Spain’s Delicate Fiscal Bullfight
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Spain’s Delicate Fiscal Bullfight

Spain’s new government has announced spending cuts and tax increases worth an estimated EUR 27bn in an endeavour to reduce the gaping fiscal shortfall from 8.5% of GDP at the end of last year to 5.3% by December 31st. Most of the pain is being absorbed by departmental spending – all ministries are to reduce spending by 17%.

In addition, power prices are to rise by 7% and the tariffs that electricity companies pay is to rise by 5%. Also, larger companies are to be taxed more heavily, the system for corporate tax payments is to be reformed, corporate tax deductions are to be reduced and there will be a crackdown on tax fraud.

These tax modifications are expected to generate EUR 12.3bn in additional revenues in the current year. Budget Minister Montoro claims that central government will reduce the size of its budget by 2.5% of GDP. Recall that Spain has vowed to reduce the size of the fiscal deficit this year by 3.2 percentage points of GDP, so the balance of the fiscal adjustment will come from the regional governments.

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This is a tough package. Politically, it should help to placate growing civil unease as pensions, VAT and social security have all been left untouched, although Rajoy will inevitably be forced to return to them. Income taxes were raised back in December. Rajoy’s ministers will discover that chopping spending by 17% across the board in such a short time is an immensely difficult task.

At the very least it will result in significant extra unemployment amongst public sector workers, at a time when the unemployment rate is already above 23%. With the economy already in recession, it would be extremely surprising if this package is sufficient to lower the deficit to the 5.3% target. Neither investors nor traders will respect the failure to tackle benefits, implement a VAT hike or rein in pensions.


Is Europe doing enough? The anticipated agreement on the expansion of the EU’s total available rescue funds should be welcomed, but at the same time can be regarded as a half-hearted approach that reflects compromise more than it does commitment. We’ve long held the view that the move was necessary, and the narrowing of peripheral bond spreads on the back of the ECB’s 3Y auctions of funds did nothing to change that view. Indeed, it made the provision of a stronger firewall all that more important because introducing it at a time of increased stress would have been seen as a reactive rather than proactive step. The reasons why Friday’s deal looks likely to fall short is that it does not fully meet the requirements pushed for by the European Commission and called for by overseas lenders such as the IMF. Combining the European Stability Mechanism (ESM) with the current (temporary) European Financial Stability Fund (EFSF) program serves to increase the availability of funds at the outset, as the ESM will take time to be built up. Still, Germany has chosen to not push for the EUR 940bln. Instead, the remaining EUR 240bln will be allowed to run alongside the ESM and may be lent, in what the FT says (quoting from the draft statement,) will be “exceptional circumstances” subject to the unanimous vote of European leaders. The key question is whether this watered-down approach will be enough to appease those in the international community who think that Europe needs to do more to help itself before it can ask for further support from elsewhere (principally the IMF). At the moment, this is looking doubtful, judging by comments seen in recent days from BRIC countries and others.

Chinese confusion. Attempting to get an accurate fix on how the Chinese economy is performing these days is more complicated than usual. Overnight, the PMI produced by the China logistics federation and the National Bureau of Statistics jumped to 53.1 last month, the highest for twelve months. However, the PMI calculated by HSBC and Markit Economics showed that the manufacturing sector continued to retreat and export orders were actually declining. The latter seems more consistent with the recent run of data emerging from the world’s second largest economy, and is likely to increase pressure on policy officials to consider further easing measures. Additional cuts to bank reserve requirements are highly likely, and the government is also expected to ease fiscal policy.

Yen may struggle to hold recent gains. In the run-up to the end of the financial year, the Japanese currency strengthened slightly. USD/JPY, which ten days ago was threatening the 84.0 level, fell below 82.0 for a time on Friday. Part of the explanation for the turnaround lies with profit-repatriation flows by Japanese companies that frequently occur around this time of the year. Also, interest rate differentials between the US and Japan are narrower, helped by Fed Chairman Bernanke’s recent remarks which scuppered talk of an early rate hike in the US. Plus, risk appetite has stalled amidst growing concern over the slower pace of growth being recorded in China and parts of Europe. Notwithstanding this improvement, now that these year-end flows have run their course it remains to be seen whether these latest gains in the yen are sustainable. As Friday’s deluge of data demonstrated, further accentuated by the soft Tankan reading overnight, the economy in Japan is still struggling to adjust in the aftermath of last year’s tsunami and earthquake. In February, industrial production was much weaker than expected, falling by 1.2% (although firms are expecting to raise production in April). Tokyo remains utterly determined to prevent any yen strength; policy-makers were overjoyed in February and in the first half of last month by the consistent decline in the currency, and they would love for it to continue. At the same time, Japanese authorities have been encouraging local residents and institutions to invest offshore, and, to some degree, they have been obliging. With yields back home essentially at zero, it is not a difficult case to make. As such, should US yields start to edge higher again, policy-makers in Japan might just get what they wish for. Their economy desperately deserves it.

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