“Deficits mean future tax increases, and politicians who create deficits are tax hikers”, Ron Paul

Spanish 10 year bond yields remain stubbornly at 5.85% while spreads widened to 450 basis points after the announcement of a budget that provides more questions than answers.This week El Confidencial published that the Spanish Government restated the 2011 budget deficit from 8.6% to 9.44% and 2012 could slip to 7.4% from the current 6.3% target. We talk constantly of regaining market confidence, but such confidence is not going to come with constant budget revisions. It will be achieved with better than expected numbers. This is the reason why I am concerned about optimistic assumptions in the budget and aggressive tax increases added to generosity in maintaining a bloated state. I mentioned a few months ago that Spain needs to apply the red pencil throughout a bloated state that spends, even in alleged “austerity times” the same funds as in the peak of the housing bubble (see here).

The 2013 Budget is a step, but an insufficient one

Spain’s Economy Minister, Mr Montoro, said that “it is impossible that Spain has lost 70 billion euro in revenues only due to the crisis.” With the number of companies in business falling from 155,000 to 135,000, the real estate bubble bursting from 650,000 homes built per year to 150,000, the collapse of the industrial activity of 2% per annum and the rise in unemployment to 24%, I think it is admirable that revenues have only fallen by 70 bn euro.

While economic measures focus in recovering lost revenues of the housing bubble that will not return, the investor perceives that Spain could forget about the medium-term risks of a predatory fiscal policy.

Voracity in tax collection with possible impact in the medium term
Almost half of the budget adjustment is, again, tax increases that reduce consumption,weaken the economy and prevent companies from creating jobs.

In a recent analysis, JP Morgan warned about a few key aspects: loss of deposits, industrial decline, poor profit margins and stagflation. The loss of deposits is less than what is estimated in the press, announcing almost 120 billion, but we should never underestimate 30 billion as “irrelevant”.

However, in Spain between 1500-2000 companies file for bankruptcy each quarter. In addition, the CPI soars to 3.5% when GDP decreases 1%. This risk of “stagflation” -inflation with recession- can be very dangerous for the economy. All this happens in an environment where profit margins have decreased to make many of the large companies and SMEs generate margins below cost of capital. The economy remains extremely rigid and tax increases are reflected in the prices immediately. Adding an unemployment rate of 24% to the equation creates a difficult horizon for recovery.

While the general government deficit remains a concern, we must also highlight the positive , and in July there was a current account surplus of 500 million euro. This is important because, if confirmed as sustainable, it implies that Spain reduces its external financial dependence .

We must appreciate it, but we must not forget that it is, in part, the result of the inability to continue to import due to falling industrial demand. Spain is still not competitive and structural reforms must stem the drain on companies, rigidity and erosion of profit margins inflicted by aggressive tax increases.

If companies are not created, if SMEs do not generate profits, then banks do not finance, debt increases, tax revenues collapse … and deteriorated companies do not hire…and the unemployed do not consume.

If we prevent businesses and citizens from becoming richer, we impoverish the country 

Goldman Sachs called the 2013 budget “Running to Stand Still” referring to the U2 song about drug addiction. The market is concerned about optimistic tax revenue expectations (+4.4%) and estimates of increase in social security contributions that are inconsistent with the government’s own estimates of unemployment increase. The market sees a high risk of seeing expenses rise above estimates and revenues fall short of target.

For example, sensitivity to two items is enormous. If VAT revenues do not increase by 13%, as budgeted, and they will very likely not increase due to loss of consumption, then the government’s estimates of tax revenue growth would fall to almost zero.

If transfers to regional governments continue in 2013, something which is quite likely given the regions’ troubled situation, that means another 12 to 16 billion of additional spending.

In terms of budget targets, it appears that the government has fallen into the same trap of previous governments. To provide estimates of GDP growth (-0.5%) that few analysts consider as conservative. The consensus range for 2013 is between -1.2% and -2%. Should the government not have taken the opportunity to build trust giving estimates in line with the consensus of economists and then beat expectations? Beating estimates is essential to regain market confidence.

The goal should be maximum expenditure, not “deficit as a percentage of GDP”

To avoid suspicions on revenue estimates, the state should give a maximum target of spending and put up remedial measures every time such goal was surpassed. If the target is “deficit to GDP”, it masks poor budget execution with ratios that can be manipulated.

Austerity? Where?

What I think is most important to note is that these budgets, as those of 2012, cannot be described as austere. Public spending rises by 5.6%. Yet I hear over and over that the problem is “the cost of debt” … as if the cost of debt was an alien who came down in a UFO surprising the population. As if such cost of debt is not the result of massive public spending.

But even if we deduct the cost of debt, primary expenditure falls only by 0.6%. This is before the regional communities publish their expenses and before any deviation due to bank bailouts or “unexpected” one-offs.

This is not austerity, it is, at best, a slight budgetary restraint
I do not know of any family that comments about their budget “we are doing okay if we remove the cost of the mortgage.” The Spanish budget does not show real cuts, just very slight revisions of previous years’ overspending.

We should highlight it because there is a huge difference between austerity and “less overspend”. Spain will keep spending, including all administrations, almost 20% more than it earns, and will also spend more than it earns without the cost of debt, leading to having to borrow around 200bn a year.

The difference between the “red pencil” and the “Troika axe”

As Art Laffer said, “give me a red pencil and the budget and I will reduce the deficit to zero in a week”. The reduction of debt, not the deficit, is the only solution. And that will come only from cutting spending. Or the Troika will do it for us, but they will do it unfairly and badly.

It is important to repeat that the State and the regions should reduce absolute expenses much more severely, that the state cannot be 56% of the economy, including all public enterprises and that Spain cannot spend 20-25% more than it collects as revenues.

There must be serious cuts in political spending. The presidents of regional governments or ministers cannot have more counsellors-each-than David Cameron.

The Spanish fiscal consolidation process will not be credible unless it structurally reduces the largest expenditure items.

The red pencil. The State can immediately attack four items:

• Public salaries , a spending of over 100 billion. We have higher public wage expense per GDP than the EU average but a number of civil servants per citizen that is less than the EU average (Eurostat). What is the problem? Too many bosses and too little workers.
• Consultants and duplicated administrations, which, according to the Association of Businessmen and the PP when it was in opposition, cost more than 22 billion euros. Even if it was half it would be too much.
• Unproductive investments : In the central government budget of 2012, direct investment in infrastructure- useless high speed trains, ghost “culture and arts” cities and others- amount to 11 billion. According to the latest Stability Program, the gross fixed capital formation, which includes more than infrastructure, was 2.8% of GDP in 2011, and another 1.0 to 1.2% is expected in 2012 and 2013.
• Subsidies: The amount in 2011 was 11.3 billion and, even in 2012 and 2013, subsidies are expected to exceed 0.8% of GDP. If we add transfers and ministries, we easily reach 15 billion.

Of course, dozens of public television networks, hundreds of public radios… If we attack subsidies and administrative duplication Spain can avoid the “axe” that will come with the bailout, which will look at the expenditure items of over 30 billion and sever them, no matter who is affected and how. Those who call for an immediate bailout request tend to forget what comes with it:

1. Pensions, a cost of over 100 billion. They may have very significant cuts.
2. Unemployment benefits, which generate a cost of c30 billion.
3. Dismissal of civil servants. Not pay cuts, dismissals.

The impact on companies

The Spanish budget impact on companies is not irrelevant. In a very interesting analysis, Ahorro Corporacion shows the companies that are most exposed to Spain (in blue) and exposed to civil works, capital-intensive activities (in gray).

The impact of the Budget, if we assume that the fall in GDP is only 1%, ranges between 5 and 7% of net profits. Less revenue from income tax, less growth, fewer jobs.

These budgets should have aimed at reducing Spain bond yields. They didn’t.

We know that the country risk will not be reduced if revenue estimates are revised down, spending items are revised up, and debt accumulates with a state structure that survives with short term emergency loans from the ECB without any control of how and when they are granted. Spain runs the risk that the system is not only tax-ridden and confiscatory, but insolvent … and investors, financial or industrial, might think that such risk is too high to invest.

From Bloomberg:

As per the Ministry’s budget statement, Spain plans to borrow €207.2bn next year. Budget Minister Cristobal Montoro said Spain’s debt will widen to 90.5% of GDP in 2013 as the state absorbs the cost of bailing out its banks, the power system, and euro-region partners Greece, Ireland, and Portugal. He added Spain’s budget deficit target of 6.3% will be met because it can exclude the cost of the bank rescue. This year’s budget deficit will be 7.4% of economic output.

The real problem, however – the reason why investors do not rush to buy Catalan bonds that give a return of nearly 12 percent in 2016 – is that it has been proven since 2004 that any increase in revenues is engulfed by the regional administration and as such, the risk of default is higher than implied by companies and the region’s financier, the Spanish central government or Germany.

I heard this a few times from colleague credit investors: “a country that doubles its expenses in four years while its revenues fall, either has oil, or gold, or it does not have my money.”

The 10-year-Catalonia bond has a risk premium –spread– to Spain of almost 600 basis points and 1,100 basis points over Germany. This difference is not because of Catalonia’s dependency on Spain, or the alleged fiscal deficit. It is caused by the massive deterioration of expenditure and revenues, and the accumulation of debt maturities far beyond institutional demand. And it is important to say this, Catalonia is one of the regions with better credit structure. So, imagine the rest.

In fact, if investors perceived the massive spread between Spain and Catalan bonds as unjustified by the fundamentals, they would take the arbitrage opportunity and load up in Catalan bonds. Any credit arb hedge fund would buy them in size. But they don’t.

Now the blame game heats up. Spain blames Germany, Catalonia blames Madrid, Andalusia blames the banks, etc. Meanwhile, with on-going downward revisions of the gross domestic product and failures in budget implementation, governments continue to believe in the mantra of eternal credit ‘because we deserve it,’ sinking the ship with the crew and passengers inside.

In the Spanish regions and the central government, each euro received of additional income, either through taxes or transfers and structural funds since 2004, has become inexorably a euro and ten cents of debt. Looking at the Spanish regions, all the money received has been spent, but all of them have expanded primary deficit as well. In 1993, the regions managed 20.1 percent of the country’s budget, today they manage nearly 60 percent, yet all of them spend far beyond their means and income, regardless of their business and economic differences. Here in Spain there is no poor state. No Alabama. We are the United States where everyone is Washington or California.

This leads us to a comment made ​​by my esteemed Xavier Sala i Martin, Spanish-American economist at Columbia University, who says that the problem of access to debt markets for companies is mainly because they are Spanish, and that if Catalonia were an independent country “it would be considered one of the world’s healthiest economies and financial markets would rush to lend it money.”

In this post, I am joined by my fixed income colleague to give readers an idea of ​​how the debt markets work, because it is false that the main indicators to buy bonds are just debt to GDP and deficit, and I remember the comments from one of the British investors when the premier of the Generalitat made the presentation of its bonds in London. “If Catalonia was an independent country it would have the same access to credit as Andorra,” he said.

But even more surprising to me, as an investor in equities and bonds, is to read that “financial markets would rush to lend money” to an independent Catalonia. That is not true, as we have seen from country after country that declared themselves independent, from Yugoslavia to the former Soviet Union. Either they have abundant energy commodities or credit evaporates until they have gained years of experience as independent states. Estonia, the example for independence movements, only saw some modest short-term credit because Germany broke the treaty rules and recognized the country quickly. Even with that, credit was modest and GDP collapsed by 14 percent in 2009 and 9 percent in 2010.

When investing in bonds – debt to GDP, which is an indicator, inflated precisely by government spending and real estate bubbles – is irrelevant. What matters is the institutional credibility, the acceleration of expenditure against income, the quality and predictability of that income, the weight of public spending, monetary stability and the primary deficit or surplus.

We assume that Catalonia has institutional credibility, but:

. An independent Catalonia would be an economy that depends by 57 percent on Spain for its “exports.” In fact, since the trade balance with “non-Spanish” countries is negative (Catalonia imports more than it exports), Catalonia’s exposure to “Spain” would remain the same if not higher, particularly on the risk of the bonds of the alleged independent Catalonia. The cost of belonging to the EU, however, which Catalonia does not pay today as a region, would expand its deficit. Add to this that an independent Catalonia would have to absorb 18 percent of Spain’s national debt on the way out, and Catalonia would have debt to GDP higher than 100 percent. In a Spanish recession, the independent Catalonia bonds would also aggressively discount that same recession.

That’s why, despite the huge attractions and exceptional positive elements of Catalonia – dynamic, open economy – the investors perceive as the biggest problem the structure of a state that swallows any extra income received as it has done since 1996, making the solvency and liquidity ratios very tight, and this will continue to impact their access to credit. In fact, it is precisely the liquidity ratio, even assuming the previously mentioned tax deficits, which scares investors. Because the deterioration of income – with the deindustrialization of the region into more competitive and less bureaucratic countries, like Morocco – is accompanied by expenditures which can only rise, and do not take into account that the economy of Catalonia is very cyclical.

We end with a note on the “negative impact of being Spanish” to finance large companies. Sala i Martin says that ”the reason (for not having access to credit) has nothing to do with the sector in which they operate or the state of their economic health. The reason is simply that they are Spanish companies.”

First, we have seen debt issues, divestitures and hybrid access by several of these companies (Gas Natural, BBVA, Telefonica and other Spanish companies have issued €7.05bn in bonds with over 10 times demand in 2012), and all are trading at less risk of default than Spain or Catalonia. What we have said in this column many times is the real problem. The average debt of the Ibex is very high relative to its peers due to the orgy of strategic acquisitions at crazy multiples, but we have seen companies do an exercise that neither regions nor the central government have done. Prudence. Aggressively reducing costs, cutting unnecessary investments, cutting dividends, funding themselves long term since 2007 to avoid the “credit crunch.” That is, the opposite of what the governments have done. Companies have been preserving cash generation as an essential policy against an uncertain future, both in its core business as in its “growth markets.”

Surprisingly, Sala i Martin takes as an example of the ‘bad influence of the Spanish state’ three companies with almost monopolistic businesses in national services, telephone, natural gas, and construction-concessions. Great companies which have financed their international expansion with a lot of debt that they have been able to accumulate thanks to very high returns generated in Spain, which allowed them to enjoy better growth than their peers in the past, with full access to borrowing that could not have been there without the support of those domestic revenues and without a Spanish government that supported high risk cost strategic adventures.

No company is Spanish only for the good times and not for the bad times. These large companies, which enjoy a very comfortable monopolistic position in our country, do not suffer lack of credit “for being Spanish.” This is like saying that France Telecom, Veolia, EDP, Telecom Italia or Areva suffer lack of access to credit for being French, Portuguese or Italian rather than their strategic mistakes of expansion with debt.

Catalonia is wonderful and deserves all the good things that can happen there and more, and it is worth a bailout, or twenty, if needed. Spain has regions-nations – whatever you want to call them – with wonderful, huge possibilities. The problem was, and remains, having an unsustainable structure of administrations that absorb any extra income they get. Everyone has the right to claim independence for romantic reasons, or whatever, but we cannot say that the markets would be jumping to provide credit. In five years we would see Barcelona wanting to cut ties with Lleida or Madrid with Guadalajara, until the final implosion of a country with a level of public spending crowding out the real economy that looks like Argentina.

In Spain today, there is a golden opportunity to change, and to unite the country in the solution, not separate ourselves in the debacle. But let’s not blame the other. The solution is in our hands.

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Here is Mr Sala i Martin’s original article and his reply to my post above

On fiscal deficits. here is the contrarian view to Catalonia’s government one.