Sunday, September 02, 2012

The Catalan Bailout (XSiM, Xavier Sala i Martin)

31 August 2012

The Catalan Bailout

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For months, all major Spanish companies such as Telefónica, Gas Natural, Abertis, ACS, etc, have had the international financial markets closed. That is, private investors do not want to lend them money at any price. And this is independent of the sector in which they operate or the state of their economic health (after all, they all have run out of credit regardless of your industry and the state of their finances). The reason is simply that they are Spanish: investors think that the possible collapse of the Spanish economy puts Spanish corporations at risk of collapse and, therefore, they optimally choose not to lend them money. And that is true even if some of these companies (such as Telefónica or Natural Gas) derive most of their revenue from outside Spain. Moody's said it clearly makes a couple of months "Telefónica's rating can only be a step above the rating of the government of Spain."
I say this because the Catalan Government has officially announced that it will request access to the Liquidity Fund,a  fund that will be set by the Spanish government to help regional governments in financial distress. Catalunya said it would ask for 5,023 million euros. Although this decision has caused much media coverage, it is not the first time that the Catalan government applies for state funds. A couple of months ago it requested loans from ICO). Why? As most major Spanish companies that lost access to international private capital markets, Catalunya has lost access to bank credit. Hence, it has no other choice but to borrow from the state rescue fund created for such occasions.
Some (anticatalan) analysts have been quick to point to the Catalan embassies (especially the one New York), the budget of the Ministry of Culture and the alleged extravagance of the Catalan public TV, TV3, as culprits for Catalunya’s financial collapse. These arguments do not merit discussion because the size of these items is ridiculously small compared to the magnitude of the fiscal problem. However, it is relevant to ask: How did Catalunya end up here?
Part of the explanation can be seen by simply analyzing the evolution of total debt since 1997. I begin in 1997 because many analysts believe that year to be the beginning of the housing bubble. The first graph (above) shows the total debt of the Government in millions of Euros. The chart below shows the deficit of the Government relative to GDP. The source of both graphs is data from the Bank of Spain (links to total debt and debt relative to GDP).

Between 1997 and 2003, when Jordi Pujol presided over the Generalitat, total debt remained relatively constant euros (just up from 9,200 million to 10,900 million euros) and, because GDP rose very rapidly due to the housing boom, the debt to GDP ratio fell from 9.7% to 7.4%.
Between 2003 and 2008 (during the triparty government Pascual Maragall and the frist two years of José Montilla), total debt increased from 10,900 to 15,776,000 euros, even though the economy was experiencing a major economic boom. And that is the first lesson to be learned. During good times governments should save money so that they have reserves during bad times. This is especially true during housing bubble. The reason is that all bubbles do come to an end. Hence, governments must realize that these episodes their tax revenues are abnormally high and, therefore, they should not commit to high permanent spending.
However, instead of saving, the Catalan government squandered the temporary windfal. And not only that, it spent much much more than it collected to the point that its debt increased by almost 50%. We all know the waste list: construction of airports with no plains and other absurd infrastructure, massive waste in a useless Forum of Cultures, increased health spending as if the boom were to last forever, government hiring friends, relatives and political affiliates, advertising campaigns for electoral purposes, metro stations decorated by the the world’s best and most expensive architects and designers, and even a “sustainable” minister designing his own office building Feng Shui-style (with a total cost of 42 million euros of taxpayers’ money). In short: a shameful display of scant respect taxpayers and their money.
All this continued until, of course, the bubble burst and the recession arrived. It was the second half of 2008. The crisis involved plummeting tax revenues. As the Government had committed to large spending and it didn’t take the recession seriously (so it did not cut back), public debt shot through the roof: from 15,776 in 2008 to 34.229 million euros. The debt when President Montilla left had doubled during his fours years in office  and tripled the debt when his party arrived at the Generalitat in 2003. As a percentage of GDP, Catalan debt had increased from 7.4% to 17.3%.
Artur Mas came to office in 2010. Although he quickly embrace German austerity, debt has continued to grow and has now reached 42,000 million (21% of GDP) according to the latest figures from the Bank of Spain. How can that be? Well, as I have explained many times in this blog, austerity, no matter how necessary it may be in the medium and long term, tends to deepen economic contractions in the short term. Hence, the austerity imposed by the Catalan government has worsened the recession and, therefore, public revenue has continued to fall. If, on top of that, the interest payments increase because the risk spread and because total debt is bigger, we have that public debt continues to rise despite the austerity measures. Looking at the data, however, it is true that during the first few months of 2012 debt seems to have stopped its exponentially growing trend. We'll see how it ends.
Conclusion: the first main cause of the financial situation of the Catalan Government is the Catalan Government’s wild extravagance and its inability to save during the bubble year. Catalan citizens must understand that the level of public spending (health, education, cultural, academic, infrastructure, etc.) reached in 2007 was not sustainable and must be reduced going forward.
That said, the increase in debt experienced by Catalunya, whether it was caused by mismanagement or not, can not by itself explain the loss of access to capital markets by  Catalonia. After all, a public debt to GDP ratio of only  21% is very small compared with the debts of all countries in Europe and almost every country in the world. Yes, I know that Catalonia is not an independent country and if it were, it would have face more obligations and, therefore, more spending (the share of spending that is now faced by the Spanish state). But it would also have more revenue. In particular, the revenue which now goes to the central administration to pay those obligations as well as all the money that now goes to the “solidarity funds” that subsidize other regions. Hence, if Catalonia was an independent state and its government debt were only 21% of GDP and if, in addition, its deficit was between 1.5 and 3% of GDP (as it is now) it would be considered one of the healthiest economies the world and the financial markets would be fighting to lend it money. Why don’t markets, therefore, want to lend to Catalunya? The reason is simple: because it is not an independent state. Instead, it is part of Spain. And this simple fact has at least three important consequences.
First, for reasons that are beyond all rationality, the government of Spain has been telling everyone that the main culprit of Spain’s budget deficit are the regional governments. This, in spite of the fact that 60% the total deficit corresponds to the central government! And of course, by repeating this mantra over and over again in all international forums, the markets have turn off the tap to ... (surprise??) the Regional Governments!
The second consequence of being part of Spain is that markets know that the taxes paid by citizens and corporations in Catalonia are not managed by the Generalitat. Instead, the money goes to Spain and it is the Spanish government that decides how much money goes back to Catalunya. It is estimated that, on average, only 60% of the axes paid by Catalan citizens and businesses goes back to Catalunya after the central government “redistributes” revenue across regions.
Obviously, if Catalonia was an independent state, its fiscal revenue would have been reduced during the recession. This happens to all countries. The problem of Catalunya is that, on top of that, it suffering falling revenue from a grim regional-financing system that allows up to 40% of the taxes collected in Catalonia disappear. As the Telegraph (a British Newspaper) puts it: “the Catalans have been forced by the perversities of Spain’s tax system to request a "rescue" even though they subsidize the rest of the country!”
The problem is that the markets do not see an end to this situation any time soon.
How would Catalunya have performed had it been independent? Hard to say. But maybe it is worth spending a few minutes analyzing the performance of another region, with a different financing status (it does not have to give all its revenue to the central government) and a similar level of commitments (education, health, police, etc.): The Bask Country.
In 1997, the difference between the Catalun and Basque debt to GDP ratio was about 2 percentage points (10% of GDP in Catalunya vs 8% in the Basque Country). By the time the recession started in 2007, that gap had widened to 7 percentage points (8% vs 1% in Catalunya Basque). From then on, the debt of both regions soared (which shows that if Catalunya had the same system of the Basque Country, Catalan revenues would have fallen because of all public revenues of all economies do) but clearly the stock Catalan debt increased much more than that of the  Basque country: in 2011 the difference reached 12.6 percentage points. Catalan austerity slowed the growth its a bit so the difference with Basque debt in 2012 has been cut back sharply to 10.8 points. Hence, if Catalonia had had a funding mechanism similar to Basque country, its debt would have increased due to the bursting of the bubble,... but not to the levels that it actually reached.
The third consequence of belonging to Spain is the Spanish brand itself. Which brings us back to the big companies like Telefonica, Natural Gas or ACS, all of which have exceeding difficulties in finding financing abroad simply because they are Spanish. The problem is that being part of Spain at the moment is an expensive scourge as the entire world witnesses the deterioration of the Spanish political and institutional environment: the King is caught hunting elephants with a young German lady while his compatriots suffer the consequences of the recession, his son-in-law has been charged with corruption and embezzlement, the chief justice of the Supreme Court has been forced to resign because it used public money to finance romantic weekends with his bodyguard, the worldwide famous Baltasar Garzón, also a member of the supreme court, forced to resign for spying on lawyers, the Bank of Spain carried stress tests and gauged that Bankia was safe just months before it collapsed. The CNMV (a supervisory institution) allows Bankia to go public even though it had information that it was insolvent, causing thousands of citizens to lose their lifetime savings as they rush to invest in this bank. The president of the CEOE (association of businessmen) Gerardo Diaz Ferran, charged with corporate fraud. The country’s principal banker Emilio Botin, boss of Santander, caught with a secret account with 2 billion euros in Switzerland. Governments of all parties doing the exact opposite of what they promised during their political campaigns. The current government postponing the presentation of the most important budget of the country‘s history in order to win a regional election in Andalusia. It is no wonder why, after witnessing the spectacular collapse and discredit of virtually all Spanish institutions, investors believe it is unsafe to lend to Spanish corporations and regional governments.
In short, despite the undeniable mismanagement by the Catalan Government during the boom years, the truth is that the incompetence and disloyalty of the central government, the faulty system of funding regional governments and the international spectacle of disrepute on the part of  key Spanish institutions made the need for a Catalan bailout all but guaranteed.
Many Spanish pundits say that the bailout demonstrates the failure of the growing Catalan indepedentist movement. I disagree. I’d say that the bailout is a win for independentists as it shows that Catalunya within the current Spain is unfeasible.  And so is Spain.

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