Article by Blevins Franks

In its twice yearly economic report, published on 4th June, the Organisation for Economic Cooperation and Development (OECD) cut its forecast for Spanish economic growth from 2.5% to 1.6% for this year and from 2.4% to 1.1% for 2009, blaming the domestic property crisis.

In reply, Economy Minister Pedro Solbes argued that this forecast was “too pessimistic” because it underestimated the impact of the economic measures which are already underway. He claimed growth “will be in the 2% range” at the end of 2008 and was optimistic gross domestic product (GDP) will again grow at around 3% in the “relatively short term”. The government’s official forecast for 2008 is 2.3%.

In April the Spanish government had announced a €18 billion fiscal plan, including tax cuts, to help shore up the economic expansion undermined by the slumping housing market and the global credit shortage.

There is currently much discussion in Spain about the drop in house prices, how far they will fall and the potential effect on the economy. There are also concerns about how Spanish banks will be affected and if we could see a Northern Rock situation in Spain. In the 1980s Spanish banking crisis 50 banks (holding 20% of the economy’s bank deposits) went bankrupt. However this led to more effective supervision and more prudent practices by the banks themselves.

With many different views on the subjects being bandied about, and newspaper headlines’ tendency to focus on the negative and dramatic, is it possible to forecast just how bad things will get? One helpful report, How Vulnerable are Spanish Banks to a Property Crash, was published by Capital Economics at the end of May. Capital Economics is one of the leading macro economic research consultancies in the world and has a reputation for original and insightful research.

The decade-long Spanish economic boom is coming to an end and Capital Economics “expects a major downturn in the property sector to trigger a sharp downturn in the overall economy”. What affect will this have on the banking sector, considering how heavily Spanish banks have lent to the property sector?

Spanish Property prices

Since 1995 house prices rose 200% in nominal terms (i.e. before inflation is factored in), and 110% in real terms (after inflation). When the increase is compared to other economic variables, like wages and rents, there is a strong argument that houses have become significantly overvalued… but by how much?

– When you compare the ratios of house prices to average wages, and house prices to rental costs, their long-run averages suggest houses could be 50% overvalued.
– A look at the house prices to household income ratio suggests house prices may be overvalued by 30%.
– Capital Economics believes the most important factor has been the fall in nominal and real interest rates since Spain joined the Euro. At present the average mortgage rate is around 5.5%, half its mid-1990s level. The mortgage repayments costs to earnings ratio suggests that house prices are overvalued by less than 20%.

Capital Economics have pencilled in a 12% fall by the end of 2009 and a further 3% in 2010. However they accept that there clearly is a risk that prices could fall by more than their forecast.

The economists believe commercial property is not dramatically overvalued – it would only need fall by 8% for yields to return to their 2001 rates. The economic downturn should only trigger a “fairly modest fall” in commercial property prices over the next few years.

Economic growth

Capital economics expects Spanish GDP growth to slow from 3.8% in 2007 to 1.7% this year and 1.2% next year, which would mean the country avoids a technical recession. However, if property prices did fall more than 20%, then GDP would slow to 1% in both 2009 and 2010.

How vulnerable are Spanish banks?

Property price falls and slowing GPD could have significant effects on Spanish banks. Over the last decade, the share of property related loans has risen from 40% of total private non-financial sector loans to 60%, equating to a staggering €1 trillion, around 100% of GDP and a third of banks’ total assets.

If GDP falls as Capital Economics predicts, bad debts could treble, but it does not expect this to cause major problems for the banking sector. While the figures initially look serious for banks, the quality of their assets suggests things may not be quite as bad:-

– Spanish banks have generally not been involved in the type of sub-prime lending that crippled the US.
– The average loan-to-value ratio (LTV) does not appear to be worryingly high, and unless house prices fall very sharply negative equity should not be widespread.
– The Bank of Spain has prevented banks using off-balance sheet vehicles.
– 20% of Spanish banks’ lending is abroad and regarded as having a low default risk.
– 80% of banking lending is still financed by retail deposits (compared to Northern Rock’s 30% in spring 2007).

Potential outcomes

If the downturn is more major than predicted this will cause problems. A combination of slowing economic activity, falling house prices and rising unemployment could result in a considerable increase in bad debts.

If, as Capital Economics expects, GDP falls to below 2% for the next couple of years, and house prices by 15%, the bad loan ratio could rise to around 3%, increasing bad debts from €16 billion to about €50 billion. Relative to banks’ total assets of €3 trillion this is still relatively small, though a significant increase on the last decade.

More dramatic falls would push the default ratio higher. A 50% fall in house prices would result in recession – the GDP level at the end of 2010 would be lower than now and bad debt could rise to around €100 billion, or just over 6% of total loans. This is still below the Spanish banks’ Tier 1 ratio of around 7.5%, plus Capital Economics thinks “a downturn of this magnitude is unlikely” and economic conditions will not deteriorate to the extent they did in the early 1990s.

Nevertheless, a major downturn in the economy could still have a significant impact on Spanish banks’ profitability. Over the last 10 years households have switched from being net lenders to net borrowers and non-financial firms are borrowing more. As the economy has been left with a shortfall in savings, Spain has increasingly replied on banks to bring overseas money into the economy to help fund demand for credit. The result is a current account deficit of 10% of GDP.

A major economic and housing downturn could result in overseas lenders reducing their exposure to the Spanish economy. This should not necessarily lead to a substantial slowdown in banking lending growth, provided bank deposits, which fund around 80% of lending, continue to grow at around 15% year on year. However a sharp drop in lending from abroad could cause a liquidity crisis and cause overall credit conditions to be tightened.

Blevins Franks Tax Advisory Service