Tuesday, 24 May 2011

Spain Still Has a Fighting Chance

In January this year I was invited to a CapitalWeek conference in Beijing to talk on the likely trajectory of Europe's financial crisis. Recall, if you can, those carefree days of January when Portugal could get 10yr money for sub-7%, Ireland for 8% and change, and even Greece's bonds sometimes dipped below 11%. Well, Europe was a bit off my geographic focus, but it seemed important, so I hashed out a simple methodology, under which I calculated a hurdle rate for nominal GDP growth, which, if a country hit it, it could stabilize its sovereign debt, but beneath which, the already-heavy debt burdens could only grow. That hurdle rate was essentially debt/GDP multiplied by market rates for 10yr sovereign debt.

Working out the likely trajectory then became a matter of judging whether it was plausible that a country could hit its nominal GDP hurdle rate any time in the foreseeable future.  Here's how it looked (then) for Portugal:
Back in January, you had to believe that Portugal could sustain nominal GDP growth of 6.2% to work down its sovereign debt burden.  Since the introduction of the Euro, Portugal has only very rarely managed that hurdle rate of nominal GDP growth, and it was inconceivable to me that it was going to do so any time soon. So the conclusion was obvious - sooner or later, the sovereign debt burden would break Portugal.  As it subsequently has. And as this reality sank in, so bond yields rose and pushed up the hurdle rate - at today's yields, it stands at 8.5%. Anyone think Portugal's going to grow at 8.5% nominal?

On this methodology, there were other victims: Greece (obviously),  Ireland (less obviously), and . . . Italy (I'm afraid).

But Spain - the current focus of market attention -  was a close call. It had a hurdle rate of only 3.7% - well within its recent historic experience, and, with a 20%+ unemployment ratio, damned easy if you closed the gap with potential output. And the curious thing is,  even though Spain is under the market cosh, the hurdle rate has risen only to 3.9%, whilst its 1Q GDP rose by a nominal 2.6%. More, since its capital stock is contracting by around 2.8% a year, Spain's ROA must be climbing structurally - which suggests short/medium term cyclical support. Here's how it looks now:

My conclusion is this: even if/when the People's Party is going to spend the next weeks finding stacks of IOU's down the back of the municipal sofa, Spain's sovereign debt has still got a fighting chance.

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