

regions have been very poor in meeting deficit

targets even when the economy was doing well. In

fact, in Q1 2011, the central government posted a

budget deficit of 0.6% of GDP.

Under the federal structure, the system of sharing

expenditure responsibilities and tax revenues is

quite complex, with regional and local

governments having their own sources of revenue

besides the transfers that they receive from the

central government. As a result, the regional and

local governments account for over 50% oftotal expenditure.

A new fiscal equalisation system for regional

governments came into force at the end of 2009

(fully implemented in 2011) that has led to further

autonomy for regional governments in terms of

funding arrangements, with the regional

governments now having greater control over tax

receipts. For example, regional legislatures are

now able to set personal income tax rates as long

as they maintain the progressive tax structure.

Regional governments also get a larger share of

various types of tax revenues including VAT.

20. Autonomous governments have repeatedly missedtargets historically

-4

-3-2

-1

0

1

2007 2008 2009 2010 2011

-4

-3-2

-1

0

1

Year-beginning target Actual

% GDP% GDP Autnomous regions

Source: Ministry of Finance

The central government has effectively lesser

power over the actual spending and revenue

decisions related to the budget. But, the Budgetary

Stability Law (2007) gives the central governmentsome oversight over the fiscal management

decisions of the regional governments.

19. General government targets were met due to centralgovernment overachievement

-10-8

-6

-4

-2

0

2

Tota l Central Regional

(autonomous)

Local Social security

-10-8

-6

-4

-2

0

2

Actual Year-beginning target

% GDP% GDP 2010 deficits

Source: Ministry of Finance


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Depending upon the pace of growth of the

economy, state governments have targets for

budget surpluses, balanced budgets or deficits. In

case these targets are exceeded, the regional

governments have to present economic adjustment

plans which are approved by the fiscal and

financial policy council (CPFF, Consejo de

Politica Fiscal y Financiera). The central

government has 50% of the votes in the council

and requires only one additional vote from

regional representatives to get a desired decision.

In the event that the fiscal progress of the regional

governments is not in line with the adjustment

plans, the central government through the CPFF

can impose additional consolidation targets. At

the same time, the central government has the

authority to refuse approval for debt issuance by

states that do not stick to fiscal plans.

Despite this oversight, however, there are clearly

loopholes that allowed regional governments to

breach their fiscal austerity targets, with nine out of

17 autonomous communities missing their deficit

reduction goals over 2010. This is possible as state

governments do not require central government

approval to issue short-term debt (a practice that

could have serious consequences in case sentiment

towards the Spanish sovereign deteriorated sharply).

In addition, Spanish regional governments also

avoid central government strictures by running

arrears on public spending (central government

outlays to the regions is based on estimated growth

targets rather than actual and these need to be paid

back in case the actual outcome is lower than

was anticipated).

For 2011, this de-centralised structure, especially

the loopholes surrounding central government

oversight of the regional governments fiscal

consolidation process poses problems. Not only

are the targets much more stringent at 1.3% ofGDP (2.4% in 2010) but each individual

autonomous community is required to meet these

targets rather than the aggregate.

The growing decentralisation, while aimed at

addressing the unique demographic characteristics

of various autonomous regions, complicates the

pursuit of fiscal consolidation. One of the biggest

problems with the current set-up is that there is a

mismatch between the expenditure and revenue

profiles for regional governments.

Regional governments are primarily responsible

for spending on health and education (these

together form over 60% or the bulk of spending

by the autonomous governments). Spending on

these two categories is driven by long-term

considerations. As this type of spending is not

really subject to inbuilt automatic stabilisers, they

are difficult to cut back during periods of

economic downturn. So to meet expenditure

cutting targets, regional governments are likely to

lean more heavily on capital spending cuts, which

might not be optimal when trying to foster

economic growth.


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On the other hand, regional governments have lost

a large part of the revenues that were linked to

construction and real estate. Now the main source

of income/funding for regional government are

tax revenues which are very pro-cyclical unlike

expenditure and imply that to meet fiscal austerity

targets, there is an over-reliance on tax increases

even during periods of economic slowdown.

While the central government has repeatedly

indicated that it is ready to use its powers of

oversight to ensure that the regional governments

stay true to fiscal austerity targets, its minority

rule in the parliament does limit the power it can

wield over regional allies.

And political considerations could yet complicate

the process. With elections scheduled to take

place at a regional level later this month (22

May), there is the possibility that regional

governments will choose to follow populist

policies to win elections.

The bigger worry is that new governments will

reveal larger deficits than previously estimated (as

happened in Catalonia following the elections in

November 2010 when the deficit was revised up

from 2.4% to 3.9%). This would raise serious

jitters about Spains fiscal austerity programme.

In fact, the new government in Catalonia has

indicated that it is unwilling to cut public

spending more than the 10% already planned and

which raises the possibility of missing its deficit

reduction target (to 1.3%) in case revenues fail to

pick up strongly. There is little reason to believe

that other newly installed regional governments

might not choose to do the same.

As we are not political analysts, it is difficult for

us to gauge whether various regional governments

are truly committed to fiscal reduction targets. In

addition, the lack of transparency in terms of

fiscal performance of regional governments (data

is only released at the end of the year, although

the central government is now trying to get

quarterly releases) makes it difficult to monitor

the situation objectively.

However, if we were to put the current situation in

simplistic terms, it becomes clearly obvious that

strong tax revenue growth seem essential for

success at the regional level in fiscal austerity

terms. This is once again is inextricably linked to

the health of Spanish recovery.

21. Draft 2011 budget: highlights

Full details of 2011 budget were announced on Sept 30th

Final approval by parliament expected in December

New measures

Public spending, excluding autonomous regions, to be cut by 7.9% to EUR122bn in 2011.

Ministry spending to be cut on average by 16%.

Hopes to raise EUR170-200mn from higher earners (as income tax for those earning more than EUR120,000 rises from 21.5% to22.5% and for those earning more than EUR175,000 rises from 21.5% to 23.5%).

Housing investment personal income tax deductions eliminated for incomes over EUR24,170.

Minimum and non-contributory pensions to rise 1% in 2011.

Previously announced measures

Suspend annual pension increase in 2011, except in case of non-contributory and minimum pension payments.

Eliminate the EUR 2,500 payment on birth of babies as of 1 January 2011.

Eliminate retroactive payments for those people claiming carers allowance. Cut pharmacy costs, including revising medicine prices.

Forecasts additional EUR1.2bn savings from regional and local governments.

Source: Ministry of Finance, Spain


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ConclusionSpain has been distinguishing itself from other

periphery countries by taking important steps in

both banking sector restructuring as well as its

fiscal consolidation effort. Weak spots in the

economy still persist with both the labour market

and housing sector likely to see extended periods

of weakness. But we do not feel that the start of

the ECB rate tightening cycle will undermine the

fragile recovery or the fiscal consolidation targets.

We do believe, however, that there are clear risks

associated with the existing fiscal structure in

Spain that in a way leaves the decisions about

fiscal consolidation targets in too many hands.

Once again, for Spain to continue to distinguish

itself from other peripherals a clear necessity over

the coming quarters will be continued recovery of

the Spanish economy.


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AppendixWeak spots persist, but aremanageable with growth

Labour markets are still struggling

The Spanish labour market remains weak overall.

Non-financial corporate balance sheets have been

strengthened through labour shedding. This in turn

has resulted in the ratio of profits to total wage

payments rising to its highest level since Spain

joined the Eurozone. The pace of de-leveraging in

the private sector also suggests that this situation is

unlikely to change drastically over the

coming quarters.

22. Improvement in corporate profitability has come at the costof wages

50

52

54

56

58

60

62

64

01 02 03 04 05 06 07 08 09 10 11

50

52

54

56

58

60

62

64

Profits/wages %%

Source: BoS, HSBC

There seem to be some initial signs of stabilisation

emerging for labour markets. The unemployment

rate has hovered around 20.5% for nearly threequarters now. In addition, part-time employment has

risen on a yearly basis for the past four quarters. The

employment components of the Spanish PMI

surveys also show some stabilisation of employment

in the manufacturing sector though this is yet to

spread to the services sector. The government has

also pushed through labour market reforms that

make it easier to hire and fire permanent workers

that should help improve labour market flexibility

(by reducing the number of days of severance thatneeds to be paid). Negotiations are also ongoing for

reforming the wage setting process that would

encourage firms to take on more permanent staff.

But scratching beneath the surface reveals a picture

that is still fragile. The participation rate has fallen

for three consecutive quarters, last seen only during

the height of the crisis in 2009. In short, disillusioned

workers are still leaving the labour force. At the

same time, the labour market reforms introduced

have yielded little result so far, with permanent

employment continuing to fall and the youthunemployment rate over 30%.

23. Spanish labour markets remain very weak, with participationfalling and construction employment a real worry

Spanish Employment

-30

-20

-10

0

10

20

00 01 02 03 04 05 06 07 08 09 10 11

50

52

54

56

58

60

62

Total (LHS) Industry (LHS)Construction (LHS) Services (LHS)Participation rate (RHS)

% yr %

Source: INE, HSBC

The biggest challenge to the labour market outlook,

however, remains the loss of employment in the

construction sector. During the boom period,

construction accounted for over 13% of total Spanish

employment. This share has already dropped to

around 8.5% and the pace of job losses acceleratedin Q4 2010, although it has moderated again in Q1

2011. The outlook for construction investment

remains bleak as even public sector investment is cut

back under the austerity drive and some of the loss in

employment in this sector look to be permanent.

Stabilisation of the labour market then depends upon

the ability of other sectors to create employment,

which is inextricably linked to continued recovery of

the Spanish economy.


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and housing sector recovery remainsfragile

The inter-linkages between the housing sector and

labour market developments are intuitive enough.

But this becomes most evident when one looks at the

chart below that shows how mortgage delinquencies

are very closely linked to the unemployment rate.

24. Delinquencies are linked closely to the unemployment rate

0

1

2

3

45

6

Mar-90

Dec-91

Sep-93

Jun-95

Mar-97

Dec-98

Sep-00

Jun-02

Mar-04

Dec-05

Sep-07

Jun-09

8

10

12

14

16

1820

22

Doubtful HH loans/Total HH loans

Unemployment rate (RHS)

% %

Source: BoS, HSBC

According to Bank of Spain estimates, there were

still between 0.7mn to 1.1m unsold housing in Spain

as of Q3 2010 that needed to be worked through the

system. As a result, housing sector activity remains

weak in Spain.

Demand for property is likely to remain sluggish

given the continued uncertainty related to the labour

market and the withdrawal of personal income tax

house purchase relief for incomes above a certain

threshold that came into effect on 1 January 2011. Inaddition, the latest release on the ECB bank lending

survey also suggests that bank lending for house

purchases is generally beginning to ease across the

Eurozone as austerity begins to bite and there is little

reason to believe that Spain will be any different.

Given the substantial overhang of supply in the

system and the still anaemic levels of demand, the

decline in house prices from the peak in 2007

according to TINSA estimates of around 19% seems

low. This is especially true when compared to the

much more substantial declines seen in other

countries that also saw real estate bubbles (peak-to-

trough decline of 32% in the US).

The national house price move, however, masks the

very strong divergences between the cities and the

coastal regions where the declines have been much

sharper. In addition, price declines for the real estate

sector, especially the undeveloped land sector, is

much higher at around 30-35%, although getting an

accurate picture is difficult with transactions

being limited.

All of these factors together suggest that house

prices are likely to continue to decline over the

coming years. However, we do not expect there to

be any sharp, disorderly declines in prices, with

housing activity also starting to bottom out. The

distressed sales of houses are limited with the

banking sector willing to hold their real estate

portfolios on their books. In addition, recent Bank of

Spain requirements have seen banks already

provision for around 30% decline in real estate

portfolios. Any pick-up in growth and a resulting

improvement in labour markets and housing demand

will only help stabilise the picture further.


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Table 1: Key forecasts for Spain

% Year 2010 2011f 2012f Q1 11 Q2 11f Q3 11f Q4 11f Q1 12f Q2 12f

Consumer spending 1.2 0.6 0.7 1.0 -0.2 1.0 0.7 0.6 0.5Government consumption -0.7 -1.8 -1.0 -0.7 -2.3 -2.2 -1.8 -1.6 -1.2Investment -7.0 -3.6 0.8 -4.7 -5.2 -3.0 -1.6 -0.6 0.5Domestic demand -1.0 -1.0 0.5 -0.8 -2.1 -0.8 -0.5 0.0 0.5Exports 10.3 7.3 4.0 7.7 7.8 8.6 5.4 4.5 4.1Imports 5.4 1.2 1.9 1.8 -1.9 3.0 1.8 1.7 1.8GDP -0.1 0.8 1.0 0.9 0.8 0.9 0.8 0.7 0.8GDP (% quarter) - - - 0.3 0.2 0.1 0.0 0.3 0.4Industrial production 0.9 0.7 3.2 0.4 -0.6 1.1 1.8 3.2 2.5Unemployment (%) 20.1 20.4 19.8 20.5 20.4 20.3 20.2 20.1 19.9Average earnings 1.2 1.0 1.0 0.8 1.0 1.2 1.0 1.0 1.1Consumer prices 2.0 2.7 1.7 3.2 2.8 2.9 2.2 1.9 1.7Trade account (EURbn) -52.3 -42.9 -11.6 -10.0 -11.0 -10.2 -11.7 -10.4 -12.0

Current account (EURbn) -47.7 -38.9 -40.5 -11.0 -9.6 -9.3 -9.0 -11.2 -10.6Current account (% GDP) -4.5 -3.5 -3.6 - - - - - -Budget balance (% GDP) -9.2 -6.7 -5.8 - - - - - -

Source: HSBC estimates. *period-end

Box 1: Irelands story

In terms of fiscal metrics, Ireland started out from a position of greater strength. The debt/GDP ratio at 25.0% in Ireland in 2007 was better thanthe 36.1% in Spain in 2007. As the crisis unfolded, Irish authorities undertook drastic austerity measures to deal with a deteriorating fiscalsituation. The initial response was to guarantee banks liabilities; following which the National Asset management Agency (NAMA) was set up topurchase an initially estimated EUR 82.5bn of property related assets.

Since then, losses on the real estate portfolio, a run on deposits and a rise in contingent liabilities pushed up expectations of further capital

requirements, with additional capital injections of EUR 46.3 bn required that added 29 ppts to the government debt/GDP ratio and a contractingeconomy saw the government deficit explode to 32.4% in 2010 from 14.3% in 2009.

More recently, Irish central bank stress tests (March 2011) and an increase in core capital ratios now show that an additional EUR 24 bn capitalinjection is required. At present, this seems manageable as it can be fully covered by the EUR 35 bn banking sector support that will be extendedto Ireland under the IMF/ECB/EU programme.

Source: IMF


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Table 2: General government accounts in 2010

______________________ % of GDP _____________________2009 2010

Revenues 34.7 35.7Taxes 18.3 19.5

Direct 9.6 9.4Indirect 8.7 10.1

Social contributions 13.3 13.2Other revenues 3.1 3.0

Expenditures 45.8 45.0Public Consumption* 20.6 20.1Public Investment 4.4 3.4Interest Payments (EDP) 1.8 1.9Social Benefits 14.5 15.2Other expenses 4.6 4.1

Balance (EDP) -11.1 -9.2Levels of government

Central government -9.3 -5.0Autonomous communities -2.0 -3.4Local government -0.6 -0.6Social Security administration 0.8 -0.2

Note *Excluding the gross operating surplus of general government, other indirect taxes and sales of productionSource: Spanish Stability Programme 2011 - 2014

Table 3: Budget for 2011

___________________ State budget in 2011 __________________ _______Budgets of the Autonomous Communities in 2011 _____EURmn EURmn

Initial budget 2011 Initial budget 2011

Revenues 106,020 Revenues 115,607Taxes* 91,381 Taxes*** 75,817Other revenues 14,639 Transfers and Other Revenues 39,790

Expenditures 150,056 Expenditures 124,915Personnel and Purchasing 30,367 Personnel, Purchasing and Economic

Agreements69,321

Interest Payments 27,421 Interest Payments 2,956Investment 5,817 Investment 8,941Transfers** 83,980 Transfers*** 43,619Contingency Fund 2,472 Contingency Fund 78

Cash Balance - 44,036 Cash Balance - 9,307National Accounts Adjustment 19,648 MemorandumNational Accounts Balance - 24,388 Primary balance - 6,351MemorandumTerritorial Administration Taxes 47,712Total Taxes 158,799

Territorial Administration financing 52,594Expenses excluding Territorial Admin. Financing 126,594Primary expenses excluding Ter. Admin. Financing 107,340

Note: *Includes contributions to "Clases Pasivas", **Current and capital, ***Current and capitalSource: Spanish Stability Programme 2011 - 2014


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25. Spains export performance has been relatively more broad-based

0

5

10

15

20

25

30

35

Food &

animals

Bevs. &

Tobacco

Crude

materials,ex. fuel

Mineral

fuels, lubric.etc

Animal fats,

oils etc

Chemicals

etc.

Manuf.

Goods.

Mach. &

trans. Equip.

Misc. manuf.

materials

Other

0

1

2

3

4

2010 weight (LHS) Contribution to 2010 growth (RHS)

Spain %pts% total

Source: Eurostat

26than that of Greece

-5

0

5

10

15

20

25

Food &

animals

Bevs. &

Tobacco

Crude

materials,

ex. fuel

Mineral

fuels, lubric.

etc

Animal fats,

oils etc

Chemicals

etc.

Manuf.

Goods.

Mach. &

trans. Equip.

Misc. manuf.

materials

Other

-1

0

1

2

3

4

5


%pts% total Greece

Source: Eurostat

27. ....or even Ireland

-40-30-20-10

010203040506070

Food &

animals

Bevs. &

Tobacco

Crude

materials, ex .fuel

Mineral fuels,

lubric. etc

Animal fats,

oils etc

Chemicals

etc.

Manuf.

Goods.

Mach. &

trans. Equip.

Misc. manuf.

materials

Other

-4-3-2-101234567


%pts% total Ireland

Source: Eurostat


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28. Only Portugal has shown a similarly broad-based recovery

0

5

10

15

20

25

30

Food &

animals

Bevs. &

Tobacco

Crude

materials,ex. fuel

Mineral

fuels, lubric.etc

Animal fats,

oils etc

Chemicals

etc.

Manuf.

Goods.

Mach. &

trans. Equip.

Misc. manuf.

materials

Other

0

1

2

3

4

5


%pts% total Portugal

Source: Eurostat

29. Spanish part-time, temporary employment has picked up strongly

-15

-10

-5

0

5

10

15

20

Q106

Q206

Q306

Q406

Q107

Q207

Q307

Q407

Q108

Q208

Q308

Q408

Q109

Q209

Q309

Q409

Q110

Q210

Q310

Q410

Q111

-15

-10

-5

0

5

10

15

20

Total Permanent Temporary contracts

Spain:part-time employment % Yr% Yr

Source: INE, HSBC

30. ...but full-time permanent employment is yet to start growing

-25

-20

-15

-10

-5

0

5

10

15

Q106

Q206

Q306

Q406

Q107

Q207

Q307

Q407

Q108

Q208

Q308

Q408

Q109

Q209

Q309

Q409

Q110

Q210

Q310

Q410

-25

-20

-15

-10

-5

0

5

10

15

Total Permanent Temporary contracts

Spain:Full-time employment % Yr% Yr

Source: INE, HSBC


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31. Spanish banks are reducing their leverage, though this is more pronounced for the commercial banks

80%

90%

100%

110%

120%

130%

140%

150%

160%

03 04 05 06 07 08 09 10

80%

90%

100%

110%

120%

130%

140%

150%

160%

Banks Cajas

Loan-to-deposit ratio

Source: Bank of Spain

32. Spanish commercial banks have been able to attract more deposits

-10%

0%

10%

20%

30%

40%

03 04 05 06 07 08 09 10

-10%

0%

10%

20%

30%

40%

Banks Cajas

Deposits growth y-o-y

Source: Bank of Spain

33. Spanish MFIs are now reducing the relative size of their balance sheets

200%

250%

300%

350%

01 02 03 04 05 06 07 08 09 10

200%

250%

300%

350%

MFI balance sheet

% GDP % GDP

Source: Thomson Reuters Datastream


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34. Pace of house price declines is easing 35. Housing starts remain anaemic but are stabilising

-20

-10

0

10

20

30

03 04 05 06 07 08 09 10 11

-20

-10

0

10

20

30

% Yr % YrHouse prices

0

20

40

60

80

100

120

140

99 00 01 02 03 04 05 06 07 08 09 10

0

20

40

60

80

100

120

140

Total houses 12m mov avg

'000 Houses under construction '000

Source: Source: TINSA Source: Bank of Spain

36. House price affordability has improved 37. ATE has fallen sharply

7

8

9

10

11

12

13

99 00 01 02 03 04 05 06 07 08 09 10

7

8

9

10

11

12

13

Affordability rat io 4Q mov avg

Affordability ratio (house price/disposable income)

15

30

45

60

95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10

15

30

45

60

Annual theoretical effort w ithout deductions*

Annual theoretical effort w ith deductions

Source: Bank of Spain Source: Thomson Reuters Datastream

38. Construction sector confidence indicators showweakness reflecting concerns about fiscal austerity impact

39. Both the private sector and government are de-leveraging, helping improve the current account position

-60-50-40-30-20-10

010203040

Q32000

Q32001

Q32002

Q32003

Q32004

Q32005

Q32006

Q32007

Q32008

Q32009

Q32010

-15

-10

-5

0

5

90 92 94 96 98 00 02 04 06 08 10

-15

-10

-5

0

5

%GDP%GDP Current account

Source: Thomson Reuters Datastream Source: Thomson Reuters Datastream


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Disclosure appendix

Analyst Certification

The following analyst(s), economist(s), and/or strategist(s) who is(are) primarily responsible for this report, certifies(y) that the

opinion(s) on the subject security(ies) or issuer(s) and/or any other views or forecasts expressed herein accurately reflect their

personal view(s) and that no part of their compensation was, is or will be directly or indirectly related to the specific

recommendation(s) or views contained in this research report: Madhur Jha

Important DisclosuresThis document has been prepared and is being distributed by the Research Department of HSBC and is intended solely for the

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Disclaimer

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Global

Stephen KingGlobal Head of Economics+44 20 7991 6700 [email protected]

Karen WardSenior Global Economist


Madhur Jha+44 20 7991 6755 [email protected]

Europe

Janet HenryChief European Economist+44 20 7991 6711 [email protected]

Astrid Schilo+44 20 7991 6708 [email protected]

Germany

Lothar Hessler+49 21 1910 2906 [email protected]

FranceMathilde Lemoine


United KingdomStuart Green+44 20 7991 6718 [email protected]

Andrew Grantham+44 20 7991 2170 [email protected]

North America

Kevin LoganChief US Economist+1 212 525 3195 [email protected]

Ryan Wang+1 212 525 3181 [email protected]

Stewart Hall


Asia Pacific

Qu HongbinManaging Director, Co-head Asian Economics Research andChief Economist Greater China

+852 2822 2025 [email protected]

Frederic NeumannManaging Director, Co-head Asian Economics Research+852 2822 4556 [email protected]

Leif EskesenChief Economist, India & ASEAN

+65 6239 0840 [email protected]

Paul BloxhamChief Economist, Australia and New Zealand+61 2925 52635 [email protected]

Donna Kwok+852 2996 6621 [email protected]

Sherman Chan+852 2996 6975 [email protected]

Wellian Wiranto+65 6230 2879 [email protected]

Seiji Shiraishi+81 3 5203 3802 [email protected]

Yukiko Tani+81 3 5203 3827 [email protected]

Sun JunweiAssociate

Sophia MaAssociate

Global Emerging Markets

Pablo GoldbergHead of Global EM Research


Emerging Europe, Middle East and Africa

Alexander Morozov


Murat Ulgen+90 212 376 4619 [email protected]

Simon Williams+971 4 507 7614 [email protected]

Liz Martins+971 4 423 6928 [email protected]

Latin America

Argentina

Javier FinkmanChief Economist, South America ex-Brazil+54 11 4344 8144 [email protected]

Ramiro D BlazquezSenior Economist+54 11 4348 5759 [email protected]

Jorge MorgensternSenior Economist


BrazilAndre LoesChief Economist


Constantin JancsoSenior Economist+55 11 3371 8183 [email protected]

Marcos Fernandes+55 11 6847 9787 [email protected]

MexicoSergio MartinChief Economist+52 55 5721 2164 [email protected]

Central AmericaLorena DominguezEconomist+52 55 5721 2172 [email protected]

Global Economics Research Team
mailto:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]

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