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Economic activity
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Rising prices will slightly lessen the economy's pace of progress
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Slow but sure growth in GDP is expected for 2011 of 0.5% year-on-year.
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Economic activity is improving in Spain, although more slowly than in most European countries. The recent rise in commodity prices has led to growth forecasts for 2011 being reduced by two tenths of a percentage point to 0.5%. An interpretation of the indicators offers a mixed picture and points towards risks levelling out, allowing the economy to progress slowly but surely. In fact, over the next few months, although the adjustment may slow up a little if high inflation persists, better performance on the part of tourism might boost the foreign sector and thereby offset lower domestic demand.
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From the perspective of demand, the variables are moving in different directions and therefore, on average, point towards private consumption improving slowly throughout the year with quarter-on-quarter rates close to 0.3%, placing the annual rate for the whole of 2011 at 0.9%. An example of this discrepancy in indicators can be seen in the trends for car registration and retail sales, which continued to fall in January, contrasting with the improvement in consumer confidence in February.
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If high inflation persists, progress in consumption might slow down a little.
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Although some factors might impair household spending, these can probably be offset by other, more favourable factors. One of the risks to take into account is the possibility that continued high inflation rates might reduce purchasing power and thereby deter consumption. Another aspect that could slow down consumption's recovery is the sluggish recovery in the labour market, which has a negative effect on the disposable income of households. However, as the savings rate is relatively high (over 14% while, in the decade before the crisis, it was close to 11%), part of the fall in disposable income might be directed towards a drop in savings, without affecting consumption to any great extent. The effect of higher prices and a worsening labour market on consumption will probably be relatively small.
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Another possible consequence of high inflation is a hike in interest rates by the central bank, which could alter the readiness to consume. However, the ECB's rise in the reference rate is expected to be very moderate and, in any case, its effect on household spending will not be immediate.
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On the other hand, we should also note some favourable factors that might help growth to pick up faster than expected, such as the increase in consumer confidence and the reorganization of the financial system. The latter is having a positive effect on market confidence, as shown by the significant drop in Spain's risk premia, in contrast to other peripheral countries of the euro area. This might improve credit flows and thereby stimulate domestic demand.
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Improved confidence might speed up the adjustment.
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With regard to public consumption, the outlook is for negative growth rates until the target reduction in the public deficit is reached. If interest rates rise, the burden of interest payments will become greater and, to offset this, the government could end up cutting back spending even further. But we should note that this scenario is increasingly less likely. Within this context, the government is making a big effort to balance its accounts by introducing some far-reaching reforms.
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Investment won't help to boost domestic demand either, as investment in construction is expected to fall significantly again in 2011. Nevertheless, the good performance of capital goods investment is important. Particularly of note is the notable rise in capital goods production in the month of January, placing the year-on-year growth rate at 4.6%. With regard to investment in construction, indicators continue to be unfavourable in general. Although most increased their rate of decline, such as confidence in construction and the permits for new builds, the demand for cement showed some signs of a change in trend.
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Capital goods investment holds steady.
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Due to the trends in its different components, domestic demand is expected to fall by close to six tenths of a percentage point in 2011. Consequently, it will be exports that will help GDP to grow approximately at a rate of 0.5% year-on-year. In fact, the figures available for the foreign sector confirm their good performance. In January, exports rose significantly, largely thanks to Europe's recovery, Spain's main trading partner. Moreover, productivity started to improve as a result of the moderation in labour costs and the fall in employment. Should this situation continue, it will help to improve competitiveness, a key factor to boost exports. For their part, imports also grew significantly, although to a lesser extent, driven by rising crude prices.
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The foreign sector underpins growth in 2011...
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The outlook is favourable for exports and this suggests that their contribution to growth will reach 1.2% this year. However, the positive trend in the foreign sector is not without its risks, as it closely depends on the trends in oil prices. If these continue to rise, imports will become more expensive and the foreign sector's contribution to GDP growth will be less. Higher inflation will also harm the purchasing power of those countries buying Spanish products, which will harm exports. On the other hand, healthy tourism might help the foreign sector to progress at a better pace.
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...but remains vulnerable to trends in oil prices.
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On the supply side, one example of the positive situation of economic activity comes to light when we look at indicators for industrial production. In fact, on average these have been looking healthier in the last few months. In the fourth quarter of 2010, the purchasing managers' index (PMI) was above 50 points, the level that separates expansionary from recessionary periods. This trend has remained during the first few months of 2011 and, in February, the variable stood at 52.1 points.
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GDP will not get back to its previous peak until the end of 2013.
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However, although the economy is expanding once again, Spain is still far from regaining its pre-crisis GDP levels. It will probably take another five quarters to get back to the same level as the beginning of 2007, when the financial crisis started. It may even have to wait until the end of 2013 to reach the peak achieved at the beginning of 2008. This contrasts, for example, with the German case, which has already regained all the GDP lost during the recession. Nonetheless, the recovery process in Spain clearly appears to be more encouraging than in Greece, Portugal, Italy or Ireland.
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Labour market
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The Labour market is still in the doldrums
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The rate of decline of total employment speeds up by two tenths of a percentage point to 1.3%.
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In spite of more dynamic economic activity over the last few months, the labour market has yet to see any improvement. The latest data available for February were worse than expected, causing us to downgrade our forecasts slightly. For 2011, our forecast is therefore higher by two tenths of a percentage point both for unemployment, up to 20.4%, and for the average rate of decline in employment, to 0.5%.
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In fact, the economy has yet to recover sufficiently to create jobs, as shown by the decrease in the total number of people registered as employed with Social Security for February, namely 14,745 (almost 38,000 once seasonally adjusted). This led to a decline in the labour market's recovery, as the rate of decline in the year-on-year employment rate accelerated, up two tenths of a percentage point to 1.3%. Moreover, this drop in the total number of employed was a shock because a slight increase was expected in employment for this month.
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With regard to registered unemployment, this grew by 68,260 people in the month of January (around 21,000 seasonally adjusted), a higher increase than expected. Registered unemployment therefore rose for the second month in a row, halting the more favourable trend of the last few months of 2010. Nonetheless, the year-on-year rate of growth fell by four tenths of a percentage point to 4.1%.
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The weakness in the labour market might result in a slower recovery.
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One consequence of the rather unfavourable trend in the labour market is that activity might end up recovering more slowly. Within this context, it's important to assess the effect of the recent labour reforms, in force since July 2010, which aim to ensure that the progress made by the economy is translated into new jobs. With this aim in mind, one of the goals of the new legislation is to reduce the dual nature of the labour market, between employees with permanent and those with temporary contracts. Although it's still too early to measure the legislation's effects, as agents have to become familiar with its specifics, the figures show that, for the moment, the proportion of temporary contracts has not changed and is still over 25%.
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Precisely one of the main measures in the labour reforms was to encourage the use of Contracts to Promote Permanent Employment (CFCI in Spanish), whose severance pay is 33 days per year worked in the firm (instead of the 45 days previously established for permanent contracts). The graph below shows that this kind of contract increased substantially at the end of 2010, motivated by the chance to convert temporary contracts prior to the reform into CFCI contracts before 31 December. However, since January 2011, the number of CFCI has fallen sharply and this, for the time being, prevents us from making any conclusions regarding whether the measures adopted to stimulate this kind of contract are working.
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The dual nature of the labour market continues.
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It should also be noted that part of the reform has yet to be implemented, such as the incorporation of the Austrian model, which consists of taking out an insurance policy, chargeable to the firm's Social Security contribution, that covers part of the severance pay and can be accumulated up to retirement. Moreover, other significant reforms, such as collective bargaining, are still being negotiated.
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The recovery in tourism might help to create jobs over the next few months.
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Another factor that might slow up the recovery in the job market is the poor prospect for employment in the construction industry. February's figures continue to show sharp falls in employment in this sector, 9.7% year-on-year, and the pace of job losses is likely to remain high in 2011. This will make it difficult to reduce the unemployment rate. However, at the end of 2012, this process of job losses should finally abate, as activity in the sector is expected to stop declining.
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On the other hand, as the months go by, some employees in the construction industry should be able to relocate to other jobs, especially in the services sector. Within this context, of note is the relatively improved tone of employment in the tertiary sector during the second half of 2010. In spite of a slight dip in services employment in the first two months of 2011, moderating its year-on-year growth rate to 0.2%, this sector is expected to absorb some of the jobs lost in construction over the next few months. This might be due to the good outlook for tourism this year, as shown by the figures for the number of nights spent in hotel establishments, up by 4.6% in January compared with the same month last year. Moreover, while the instability continues in the countries of North Africa, Spain could benefit from a redistribution of both national and international tourism.
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Another factor that will determine the pace of recovery in the job market over the coming months is how far wages will adjust. In Spain, these tend to react slowly and very moderately to changes in the economic cycle. This leads to greater employment volatility in relation to changes in GDP than in other advanced countries, as adjustments are made via job losses rather than wage variations. In fact, as can be seen in the graph above, real wage costs per worker took time to fall and didn't do so until the third quarter of 2010, after two years of economic recession. However, the figures are finally showing significant wage constraint.
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Real costs per worker fall.
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Wages are expected to continue moderating, although the extent of the adjustment will depend on the extent of wage indexing. Unlike Spain, in several European countries wages are linked to core inflation. This limits the impact of rising oil prices on wages and helps productivity to improve.
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Job creation will continue weak throughout the year.
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In short, the labour market is likely to pick up gradually throughout 2011, although jobs will not be created until 2012. There are some factors that might slow up this adjustment. Firstly, if the inflationary trend continues, households' purchasing power could be affected, hindering the recovery in consumption. As a consequence, the improvement in activity, and employment, might slow up. Secondly, a rise in interest rates could reduce the incentive to consume and thereby slow up activity, although this effect is expected to be quite limited. However, not all the risks are unfavourable, as the better performance shown by sovereign debt in the last few weeks might have a positive effect on the adjustment in economic activity and thereby boost job creation.
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Prices
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The rise in oil prices pushes inflation up to 3.6%
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Due to rising oil prices, the average annual increase forecast for the CPI in 2011 is raised by four tenths of a percentage point to 2.9%.
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The year-on-year change in the consumer price index (CPI) increased by three tenths of a percentage point in February to 3.6%, following the upward trend of the last few months. This upswing in the CPI's year-on-year rate was largely due to higher fuel prices, responsible for half this increase. The rise in oil prices has actually speeded up over the last few months and is now starting to be reflected in high inflation rates the like of which has not been seen since 2008. This has led to us raising our forecast for average inflation in 2011 by four tenths of a percentage point, up to 2.9% year-on-year. Core inflation, on the other hand, which excludes energy and fresh foods, was quite a lot lower in February, namely 1.8% year-on-year, and its outlook for this year remained unchanged at 1.7% year-on-year.
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This inflationary trend is expected to be temporary...
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As households have a high expenditure on oil derivates, the trend in the CPI is closely linked to oil prices. Price changes in crude are therefore fundamental to determining inflationary periods. In fact, one of the risks is that this rise in oil prices, which we expect to be temporary, will continue for quite a few months and thereby deduct several tenths of a percentage point from the growth in GDP.
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...because the risks that might make it last longer are unlikely to come about.
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Although oil prices are not likely to continue on the up for long, this might happen if the conflict in North Africa doesn't stabilize soon. However, should this be the case, the Organization of the Petroleum Exporting Countries might increase their crude production to curb the increase in prices, as they don't want their buyers to fall back into a recession.
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Wages might also affect price trends if they are linked to price rises. Within the current context, however, wages are not expected to add to inflationary pressures. Firstly, the belief has been growing that it's important to maintain firms' competitiveness in order to shore up the recovery in activity. On the other hand, the very high unemployment rate is easing wage demands by employees. Consequently, although the agreements signed in January included a 3% average increase in salary scales for 2011, higher than the initial rates agreed in 2010, which rose by 1.3% on average (2.1% taking into account the effect of the severability clause), this trend is not expected to continue.
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Substantial rise in production costs.
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Another indirect effect of rising commodity prices is the increase in production costs, as these are closely linked to the trend in oil prices. Producer prices rose significantly in the month of January, up 1.5 percentage points to 6.8% year-on-year, the highest rate since September 2008, particularly pushed by energy goods. Rising crude prices also have a significant effect on import producer prices, up by 11.9% in the last twelve months to January, almost two points higher than the previous month's figure. Rising production costs and import producer prices might slow up the recovery process, as firms must either reduce their profit margins or pass on these increases to the product's end price, to the detriment of the consumer.
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The price differential compared with the euro area is at one percentage point due to the energy component.
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From other perspective, one consequence of high inflation in Spain might be a loss of competitiveness if the price rises in this country exceed the rise recorded in the rest of the countries of the euro area. According to Eurostat figures, the euro area's harmonized inflation rate for February stood at 2.4%, while the index recorded in Spain was 3.4%. The upswing of inflation observed in Spain in the last few months has been sharper than the one recorded in the euro area, so that the inflation differential has gone from zero in December 2009 to one percentage point in February 2011. This figure can be mostly put down to the energy component, as happened in 2008 when the gap reached 1.2 percentage points in July. However, the differential is expected to narrow again once inflation's volatile components disappear, as these have a greater weight in Spain.
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The year-on-year inflation rate will tend to ease by the end of 2011, thanks to the disappearance of base effects due to tax hikes and the price of crude.
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Inflation is therefore expected to continue rising slightly due to higher oil prices over the next few months, while the situation in the Middle East remains tense. However, the year-on-year inflation rate should subsequently slow down, once the conflicts are resolved and the base effects associated with past events, such as tax hikes, disappear. We should therefore see a reversal both in the effect of the hike in value added tax in the summer months as well as the effect of higher oil and tobacco prices in the fourth quarter.
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Foreign sector
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Dependence on energy slows up the correction in the trade deficit
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Oil prices will set the trend in the trade balance.
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Over the last few months, oil has become the main obstacle to adjusting the trade balance. In fact, the persistent rise in the price of crude since September last year has considerably damaged the energy balance, neutralizing the large correction recorded by the rest of the components. The trend in the price of this commodity, conditioned by the resolution of the political conflicts in North Africa, will be a key factor in adjusting the trade imbalance.
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This obstacle to the trade deficit's correction is the result of the Spanish economy's high dependence on energy. As can be seen in the graph below, Spain imported more than 80% of the energy it consumed in 2008, much higher than the European average. This low level of self-supply has not significantly altered since then. During the first three quarters of 2010, the energy generated in the country, mainly nuclear or renewable, only covered 26.1% of the total energy consumption. This is mainly due to the large relative weight of fossil fuel consumption, accounting for 72% of the total. This high percentage explains the Spanish deficit's sensitivity to commodity price variations. Consequently, pressure on the trade deficit is unlikely to ease until the political situation in North Africa gets back to normal.
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The trade balance with the euro area continues to improve.
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The expectations regarding the non-energy balance for 2011 are more optimistic. The recovery of the Spanish economy, less than that of its main trading partners, will keep the growth in imports below that of exports. January's figures, with a 32.0% year-on-year growth in exports, more than six points above imports, support this hypothesis. Of note is the trend in the balance for the rest of the countries in the euro area, Spain's main trading partners. The recovery in the main European economies, particularly Germany and France, meant that exports accumulated over the last twelve months practically equalled imports, something that hasn't happened since the single market was created. In the case of France, the trade surplus accumulated since February 2010 reached 8.45 billion euros, the highest since records began. We expect Spain's role as a net exporter in the rest of the euro area to continue over the next year. However, there are some risks that might reduce this tendency for the trade balance to improve compared with the rest of the countries in Europe. These include a greater impact than expected on the part of inflation or rising interest rates on European demand for Spanish products.
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Good prospects for tourism
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The lower deficit of the income balance in 2010 helps to correct the current balance.
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The imbalance of the balance of payments fell by 18.2% in 2010. Even the slight deterioration in the balance of goods, the main factor behind the adjustment in the current imbalance in previous years, was neutralized by the improvement in the rest of the components over this period. Of note is the correction in the income balance deficit for the second consecutive year. This was mostly due to the decrease in payments of interest on investment. A trend that, nonetheless, could slacken as from the second half of the year.
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Tourism picks up in 2011.
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Given the smaller improvement in the income balance, tourism is expected to take over the reins, contributing positively to the correction in the current imbalance. This recovery started to take place in 2010, when both the number of tourists and the income generated by them increased. This put an end to the huge shrinkage recorded since June 2008. The recovery in the world economy, and in particular in Europe, is expected to lead to a further rise in the number of tourists visiting Spain in 2011. This will undoubtedly be boosted by the flow of visitors who, given the political turbulence in North Africa, decide to holiday in Spain. According to our estimates, these will exceed one million, pushing the total figure above 56 million in 2011, which would represent an annual growth of 6.6%. As a consequence, the services sector is likely to contribute significantly to the Spanish economy's growth this year.
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Portfolio investment was the main source of capital inflow in 2010.
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With regard to financial flows, portfolio investment was the main source of capital inflow in order to meet Spain's financing needs. The expected improvement in country risk means we can expect new inflows of direct investment and also portfolio investment throughout this year.
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Public sector
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Spain does its homework
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European leaders approve the Euro Plus Pact to boost competitiveness and tackle the debt crisis.
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«A historic reform of economic governance». That's how Olli Rehn, EU Monetary Affairs Commissioner, defined the agreement between the leaders of the seventeen countries of the euro area to boost competitiveness and successfully tackle the debt crisis. This agreement was subsequently ratified by the European Council, christening it the Euro Plus Pact. Without any doubt, this Pact must be seen as an important step towards common economic policy in the monetary union. In Spain's case, this agreement could become the salutary lesson needed by the economy to finish off the structural reforms undertaken that are aimed at improving its competitiveness. An expectation that seems to be shared by the markets, judging by the improvement in the risk premium associated with Spain's debt. Adopting the necessary measures to comply with the Pact and the tough reduction in the fiscal deficit planned for this year will be two important challenges for the Spanish government in 2011.
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The Pact contains measures aimed at reinforcing budgetary discipline and reducing economic imbalances, commitments that boost competitiveness and employment, contribute towards the sustainability of public finances and reinforce financial stability. The plan is that these results will be assessed every year and any non-compliance could give rise to penalties.
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Spain has implemented various reforms in line with the Pact's guidelines.
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In addition to these decisions, the Council has also decided to guarantee the European Financial Stability Fund (EFSF) an effective loan capacity of 440 billion euros. Moreover, a permanent bail-out fund will be created as from June 2013, namely the European Stability Mechanism, which will replace the current EFSF and will be provided with 500 billion euros.
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Most notable in the Spanish case has been the effort made by the government over the last few months to adopt new measures in line with the guidelines agreed in the Euro Pact. Among these are those carried out on the financial system, the pension system and the labour market. However, some additional reforms are still required, particularly in the case of the labour market. The proposal to reform collective bargaining is along these lines, aiming partly to link wages with employees' productivity.
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Spain's risk premium improves, unlike the rest of the peripheral countries.
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The reception given to such measures is reflected in the trends in the government bond market. The cost of financing Spanish ten-year debt compared with German debt (the latter normally being used as the reference yield) gradually fell in March, going below 200 basis points at the end of the month, 15 points below its average for February. Only Moody's rating downgrade temporarily hindered this adjustment process. Within this context, the Spanish Treasury issued new debt onto the market at lower interest rates than those paid at the end of last year. These issues have almost managed to cover all April's maturities until July.
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The government expects to reduce the deficit to 6.0% of GDP in 2011.
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As can be seen in the graph below, the greater market confidence in Spanish debt contrasts with the widening spreads for the rest of the peripheral countries. The case of Portugal particularly stands out in this respect, forced by its low competitiveness, political instability and difficulty in correcting its fiscal deficit, and the country is on the point of bail-out. A fact that, should it occur, is not expected to significantly affect Spanish financing.
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This change in trend in the sovereign risk premium can be partly explained by the improvement in the Spanish public deficit in 2010. Cost-cutting and, to a greater extent, the rise in revenue reduced the public sector's financing needs to 9.2% of the gross domestic product (GDP) last year. A figure that is even one tenth of a percentage point higher than the level set in the fiscal adjustment plan, thanks to the extensive correction in the central administration deficit.
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The government's forecasts for 2011 are even more ambitious. According to its adjustment plan, the fiscal deficit will fall to 6.0% of GDP this year. It is expected that, of the 3.2 percentage points' reduction compared with 2010's deficit, more than two thirds can be put down to lower public spending. This contrasts with the important role played by greater revenue in the deficit correction of 2010. Should these targets be met, the fiscal adjustment, whose aim is to achieve a 3% deficit by 2013, will be more than halfway towards its goal by the end of this year.
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Autonomous communities will have to extensively reduce their deficit as from 2012.
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January's figures do not provide enough information to be able to compare how the public accounts are performing. A deterioration can be seen in January's cash deficit compared with the previous month, namely 7,706 and 3,590 million euros, respectively. However, this increase in the month-on-month deficit, of more than 100%, can be put down to calendar effects, which delayed the maturity payments for debt from the first month of last year. In fact, the primary balance for January 2011, i.e. excluding the interest charged, was 37.7% less than the figure for the same month a year ago.
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Consequently, the 6% target for the fiscal deficit for 2011 is possible if the government maintains the rigidity shown over the last few months. For such an undertaking, however, it will be necessary to control the spending of the autonomous communities. According to the government's forecasts, these administrations' deficit will account for more than half the total in 2011. One of the main challenges for the Spanish government will undoubtedly be ensuring that these communities get back to lower deficit levels in 2012.
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Savings and financing
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Weak demand might slow up the recovery in credit
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The banking system needs 15.15 billion euros to comply with the new capital requirements.
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In March, attention regarding Spain's financial system was focused primarily on the publication of its recapitalization requirements, estimated by the Bank of Spain. According to this institution, the financial system needs 15.15 billion euros to meet the new capital requirements demanded in the Financial Sector Reinforcement Plan. This figure accounts for 1.4% of Spanish gross domestic product (GDP) and is lower than the estimates by leading international analysts. The greater basic capital required for savings banks compared with banks, 10% and 8% of risk-weighted assets respectively, means that the former have a greater need to recapitalize.
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However, the amount published by Spain's banking regulator will be lower as several savings banks that do not meet the minimum capital ratio demanded by the Bank of Spain have announced their intention to go public. In this case their capital requirements will be lowered by two percentage points to 8%, the same level as the one required for banks. In any case, covering the additional capital required by the system is guaranteed, either through private investors or through contributions from the Fund for Orderly Bank Restructuring (FROB in Spanish). This recapitalization will undoubtedly strengthen the solvency of Spain's financial institutions. They will therefore find it easier to pass the new stress tests that will be carried out on banks in the spring. In short, this is a step forward in restoring confidence in the Spanish financial system.
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The strength of the financial sector will open up wholesale financing markets to banks.
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What effect will bank recapitalization have on credit trends? On the one hand, the European Central Bank (ECB) believes that adopting this plan might hinder the recovery in credit for households and firms. However, a more solid financial system is expected to encourage wholesale financing markets to open up to banks. As a consequence, Spanish banks' dependency on ECB financing will lessen, continuing the trend that started last August. All this will help to channel credit towards the private sector.
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The recovery in industrial activity and services is reflected in an increase in their financing.
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There are, however, other factors that might slow up the recovery in credit in 2011. In spite of fewer doubts regarding the financial system's real estate risk, this system performing less well than expected might prevent the wholesale markets from opening up so readily. It will therefore be important to keep a close eye on trends in real estate doubtful debt over the next few months. As we expected, this ratio rose again in December 2010, boosted by the large amount of doubtful assets related to real estate development and construction. The continuation of this trend raised the banking system's doubtful debt rate to 6.06% in January this year.
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But the factors that will hinder credit growth can be mainly found on the side of demand. Of note is the weak recovery in the Spanish economy expected for 2011. Albeit to a lesser extent, the ECB raising interest rates will also have a slight impact on credit demand. In this last case, our forecasts predict two hikes in the reference interest rate, in May and October, placing it at 1.5%. Given such expectations, the interest rate for new credit granted rose by 26 basis points in January. For its part, the interbank market interest rate (Euríbor) has accelerated its growth since the start of year, a trend that is expected to slow up over the next few months. Demand for mortgages to buy housing won't be very dynamic either this year. This is due to the mortgage burden of households because of the rise in interest rates and especially the withdrawal of tax deductions. However, the fall in house prices will keep this effort at stable levels.
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Given this scenario, the reduction in private sector financing in January comes as no surprise. But this fall will not become generalized throughout the year. A breakdown of financing by sector shows that industrial activity and principally that of the services sector grew in 2010, a trend that might remain for the whole year. On the other hand, general government debt continued to grow in the first month of the year.
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However, weak demand might reduce the outstanding credit balance in 2011.
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In short, a good result for the Spanish financial system in the stress tests is expected to dissipate doubts regarding the sector, opening up wholesale financing markets to banks. However, the economic situation augers weak credit demand which might lead to a reduction in the outstanding credit balance in 2011.
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Fall in deposits and the return on liabilities in January.
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The balance of bank liabilities compared with households and firms fell by 1.9% month-on-month in January. This decrease took place within a context of falling interest rates, down for the second month in a row. The performance of returns on deposits is expected to affect the change in the future balance of bank liabilities. However, there are several factors that will push interest rates in opposite directions over the coming months.
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Will the fall in interest rates on bank liabilities continue?
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On the one hand, the gradual opening up of financing markets to Spanish banks should reduce the need to attract customer deposits. This will reduce competition between institutions and thereby the interest rates for new deposit operations. This is probably the main reason for the fall in returns on bank deposits in January.
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However, this effect might be weakened by the action taken by the main European monetary authority over the next few months. The possibility of the ECB toughening up the conditions for accessing liquidity auctions and the probable rises in the official interest rate will push up deposit returns. This second effect is expected to become more significant over the next few months, leading to a new period of rises in rates for liabilities during the second half of the year.
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In the medium term, interest rates are expected to rise again.
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However, the trend in bank deposits may be affected by the upswing in mutual funds. In fact, February's figures show that net subscriptions for mutual funds increased, this being the first rise since November 2009. The gradual reduction in risk aversion in the markets expected for this year might keep this trend going during 2011.
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Stressing banks at times of stress
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The deficiencies in the financial sector's supervisory system came to light during the Great Recession of 2008-2009. After this episode, no-one could doubt that the supervisory mechanisms needed a thorough overhaul and this has meant that, in a very short time, numerous measures have been implemented to ensure that the risk taken by the different institutions is controlled more precisely. And the stars of these initiatives are the so-called stress tests.
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The United States led the way in carrying out these tests and, partly thanks to this, managed to restore investor confidence in its financial system. The countries of the European Union (EU) followed suit last year but, in this case, the reaction ended up being the opposite. Although the markets interpreted the tests' results positively in the short term, the failure to predict the collapse of the Irish financial system seriously damaged their credibility. The effectiveness of the stress tests is therefore not guaranteed. In this Box we will review their key aspects.
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As is common knowledge, the aim of carrying out stress tests is to analyze the capacity of the different institutions to withstand highly adverse conditions. For example, in the stress tests carried out on European banks over the last few months, a fall in GDP has been assumed for the euro area that, according to the ECB's estimates, has less than a 1% likelihood of occurring, as well as a drop in housing prices greater than expected and that unemployment rates will remain at abnormally high levels (see the table below). This stress scenario also assumes an upswing in risk premia and therefore also in interest rates.
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In the Spanish case, for example, the stress scenario assumes a 1.0% fall in GDP in 2011, a 12.3% drop in housing prices and an unemployment rate of 21.3%. These are the key variables that form the basis for each institution to estimate its resistance, in collaboration with a national supervisor and coordinated by the European Banking Authority (EBA). The key, naturally, lies in determining, with some precision, the increase in the default rate and the fall in brokerage margins such scenarios would entail.
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The aim is to determine whether any institution has a significant imbalance. Fundamentally, whether it would have enough capital to survive. In this respect, it's vital for each country to have designed a system to recapitalize its institutions, by injecting either public or private capital. This ensures there are the right incentives when the stress tests are carried out and no fear of any institution failing them. While, in the United States, these systems were designed before the stress tests were carried out, in the EU last year not all the countries had done so. This year, however, the EBA wants all countries to have such mechanisms ready before it starts.
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The success of the stress test also depends on other factors. A group of economists from New York University, led by the Nobel prize-winner for Economics, Robert Engle, points out the following two aspects.(1) Firstly, very thoroughly justifying the shocks the banks are subjected to. It wouldn't make much sense to assume a scenario that only has a very remote chance of occurring. Scenarios must be improbable but plausible. In this respect, the option chosen by the EBA, to justify the fall in GDP of the euro area by using the probability distribution of the ECB's forecasts, is a step in the right direction. What is not clear, however, is how the EBA has arrived at the scenario for each country. Secondly, they point out the need to make the scenarios' estimated impact as transparent as possible. But this is difficult to carry out as, ultimately, it relies on the assessment made by the supervisors and institutions in each case, based on their internal models. Lastly, they also point out that carrying out these stress tests once a year may not be enough because, if instability unexpectedly increases 2 or 3 quarters after the tests have been carried out, they might not provide much information.
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To resolve these aspects, Engle and his collaborators suggest complementing the stress tests carried out in the United States with stress tests that use only publicly available data: stock market prices. In fact, from their website you can download a weekly update of each institution's capacity to withstand stress.(2) For the moment, the results are available for the main institutions of the United States but it has been announced that, in the near future, they will also provide results for Europe and Asia.
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(1) Acharya, V., Cooley, T., Engle, R. and Richardson, M., «Overseeing Systemic Risk», Voxeu.org (2011).
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(2) http://vlab.stern.nyu.edu/
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Specifically, to calculate each institution's potential need for capital given a systemic shock, they estimate how much the value of its stock would fall if the index as a whole fell by 40% over six months. To this end, they use sophisticated econometric models that allow them to take into account the correlation of the share price of each institution with that of the market as a whole, as well as volatility and performance when sharp movements occur. This information is combined with each institution's degree of leverage and they estimate how this would change in the stress scenario. This allows them to infer each institution's potential need for capital to be able to keep its capital ratio at 8%.
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Unlike the stress tests carried out in the United States and the EU, this measure can be validated using historical data. The authors have discovered that, in July 2007, the model would have identified Citigroup, Merrill Lynch, Freddie Mac and Lehman Brothers as the institutions with the greatest potential need for capital. Moreover, they also show that their model's findings are very similar to those of the stress tests carried out in the United States in May 2009. This they consider to be a success, since the method used is simple, transparent and can be regularly updated.
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But the method presented by Engle and his collaborators is not without controversy. Stock market movements are not always due to structural reasons and this might harm the model's predictive ability. As pointed out by the authors themselves, their proposal must be seen as complementing the stress tests carried out by supervisors. This is the spirit that must continue over the coming years. The process of transforming the supervisory model is merely in its early stages and, given that there is no single, definitive solution to improve it, we must be on the look-out and take on board the new contributions that will very likely be made by the academic, regulatory and business world.
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This box was prepared by Oriol Aspachs Bracons
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European Unit, Research Department, "la Caixa"
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