But the debt-fueled boom of the last decade created an artificial economy, sending Spain's unemployment rate down to as low as 7% in 2006. Spain functioned for years with high unemployment, but such a system won't fly now. Back then its citizenry and businesses had little debt, so if a person couldn't find work or if a business failed, it would be a relatively self-contained crisis.
For example, in 1989, household debt was around 31% of GDP while corporate debt was 49% of GDP. Today, household debt has nearly tripled at 85% of GDP while non-financial corporate debt has soared to 140% of GDP. Around 80% of household debt is linked to mortgages and is thus intimately tied to the housing bubble. The corporate debt is linked to huge dilutive acquisitions taken on behalf of Spanish companies and a multitude of questionable infrastructure deals. Together, Spain has a total private debt ratio that is the third highest in eurozone behind Ireland and Portugal.
Much of the money that fueled the speculative boom came from profligate Spanish banks. The government has propped up its creaky system through several rounds of bailouts, which have totaled 105 billion euros so far, equivalent to 10% of the nation's GDP. But even with all that bailing, Spanish banks have still come perilously close to failing. For instance the government said that around 50% of the total exposure that banks have to property are considered "problem assets" and that they only hold enough reserves on hand to cover 30%. As the housing crisis unfolds, painfully slow as most of these houses are primary residences, the banks will start to take tons of losses. That forces the government to pledge more cash to bail out the banks, turning that private debt into government debt.
The one thing Spain has going for it is that its government debt to GDP ratio is a relatively tame 70% of GDP. That compares to the eurozone average of 91% and is half that of Greece at 140% and much stronger than Italy at 120%. But it's the private debt ratio of 240% of GDP that has investors worried. As banks fail, that debt gets passed on to the government. As the economy contracts, and as debt rises, the debt to GDP ratio for the nation starts to increase at breakneck speed. If the Spanish economy stays in deep recession, Credit Suisse (CS) estimates that the government's debt to GDP ratio would reach an unsustainably high 100% by 2020.
On Thursday, the government sold 3.6 billion euros in sovereign debt at 6.975%, dangerously close to the 7% threshold that forced Greece, Ireland and Portugal to seek assistance from the European Central Bank. While Spain has not sought formal help, i.e. a bailout, from the ECB, it has benefitted from ECB buying up billions of dollars worth of Spanish debt in the secondary market in a move to keep borrowing rates low. If the ECB were to end that bond buying program, Spanish debt would shoot well past that 7% threshold.
The Spanish sovereign is sick but unlike neighboring Greece, it is in no immediate danger of going bust. But as those banks start blowing up and its economy shrinks, Spain will look more like its spendthrift southern European neighbor. Mr. Rajoy now has been handed the unenviable task of recreating an economy that never really existed.
