Sustained period of GDP growth above 3% — check. Continually falling unemployment — check. Considerable progress in fixing the banking sector — check. Ten-year government yield falling from 4% to less than 1.5% — check. For over two years Spain has continually been one of the fastest growing economies in the euro area. In the second quarter of 2017 Spain recorded quarterly growth of 0.9%, above the already impressive 0.6% average for the whole of the euro area.
This notwithstanding, Spain’s unemployment rate still stands at 17%, the highest rate among major euro area countries apart from Greece. Additionally, the level of GDP, measured in constant prices, has only just now, in the second quarter of this year, exceeded its pre-crisis peak. It is still almost ten percentage points below that of Germany and three percentage points below that of the euro area as a whole. Can Spain’s economy continue to catch up? Answering this question requires analysing the drivers of Spain’s economic recovery.
Looser policy, both fiscal and monetary, has been one contributor to Spain’s impressive growth performance. Our Fathom Macroeconomic Policy Indicator (FMPI), which weights together both fiscal and monetary policy to give a gauge of a nation’s macroeconomic policy stance, indicates that the magnitude of austerity in Spain, like in most other euro area countries, has fallen. This has supported economic growth. As have low real interest rates.
The banking sector played an even bigger role in the impressive recovery of the Spanish economy, in our view. As Spanish banks played a crucial role in fuelling the house price bubble in the period leading to 2008, the subsequent bust brought lenders to the edge of collapse. As the doom loop between the banks and the sovereign, i.e. the weaker the sovereign the weaker the banks, and the weaker the banks the weaker the sovereign, took hold, Spain required a bailout from European authorities. In June 2012, a €100 billion rescue package to prop up failing Spanish banks was agreed by euro area finance ministers. The restructuring of many banks and cajas, or savings banks, and nationalisation of Bankia, the country’s largest mortgage lender at the time, was supplemented by recapitalisation and guarantee of assets. This helped to ensure confidence in the financial sector did not evaporate. In the case of banks deemed non-viable, a speedy resolution plan was put in place. Most importantly a bad bank named SAREB was established to absorb the banks’ non-performing loans (NPLs) and soured real estate assets. With over €50 billion transferred to the part government- but majority privately-owned asset management company, banks were able to remove NPLs from their balance sheets and focus instead on restructuring and new profitable activities. Peaking in 2013, NPLs as a percentage of total gross loans were 9.4%. At the end of 2016 they had fallen back to 5.6%, just above the euro area average.
Disposing of NPLs as promptly as possible is crucial. As the graph below shows, the larger the share of NPLs in total gross loans, the less banks are willing to lend. This hurts businesses which require loans to grow, as well as consumption, which in turn undermines GDP growth. Although the amount of lending to residents is still contracting, the pace of decline has fallen substantially. Further progress in improving banks’ balance sheets and consolidating the Spanish banking sector would continue to support bank lending and hence economic growth.
Indeed, this year has already seen high volumes of transactions in distressed debt. Following the acquisition of Banco Popular, Santander was quick to begin the disposal of the non-performing assets it had acquired from the failing lender. Earlier this month, in a deal worth €10 billion Blackstone acquired a majority stake in Banco Popular’s real estate portfolio, including properties and loans. Some lenders prefer to keep soured assets on their books, either because they hope for a pickup in their prices or because they simply cannot afford to write them off and realise losses. In contrast, Santander has chosen what we view as the more successful approach. Selling NPLs for a lower price may be painful in the short run for a bank as it disposes of those assets below what the bank originally thought it would get for them. However, it is in the interest of the economy as a whole for banks to dispose of as many of their NPLs as quickly as possible.
Market clearing in Spain is evident not just in the banking sector but in the non-financial private sector too. Credit to the non-financial sector has fallen greatly from its peak in 2010 of almost 220% of GDP to the current level of under 170%. While the figure is still above the average for the euro area, credit has fallen substantially relative to income. In conclusion, prerequisites of both supply and demand for bank lending have strengthened.
Before the crisis, credit was channelled into inflating the housing bubble, as opposed to being allocated to productive assets, which increase the supply side of the economy and therefore its long-run output potential. Is this time different?
There is evidence that suggests that this time might indeed be different. While outstanding loans to non-financial corporations (NFCs) are still declining, the trajectory is positive. The twelve-month percentage change of loans to NFCs has risen from -20% in late 2013 to -4% in June 2017. Household loans for uses other than house purchases meanwhile have been growing for over a year now.
After consumption, investment has contributed the most to GDP growth since 2014. However, unlike in the run-up to the crisis, investment in the housing sector has been subdued. By contrast, evidence suggests that investment is going towards more productive assets. Gross fixed capital formation (GFCF) excluding dwellings as a percentage of GDP, has risen in the last three years or so, both measured in current and constant prices. This combined with the finding that the share of GFCF of dwellings in GDP has flatlined, when measured in constant prices, suggests that investment is allocated more efficiently this time.
Theoretically, it is the constant price series that matters. However, the GFCF deflator is notoriously difficult to measure as improvements in quality are especially challenging to take account of compared to the other components of GDP. Therefore, it is useful to look at GFCF data both in constant and current prices. Indeed, the share of GFCF of dwellings in GDP has risen to around 5% in 2017 Q2 from 4% in 2015 Q1 when measured in current prices. However, it is close to historical lows and far below its long-term average. So, in our view, evidence suggests that this time is different and investment has been allocated more efficiently.
Although investors have recognised the progress made by the Spanish economy and by its lenders they have remained cautious. Looking at an index of Spain’s seven biggest banks, since 2014, when the Spanish recovery started, Spanish banks’ share prices have outperformed those of euro area banks by around ten percentage points. This notwithstanding, they are 5% lower than they were in early 2014, and have performed worse than Italian and French banks over the same time period.
While the aggregate price-to-earnings ratio of Spanish banks is in line with those of other euro area countries, Spanish banks have the highest price-to-book ratio among those of major euro area countries on aggregate. However, there are important differences across Spanish banks, reflecting the strength of their balance sheets. When you compare the price-to-book values of individual banks, they more or less reflect the amount of their NPLs. In other words, banks with a high proportion of toxic loans as a proportion of total loans trade at lower price-to-book values. Anecdotally, as soon as Banco Popular was acquired, the next weakest lender, Liberbank was under pressure as it is the bank with the highest NPL ratio. Authorities were forced to introduce a ban on short selling to prevent the stock price from freefalling.
The substantial NPL burden of some banks highlights that Spain has not yet reached the end of the road. Further cleaning up of the balance sheets of Spanish banks would continue to support lending and investment, and hence economic growth and banks’ earnings.
While new regulation and much stricter controls on lending could foster more sustainable growth in the banking sector, there are some headwinds ahead. A low interest rate environment which, as our clients will be aware, we think is likely to remain for longer than markets currently anticipate, will continue to put pressure on the profitability of euro area, including Spanish banks.
Most importantly, Spanish lenders should be careful to not fall into the same trap as in the period leading up to the crisis. The loan-to-value ratio is at its pre-crisis level, having increased nearly 10 percentage points since late 2013. To quote the Spanish philosopher and novelist George Santayana: “Those who do not remember the past are condemned to repeat it.”
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