Back in July I wrote a post on Spain explaining why I thought the country had reached a point where a renewed fiscal push was likely to be counterproductive in terms of the national deficit because of the structure of the economy and the limits of a strategy around internal devaluation. This was best summed up by the following paragraph:
If a country’s current account deficit is structural … then these efforts are very dangerous because this can easily develop into a damaging feedback loop. The loss of income through the external sector leads to a loss of income in the private sector, this then drives the stronger desire to save, meaning government revenues fall further. This inevitably leads to calls for higher taxes, which once again drain income from the private sector … and around we go. The result of this dynamic is a rise in unemployment, therefore national production and income, meaning once again the government sectors revenue decline while private sector spending and investment fall further.
You can see from the April S&P downgrade of Spain that the 2012 deficit target was 5.3% which was later revised up to 6.3%. Yesterday I mentioned that even this target was looking likely to be missed and overnight this appears to have been confirmed by the Spanish Treasury minister:
Spain on Tuesday softened its insistence it would meet its year-end deficit target of 6.3 percent of Gross Domestic Product and said the good performance of its regions in cutting spending was not a guarantee that the objective would be achieved.
At a news conference in Madrid, Treasury Minister Cristobal Montoro declined twice to confirm Spain would meet the European Union-agreed target and instead referred to the European Commission forecast of a budget gap of 7.0 percent of the economic output.
“The formal target remains the same and the European Commissioner for Economic and Monetary Affairs, when he assessed the measures taken by the government said Spain’s deficit could be around 7 percent of GDP,” Montoro said.
“What is really important is to reduce the deficit. The quicker the better but without deepening the recession… We shouldn’t focus too much on this magic figure of 6.3 (percent of GDP),” he added.
Overnight Spanish authorities released the latest unemployment figures which showed that another 74,000 people became unemployed in October pushing the total to 4.91 million or 26.2%, and this is before the banking restructure has occurred which is likely to see another round of job cuts.
Spain, however, is not the only nation I see displaying the same feedback dynamics. News from Portugal suggests the same is occurring there:
Portugal’s budget deficit in the fourth quarter will need to be less than 4.3 percent of gross domestic product (GDP) in order for the country to meet its target of 5 percent agreed in the financial bailout process, the Technical Budget Support Unit (UTAO) said in Lisbon.
An analysis of budget execution until the end of September led UTAO to estimate that the budget deficit in the first nine months of the year would be between 5.9 percent and 6.3 percent of GDP.
UTAO, which has its headquarters in Portugal’s parliament, also said that meeting the 5 percent budget deficit target in 2012, “implies that in the final quarter there be a deficit that is unprecedented in recent years, even considering the amount expected for concession of the public airport service.”
According to the Autumn Economic bulletin (September) from Banco de Portugal the deficit was 6.8% of GDP in the first half of 2012 and there is reason to suspect, given PMI and credit data, that the economy has worsened since. The Portuguese authorities are sticking to their 5.0% target but as we saw 12 months ago it took one-off transfers from pension funds to make the books balance last time, this year the hope it to raise €2.5bn from the sale of the National airport operator ANA.
Adding to my concerns is the latest financial stability report, again from Banco de Portugal, which clearly shows the economic fallout has taken on balance sheet recession dynamics (note points 3 and 4 ):
- The environment in which the Portuguese banking system has been operating remained highly unfavourable. The sovereign debt crisis in the euro area and the interaction between market players’ perception of the risk attached to Government debt and to the banks of the respective jurisdiction continue to be a major source of uncertainty and vulnerability for Portuguese banks. In addition, the uncertain recovery of global economic activity is a constraining factor on the future evolution of the Portuguese economy. The downside risks to the growth of the international economy are not only the result of the uncertainty surrounding the resolution of the sovereign debt crisis but also the need for the adjustment of the imbalances of the private sector in several advanced economies. In such a context, together with the demanding adjustment underpinning the economic and financial assistance programme, the Portuguese economy is going through a prolonged recessionary period, with a strong adverse impact on banks’ operating conditions.
- In the first half of 2012, Portuguese banks continued to promote a gradual deleveraging of their balance sheets, which occurred in a context of lower credit granted and, simultaneously, high resilience of households deposits. The profitability of the banking system has deteriorated over the first half of 2011, reflecting the increase in provisions and impairments associated with banks’ loan portfolio and the evolution of net interest income. Nevertheless, there was an improvement over the results presented for the second half of 2011, though these have been strongly penalized by extraordinary events.
- Households and non-financial corporations continued to adjust their balance sheets. The two sectors together registered a net lending position, that is, saving is higher than investment, which happens for the first time since the inception of the euro area. The reduction in disposable income arising from higher unemployment, lower wages and higher tax burden led to an increase in the materialization of households’ credit risk. This increase was particularly pronounced in the consumption and other purposes segment and relatively mitigated in the case of loans for house purchase. The observed reduction in housing prices, which is related with the slowdown in demand, may involve some risk of losses for credit institutions in those cases where default results in payments in kind and mortgage foreclosures, despite an overvaluation of prices in this market before the crisis has not been observed.
- The sharp contraction in domestic demand had a strong impact on non-financial corporations’ performance, limiting their ability to finance themselves through internally generated funds. This has been aggravated by a significant tightening of bank credit standards, which happened in a context of high uncertainty and increased perception of risk by banks. The tightening of credit standards has been more pronounced in the case of smaller firms, more opaque and less profitable and in those sectors more dependent on domestic demand. These are also the sectors that have contributed the most for the materialization of credit risk. The high level of bank exposure, both direct and indirect, to the construction and real estate activity sectors, coupled with the sharp deterioration in the financial situation of companies in these sectors, led Banco de Portugal to conduct a cross-inspection on the credit quality of these loans.
- The ongoing adjustment of the Portuguese economy will tend to persist in the future with direct implications on credit risk materialization prospects. Households and non-financial corporations’ default should thus continue to increase in the coming quarters. It is important to ensure that this process is consistent with the ongoing restructuring of the Portuguese economy, ensuring that the dynamics of the economic recovery in the medium term is not postponed. The financial position of the corporate sector and households will, thus, continue to be monitored in order to identify possible measures to mitigate the effects of the high debt of these sectors on their financing capacity and on credit risk of the banking system. In parallel, the national authorities, including Banco de Portugal, are identifying measures aimed at diversifying financing sources and supporting the financing of the most dynamic and productive segments of the economy.
- In the course of 2012, the liquidity position of the Portuguese banking system improved, following the measures announced by the ECB and the European Union to mitigate tensions in financial markets stemming from the euro area sovereign debt crisis. These measures have helped stabilize banks Eurosystem funding and thus substantially reduce banks’ short term refinancing needs. The latter led to an improvement in banks’ liquidity gaps in all maturities, thus, helping to increase the resilience of the banking system to potential negative shocks on its financing capacity. More recently, two Portuguese banks issued debt securities in international financial markets. Despite the positive trend observed recently in international investors risk assessment of the Portuguese banking system, Portuguese banks’ access to international financial markets remains conditioned. Therefore, and given the persistence of tensions in international financial markets, banks should continue to further strengthen their pool of available assets for use as collateral in monetary policy operations. Furthermore, the adoption of more stringent rules under the future European regulation on liquidity requirements is an additional challenge for banks internationally, including the Portuguese ones. In this context, the ongoing gradual adjustment of Portuguese banks balance sheets, translated into a gradual reduction of the ratio between loans and deposits, will allow banks to converge over time to a more sustainable funding structure, less sensitive to changes in risk perception by international investors.
- The profitability of Portuguese banks is expected to remain under pressure in sight of expectations of deterioration in bank credit quality, combined with the persistence of very low levels of interbank interest rates. In this context, the maintenance of adequate capitalization levels remains crucial to preserve the soundness and strength of the banking system when faced with adverse shocks. Moreover, it is essential that the strategy behind the restructure of banks commercial networks and, more generally, the rationalization of banks costs, continue in the near future, allowing banks to adapt their installed capacity to the structural decrease in demand for banking services. This should occur simultaneously with the entry into force of the new European regulatory framework. The latter largely reflects the precepts of Basel III, which translates in gradually more demanding solvency and liquidity requirements. Recent evolution of Portuguese banks solvency and liquidity is consistent with planned goals and timeframe.
- Banks financing conditions continue to be heavily influenced by the financial situation of their states. Thus, it is crucial that the commitments assumed at the euro area level over the past few months, aiming at the creation of a Banking Union, are met. The implementation of the latter should ensure greater integration both at the financial and fiscal level creating the necessary mechanisms to stop the interaction effects between sovereign risk and financial stability.
As we have seen across the European periphery when targets are missed the solution is to try pushing harder on the string. Portugal has the same solution:
The parliament of recession-struck Portugal has passed a budget promising another year of austerity measures.
The coalition government ensured enough discipline to muster a majority despite every opposition party voting against.
The budget, which includes the biggest tax rises in the country’s recent history, was opposed by thousands of protesters surrounding the parliament.
….
The measures in the budget include:
- a rise in the standard income tax rate from 24.5% to 28.5%
- a rise in the top rate from 46.5% to 48%, plus a special 2.5% “social solidarity” tax
- a lowering of the threshold for the top rate from 153,300 euros (£123,700; $198,200) to 80,000 euros (£65,000; $104,000)
- an additional 3.5% surcharge on all incomes in 2013
The tax rises are equivalent to more than a month’s wages for most Portuguese workers, and aim to increase government revenues by 30%. Finance Minister Vitor Gaspar conceded that the tax rises were “enormous”, but also called them “another determined step toward recovery”.
Meanwhile, spending is also being cut by 2.7bn euros.
As I said yesterday, I really do think the markets have got ahead of themselves. I suspect Portugal will prove that point over 2013.