Almost a year on from the credit crunch, one verdict at least seems reasonably settled. The euro had a good crisis. Despite all the warnings, particularly from this country, about the system’s fragility, the single currency sailed through the collapse largely unscathed. The banking system didn’t implode. The European Central Bank dealt with the challenge smoothly. There were no rioters on the streets demanding the return of the deutschmark or the franc. If the key test of a currency is its ability to deal with tough times, then the euro appears to have acquitted itself.
But hold on. Maybe it is too early to tell. The euro still has to deal with the unfolding horror story of the Spanish economy.
Spain always looked like the weakest link in the euro chain. It had the biggest property bubble of any major euro-area economy – only Ireland came close to matching it. It had the fastest-growing banking sector, and the most spectacular economic growth. Now it looks as though it will face the deepest downturn of any of the main economies.
The economic figures coming out of Spain are wretched. It has been hit harder by the global recession than most of the euro area, and shows no sign of sharing the modest recovery being enjoyed by Germany and France. In the latest quarter, the economy was still shrinking at an annual rate of more than 4%. Unemployment has already climbed to a staggering 18% of the workforce and will climb higher still before the economy recovers. According to forecasts from the Organisation for Economic Co-operation and Development (OECD), Spain will be the third worst-performing nation of its 30 members this year. Only Hungary and Ireland will do worse. The government is running a budget deficit of 9.5% of GDP, almost as bad as Britain: the big difference is that the UK isn’t supposed to be keeping its deficit to 3% of GDP, as required by the euro rules.
And that’s just the obvious problems. Look underneath and the picture doesn’t get any better. Spain now has as many unsold homes – more than a million – as the US, even though the US economy is more than six times the size of Spain’s. About a third of new homes built in the EU since 2000 were built in Spain, although it accounts for only about 10% of the euro area economy. Most of that was with money borrowed from the rest of Europe: there are now close to e500bn of loans outstanding to Spanish developers and construction companies. It’s hard to believe that much of that is going to be paid back.
“Spain is set for a long, painful deflation that will manifest itself via a spectacularly high unemployment level for an industrialised economy, a real-estate collapse and general banking insolvencies,” argue analysts at the economic consultancy Variant Perception in a recent report.
And much as it might like to, the rest of Europe won’t be able to ignore Spain’s problems. Between 2003 and 2005, 39% of euro-area growth came from Spain. Without it, the region would hardly have grown at all. Banco Santander, now a familiar name on British high streets, is the biggest bank in the euro area, measured by market value. BBVA is one of the top five. So without a Spanish contribution, Europe will hardly grow. And if the Spanish banking system collapses, it will blow a hole in the euro’s hull that could capsize the whole vessel.
So far, none of the big Spanish banks has collapsed. Santander has taken the chance to expand, taking over the UK’s Abbey and Alliance & Leicester at what may well prove the bottom of the market. But their troubles may be hidden. Spanish banks are thought to have been raising around 40% of their funds abroad at the peak of the property boom. It’s hard to believe they’ll find it easier to refinance those loans when the time comes.
Sure, the banking system in Spain is generally held to have been more prudent than elsewhere. A system of ‘dynamic provisioning’ forced Spanish banks to salt away more money when times were good; other countries, such as the UK, may end up copying that. But it’s unlikely the banks have built enough of a cushion to pull through a property collapse on the scale Spain now faces without serious losses. These may be hidden for a time by lax accounting rules, artificially inflating asset values, or expanding abroad to raise money. But banks can seldom hide their losses permanently: the market always catches up in the end.
Traditionally, a country with Spain’s problems would devalue its currency, as Britain has in effect done. But that door is now shut. Spain faces a protracted slump, one that will test its social fabric to breaking point. Unemployment could go as high as 25%: that’s a lot of punishment for any country to take.
So in truth, the real test for the euro over the next five years is how it deals with the Spanish patient. If Spain can pull through and start to grow again, investors will conclude, rightly, that the euro can survive just about anything. But don’t be surprised if a long and grinding recession results in calls from the Spanish people for the return of the peseta.