‘Lose-lose’ dilemma over Spanish cuts

After a short honeymoon with a right-wing government that was elected with a majority and promised to implement free-market reforms, investors are again looking at Spain just as a vegan would approach a meaty fabada asturiana (Spanish stew).

Yields paid by the Spanish Treasury to borrow from the markets have risen, and local equity markets have fallen, as doubts have been raised about the willingness of Mariano Rajoy, the prime minister, to implement tough measures to cut the country’s deficit.

Or has it been because his government is implementing austerity measures that are so drastic they are likely to further stifle Spain’s floundering economy?

Intriguingly perhaps, both explanations apply. The feeling that Spain is going to be punished no matter what it does was expressed by Luis de Guindos, the finance minister, during an interview with the Wall Street Journal Europe last week.

As the government prepared to make official a hard-as-nails budget, he said the country was facing a “lose-lose” situation when it comes to putting its finances in decent shape. (News analysis continues below)

Any sign of slack on Rajoy’s commitment to put the Spanish house in order, as when he asked the European Commission in March to relax deficit reduction targets, has the effect of spooking the markets.

But if the cutting and taxing go too far, the economy will fare even worse than it is has of late. “We have no margin for error,” Guindos said. Or, he might as well have added, for getting it right.

The austerity measures announced by the Spanish government certainly look dramatic. Rajoy aims to cut the public deficit from more than 8% of GDP in 2011, to 5.3% this year, a huge reduction, even though his target ratio is higher than the 4.4% originally demanded by the Eurocrats.

To achieve this, the government has announced tax rises for the middle classes and the rich, as well as for companies, which will see several corporate tax loopholes closed.

Ministries will have their budgets cut by an average of almost 17%, electricity bills will rise by 5-7%, and public investment will fall considerably. Rajoy has also, at least nominally, bought a fight to clean up the financial mess of Spain’s powerful and wasteful autonomous communities, many of which are led by parties not aligned with the government.

It is strong medicine to slash the public deficit by a total of €42 billion (£35 billion). The cuts and tax rises in the budget amount to €27.2 billion, while some €15 billion of other ­emergency austerity measures had been announced when Rajoy came to office.

But the sacrifice may fall short of the government’s goals. The targets will require the Spanish economy to meet growth forecasts of between 1.3% and 1.7%, which most analysts argue is unlikely to be achieved, especially considering the effects the tax rises and spending cuts will have on economic activity.

“It will be hard to meet deficit and GDP growth targets,” says Javier Andres, an economist at Universidad de Valencia. “One of them is likely to be missed, or even both.”

Before the budget was announced, BBBVA, a bank, forecast that Spanish GDP would shrink 1.3% in 2012, which would enable the government deficit to be brought down to the 5.3% of GDP it targeted. Such estimations could be revised downwards with the new ­budget. Others already sound much gloomier.

Standard & Poor’s, a rating agency, says the economy could contract by up to 4% this year if a worst-case scenario develops in the eurozone. In any case, Spain is likely to be the last large European economy to shrug off a recession, even after Italy, according to the firm.

Reasons to be bearish about the Spanish economy are not hard come by. As a rule, the state of the economy is dreadful, no matter where you look. Government demand for goods and services has been sliding, as have imports and exports.

Indicators of economic activity, such as electricity demand and industrial production, have fallen worryingly in the past nine months, after modest spikes early in 2011.

Consumers, who were among the main drivers of economic activity before the crisis, are keeping their wallets closed. La Caixa, a Barcelona-based bank, has noted that the drop in domestic consumption in January was even bigger than expected.

The banks’ analysts argue that consumers may have adopted a more cautious stance because of the uncertainties in the eurozone and their effects on the Spanish economy, and may have chosen to save rather than spend.

That would be the positive scenario, where consumption could resume quickly once confidence was restored. If the drop in consumption is owing to ever higher unemployment, however, perspectives for domestic demand would be much worse.

Recent unemployment data released by Eurostat, which has taken the Spanish rate to a terrifying 23.6% of the active workforce, ominously signalled that the latter scenario could actually be the case.

Huge unemployment levels have been among the main factors noted by analysts when they express their dismay about the prospects for Spain.

Earlier this year, Rajoy took advantage of a decisive election victory to launch a package of reforms that aim to make the country’s rigid labour laws more flexible.

Although the reforms fell short of the kind of liberalisation advocated by Anglo-Saxon economists, they represent remarkable progress in a country where workers are virtually impossible to fire after they have lodged some years with a permanent contract in a company.

However, even if the labour reforms prove to be a hit, their effects will take a while to be felt, Andres says.

Labour markets tend to react with some delay after the economy starts to recover, and the main question is really when that momentous time will come. “Fiscal policy that is so restrictive, in a context where the private sector is plunged into a deleveraging process, will accentuate the drop of domestic demand and the falls of GDP and employment levels,” says Angel Laborda, a director of Funcas, a think-tank.

“As a minimum, it could reduce GDP growth in 2012 by two percentage points,” he adds.

Not all the evidence is for the worse. La Caixa has noted that, even though the first statistics of the year remained negative, many of them, including an index of industrial confidence, were not as dreadful as in the fourth quarter of 2011. The bank hinted in a report released in March that the economy may have reached a turning point, although it stresses it is far too soon to say this with any kind of confidence.

And then there is the not so small matter of the still-to-be-completed restructuring of Spain’s banking sector. Dozens of mergers and acquisitions have taken place in the past two years, in a drive, accelerated by the present government, to boost the capital position of the entities that remain in the market.

But a shadow still hovers over the banking sector, in particular considering its huge portfolio of loans linked to the property sector, which went bust in catastrophic way in 2009.

Analysts argue that banks have not written off the full amount of losses they suffered with the bursting of the property bubble, to a great extent because they have gone to a tremendous effort to prevent property prices falling as much as they should.

In fact, property prices in Spain have fallen less than 25% since their peak, which for many analysts is simply preposterous, considering the size of the bubble. Hundreds of thousands of new flats remain unsold, and banks’ portfolios are packed with virtually valueless development land they had to take on after their clients defaulted on loans.

The most pessimistic commentators, such as the British-based think-tank Open Europe, reckon house prices in Spain are set to fall a further 35%, in which case the market would require the injection of dozens of billions of euros in extra capital.

The government – or, more likely, the EU’s stigmatising rescue instruments – would have to foot the bill.

“Much has been done in the restructuring of the banking sector, but there is still a way to go,” Laborda says.

“The problem is that, to go further than the latest measures, it would be necessary for the state, just like in other countries, to put more money on the table. The current government, as well as the last one, do no want or do not have the means to do it.”