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In Spain, new leadership, same problems

November 21, 2011: 10:50 AM ET

Spain is in no immediate danger of going bust. But as its economy shrinks and its banks start to crumble, Spain will look more like its spendthrift southern European neighbor, Greece.

By Cyrus Sanati, contributor

Spain Partido PopularFORTUNE -- Spaniards voted in a new conservative government yesterday on hopes that a change at the top could help save the country from its economic woes. But it's unclear if the country's new leaders can do anything to save a nation that is drowning in debt.

While the government has been fiscally prudent over the years, Spanish households and companies have been levered up like they were private equity takeovers. With limited growth prospects and an unimaginably high unemployment rate, those debts could soon become Madrid's problem, which in turn would become Frankfurt's problem as it spills over into the eurozone.

Spain's Socialist government, led by José Luis Rodríguez Zapatero, has governed the nation since 2004, during what was arguably one of the biggest economic booms for the country since Imperial Spain discovered the New World. But unlike the 16th century boom, which was fueled by gold, this one was fueled by debt. The boom, which lasted for most of the last decade, imploded in 2008 when the credit crunch cut off its life blood. Spain's economy now has to figure out how it will grow using whatever capital it has left.

Europe has itself to blame for bank sell-off

The conservative Partido Popular (PP) party, led by long-time party boss Mariano Rajoy, has been chomping at the bit to get back in power for years. The party won a resounding victory on Sunday, claiming an absolute majority in the lower house of parliament. That gives it not only the prime minster position, but also a strong mandate to pass whatever legislation it basically wants.

To remain in power, the PP will need to undertake some bold initiatives to help pull Spain's broken economy out of the gutter. In October, the party released a thick document outlining some of its goals. It was heavy on conservative rhetoric – cutting taxes and ending big government – but light on specifics. It is believed that the PP will continue the austerity measures instituted by the Socialists, but will also move to cut taxes on small businesses. It will not raise taxes on the rich, as the Socialists had proposed, and will instead cut government subsidies and the like.

Finding jobs

Getting people back to work as soon as possible is imperative if the PP and Spain are to survive. One of the PP's key proposals is to radically overhaul the nation's labor laws, making it easier to hire and fire people. The country's unemployment rate has continued to grow during the crisis despite all the massive government stimulus packages and bank bailouts. Unemployment tipped the scales in October at 21.2%, the highest in Europe. Its youth unemployment rate, meanwhile, hit a mind-bogglingly high 46.2%. To give some perspective, those unemployment levels are near where they were in the United States during the Great Depression.

But the Spanish are used to high unemployment; in fact, one could see the Spanish economy taking a debt-fueled round trip. Up until the mid to late 1990s, before credit and the euro, unemployment in Spain was normally around 20%. Young Spaniards would usually go abroad to find work and would send cash back home, giving a nice boost to the local economy.

But the debt-fueled boom of the last decade created an artificial economy, sending Spain's unemployment rate down to as low as 7% in 2006. Spain functioned for years with high unemployment, but such a system won't fly now. Back then its citizenry and businesses had little debt, so if a person couldn't find work or if a business failed, it would be a relatively self-contained crisis.

For example, in 1989, household debt was around 31% of GDP while corporate debt was 49% of GDP. Today, household debt has nearly tripled at 85% of GDP while non-financial corporate debt has soared to 140% of GDP. Around 80% of household debt is linked to mortgages and is thus intimately tied to the housing bubble. The corporate debt is linked to huge dilutive acquisitions taken on behalf of Spanish companies and a multitude of questionable infrastructure deals. Together, Spain has a total private debt ratio that is the third highest in eurozone behind Ireland and Portugal.

The trouble with France

Much of the money that fueled the speculative boom came from profligate Spanish banks. The government has propped up its creaky system through several rounds of bailouts, which have totaled 105 billion euros so far, equivalent to 10% of the nation's GDP. But even with all that bailing, Spanish banks have still come perilously close to failing. For instance the government said that around 50% of the total exposure that banks have to property are considered "problem assets" and that they only hold enough reserves on hand to cover 30%. As the housing crisis unfolds, painfully slow as most of these houses are primary residences, the banks will start to take tons of losses. That forces the government to pledge more cash to bail out the banks, turning that private debt into government debt.

The one thing Spain has going for it is that its government debt to GDP ratio is a relatively tame 70% of GDP. That compares to the eurozone average of 91% and is half that of Greece at 140% and much stronger than Italy at 120%. But it's the private debt ratio of 240% of GDP that has investors worried. As banks fail, that debt gets passed on to the government. As the economy contracts, and as debt rises, the debt to GDP ratio for the nation starts to increase at breakneck speed. If the Spanish economy stays in deep recession, Credit Suisse (CS) estimates that the government's debt to GDP ratio would reach an unsustainably high 100% by 2020.

On Thursday, the government sold 3.6 billion euros in sovereign debt at 6.975%, dangerously close to the 7% threshold that forced Greece, Ireland and Portugal to seek assistance from the European Central Bank. While Spain has not sought formal help, i.e. a bailout, from the ECB, it has benefitted from ECB buying up billions of dollars worth of Spanish debt in the secondary market in a move to keep borrowing rates low. If the ECB were to end that bond buying program, Spanish debt would shoot well past that 7% threshold.

The Spanish sovereign is sick but unlike neighboring Greece, it is in no immediate danger of going bust. But as those banks start blowing up and its economy shrinks, Spain will look more like its spendthrift southern European neighbor. Mr. Rajoy now has been handed the unenviable task of recreating an economy that never really existed.

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