One Year Ahead Five Years Ahead
Risk Category Year Ago Current 07/10 Worst Case Best Case Worst Case Best Case
Political Risk 75.5 72.5 68.0 79.0 74.0 84.5
Financial Risk 35.0 33.5 30.0 35.5 28.5 38.5
Economic Risk 34.0 31.5 26.5 32.0 22.5 33.5
Composite Risk 72.3 68.8 62.3 73.3 62.5 78.3
Risk Band Low Mod. Mod. Low Mod. Low


Government Stability
PM Forced to Reverse Course

In a clear display of how international pressure can trump local politics, early May witnessed a remarkable change in policy direction by the government of José Luis Rodríguez Zapatero. The Socialist premier, who was re-elected in 2008 on campaign promises of boosting pensions, full employment, and more welfare disbursements, caved in to pressure from the rest of Europe to reduce spending to avoid being dragged deeper into the Greek crisis.

A fiscal austerity was package pushed through parliament in May by a margin of one vote. Valued at some $18.4 billion in cuts, the measures are intended to slice the deficit from 11% of GDP to 6% of GDP by 2011 – a level much higher than the eurozone ceiling of 3% (although lower than Greece’s 13.6%) – and will come largely in the form of reductions to public salaries by 5%, a freeze on pensions at 2010 levels without the annual inflation-linked adjustments, and an increase to the value-added tax. Higher income taxes on wealthy Spaniards are also contemplated, along with a reduction of $1.4 billion in transfer payments to the regions. For his part, Zapatero has promised to cut his own salary, along with other senior government officials, by 15%.

The passage of the bill was only possible because of the abstention of 13 lawmakers. Zapatero’s Socialist Party (PSOE) has governed since 2008 with 169 seats in the 350-seat parliament, which has forced the premier to depend on the support of regional and smaller parties to pass laws. Yet no other party was willing to support the cuts – at least directly. Only through the abstention of the center-right Catalan CiU with 10 seats and two smaller regional deputies did the bill pass. If the conservative Popular Party (PP), with its 153 members, had combined with left wing and regional parties the bill would have been defeated and most likely the government brought down.

The PP said that it would be better cut less-than-useful government departments and other wasteful expenditures rather than going after government workers and pensioners. For its part, the CiU leader Josep Antoni Duran Lleida said his party was abstaining not because it approved of the plan but because bringing down the government at this moment would put the country into an even deeper hole.

The Polls and an Early Election?

Not surprisingly, Zapatero’s popularity ratings and those of his party’s are depressingly low, with the latest polls suggesting that the PP would defeat the PSOE in the next general election. Complicating matters, the PP has found strength in areas that have historically voted left, including five autonomous communities where it currently sits in opposition.

But the public remains divided on whether their Socialist government should see out its full term or call early elections. Moreover, the next election is not until 2012 and if the economy improves over the short- to medium term, Zapatero and his government have a chance to rebound. The real question therefore is whether the PP wishes to take on the policy headaches of the current administration should it prevail in an early legislative vote, or whether it would be more politically prudent to simply wait until the bulk of the more controversial legislation is passed before calling Zapatero’s minority government out. Given that the road to an improved economy is going to be a long one and that the opposition parties appeared to have voted strategically during the fiscal austerity vote, ICRG thinks Zapatero’s government should be safe for now.

Internal Conflict/Investment Profile
Labor Reform Bill and Public Sector Strikes

The fiscal austerity package clearly did not sit well with the country’s labor unions, which engaged in strike action on June 8. Total turnout was largely seen as less-than-expected, with only 12% of central government workers stopping work, compared with union claims of up to 75%. Nonetheless, traffic was blocked and protestors banged pots and pans, calling for Zapatero’s resignation. Basic services were offered at some schools. Transport systems were shut down in places. Some local governments ran only with limited staff.

Yet more protests may be coming. On June 22, parliament passed a labor market reform bill aimed at reducing the number of temporary contracts and changing the rules governing hiring and firing employees. Overall, the goal is to make it easier for employers to use part-time employees and address the problem of a high rate of youth unemployment. The bill passed by a margin of 168 to eight, with 173 abstentions, most of which came from the PP.

Workers with permanent contracts have very generous severance packages, with standard contracts guaranteeing 45 days of salary for each year worked. The government has proposed to use alternative permanent contracts – so called “job boosting” contracts – which would provide for severance packages of 33 days per year worked. At the moment such contracts can only be made according to special categories of workers based on socio-economic status, age, and the duration of the jobless period. The reform means that a wider range of people could be offered employment, as long as they have been without a job for three months. Published data indicates that three-quarters of the unemployed have been that way for more than three months.

The bill also proposes to allow firms to offer smaller severance payments to workers at companies in financial difficulties, and to provide employers with an enhanced tax incentive to hire and train young people, hoping to tackle youth unemployment which stands at 40%. Firms will also be able to terminate collective wage agreements if their financial stability or outlook is uncertain and to reduce working hours by as much as 70% in the event of an economic slowdown as opposed to laying-off employees.

In terms of collective wage agreements, while union membership represents only 16% of Spain’s workforce – membership is concentrated among permanent contract holders in the public sector – the wages are indexed to past consumer price inflation. This creates a major problem for companies when the jobless rate soars and growth stalls, and adjustments to collective bargaining agreements are rarely undertaken in the face of union intransigence. Consequently, since wages cannot be changed easily, firms cope by reducing the number employed by canceling the contracts of those retained on a short-term basis.

Bank Takeover and Mergers

Meanwhile, the Bank of Spain has been forced to take over Cajasur, a savings bank that faced severe financial troubles after investing heavily in the Spanish housing market, in a move that has many investors nervous about the country’s creditworthiness. After seeing losses of $750 million in 2009, the bank had been in merger talks with the larger, more profitable Unicaja for over a year. However, when these talks failed, the government stepped in with $686 million of emergency funding.

Cajasur is not the only bank to be hit hard by the financial crisis. Many of the country’s 45 ‘cajas’ invested heavily in the real estate and construction industries, causing the banks to see rapid growth as these sectors boomed for a decade, only to be met with a property collapse which saw these banks’ loans go bad.

Cajasur, representing 0.6% of the overall Spanish banking system, now has some $2.5 billion in bad loans. After the merger talks failed with Unicaja, the government stepped in and fired Cajasur’s management and replaced it with state administrators. Liquidity will be provided while the government decides whether to auction the bank off, sell some of its assets, or liquidate it. The Bank of Spain has stressed that Cajasur’s takeover poses no threat to the country’s financial system as a whole, although it has resulted in the euro dropping farther against the dollar and pound.

The government has been pressuring the ailing banks to merge and has laid out restructuring guidelines for banks in order to gain access to the Fund for Orderly Restructuring of the Spanish Banking System (FROB). Zapatero has set a deadline for the end of June for the cajas to clear up their balance sheets and ask for funding from the FROB if needed. The number of cajas in the country, currently at 45, is expected to drop by half via mergers. Most banks are keen to avoid government takeover, and already over two-thirds of the cajas are in merger talks. Meanwhile, the central bank said it will “soon” publish results of “stress tests” carried out on the country’s bank to see if they have sufficient liquidity to withstand future economic downturns.

Very Little Good News in the Short-Term

The outlook for the economy this year is anything-but-sanguine as real GDP is expected to contract by 0.6%. Along with considerable uncertainty over the sustainability of the global economic recovery, housing prices are expected to drop another 12% this year (on top of the 16% drop from their peak in 2008), the jobless rate is 20% and should tick upward given the June fiscal austerity measures, and consumers are indebted.

The only really piece of good news for the economy came on June 19 when the government announced that it had raised 3 billion euro of 10-year notes at an average yield of 4.8% and a half a billion euro of 30-year bonds at 5.9%. The issuance was fully subscribed and helped ease the debt worries of the eurozone.  It also helped the euro hit a three-week trading high against the US dollar.

Last year was marked by deflationary pressures wrought by lower commodity prices and weak domestic demand. For 2010, an average inflation rate of 1.6% has been penciled in – well within the European Central Bank’s target of just below 2% over the medium-term. Wage demands will be largely muted by the state of the economy, but higher energy prices and a continuing weak euro will pose a risk to imported inflation.

The narrowing of the current account deficit that began during the global economic downturn in late 2007 will continue this year as feeble domestic demand will translate into a lower import bill. Regional economic weakness and Spain’s overall lack of competitiveness will do little to spur export receipts and bank lending will remain anemic given the state of the sector. For 2010, the current account deficit is forecast at 4.3% of GDP.