The recent nationalization of Bankia, one of the largest financial institutions in Spain, made it clear that a significant part of the country’s banking sector could not survive without economic assistance. On June 10, that assistance materialized when Spanish Prime Minister Mariano Rajoy announced an agreement with the European Union for a 100 billion euro loan to the country's banking sector. What will this rescue accomplish, and what repercussions will it have on the economy of Spain and the future of the euro? Universia Knowledge at Wharton spoke with Rafael Pampillón, professor of economics at the IE Business School, about these and other questions.
The following is an edited version of the interview:
Universia Knowledge at Wharton:Prime Minister Rajoy’s announcement on June 10 was notable because of the absence of the term “rescue.” Has Spain been rescued – or hasn’t it? If so, from what? And why has everyone avoided using the term “rescue”?
Pampillón:It is a “rescue” if a bank is insolvent, with overvalued assets whose prices must be lowered. When you set the market prices for property development, mortgage loans and loans to creditors, the shares of the companies involved will register losses and their capital will be reduced. [The Spanish government] has to help the sector, but it cannot because it doesn’t have the capacity to go out in the market to finance itself because interest rates are very high, so they need to get outside aid. What the government has done is to isolate the problem and concentrate exclusively on the banks.
It is not a rescue for the country because that happens when you are refinancing its public debt. In this case, they are not refinancing the public debt; they are recapitalizing the banks.
Universia Knowledge at Wharton:It has been announced that the Troika (the European Central Bank, European Commission and the International Monetary Fund) is going to monitor all economic activity very closely. What exactly is your position?
Pampillón:What they want is for Spain to give back the loans that they are going to grant to it. For that to happen, we must carry out an appropriate economic policy, which allows wealth to be generated. This will have to be done by two routes: reducing public spending and increasing revenues.
The problem is that the markets have perceived that the government is going to increase its indebtedness by some 100 billion euros — enough to make it a priority when it comes to giving back what is owed. That is to say, they will have to pay European partners before [they pay back] the debt that is issued.
Universia Knowledge at Wharton:How is this different from the rescues that Greece, Portugal and Ireland obtained earlier?
Pampillón:The rescues of those three countries are rescues of an entire economy. In addition, the Troika gets into their ministries and imposes on them what they have to do. More explicitly, they write out their economic policy. That is not going to happen in Spain. Here, the government is going to continue to carry out economic policy. Spain does not want to undergo the humiliation of being managed from outside. In addition, Spain is an exemplary country within the European Union, because it has continued to comply with the requirements that have been imposed on it. They have not taken control of us, but we are going to try to keep our partners happy.
Greeceneeded about 75% of its GDP, while the rescue of Ireland was 50% of its GDP and the rescue of Portugal was 32% of its GDP. In Spain, we are talking about a rescue of 10%, and it is only for the banking sector. If it were for the entire country, it would be much greater, and economic policy would remain in the hands of the Troika. That is not going to happen, as the [Spanish] government has explained on numerous occasions.
Universia Knowledge at Wharton:So what is the difference? Spain enacts the economic policy that it wants, but before that happens, the Europeans tell the country what has to be done?
Pampillón:The nuance is that you maintain your independence, but you are part of a club. It is as if you bought a house and the bank gave you a mortgage. The financial institution grants you the money but as a condition it makes you take out insurance to protect the house, which is a guarantee of the loan. You decide where you want to have this insurance. The nuances are difficult to distinguish between but, for example, one gesture of independence has been the recent nomination of the governor of the Bank of Spain. The ECB [European Central Bank] wanted us to nominate González Páramo or Sáez de Vicuña, who are both within their orbit, and we have decided to choose Luis Linde, who is neither known in international markets nor supported by the ECB.
Universia Knowledge at Wharton: Ireland and Portugal have complained that Spain’s loan conditions are better than theirs. Can this situation lead to problems for the European Union?
Pampillón:Those countries were given bigger loans, when compared with their GDP. And, to start out, they did not give Spain a loan to pay back the debt; we can repay the debt with our own means, but they cannot. They needed intervention in order to be able to repay the public debt that they had contracted. We are the only ones who have asked for a loan to recapitalize the banks.
Universia Knowledge at Wharton: What is Spain going to gain with this type of rescue?
Pampillón: The rescue will permit Spain to reduce the financial cost of its debt. This new debt will be repaid at 3%, while the market rate is 6%. Lowering our interest payments will reduce the public-sector deficit.
Universia Knowledge at Wharton: What impact will this have on the finances of the country and the Spanish economy?
Pampillón: The ideal thing would have been for the rescue to take place with contributions of capital; that is to say, for the European fund itself to contribute money to recapitalize the 22% to 30% of Spanish banks that have problems. They took another route. They asked for a loan from that European fund — and that credit line, to the extent that it is used, will mean an increase in the [country's] indebtedness. Spain’s debt was going to close out this year at about 80% of its GDP, but it will increase to 90%. This is a significant figure, especially in case they use the 100 billion euros, but we are waiting to find out the results of the audits of the country’s banking system. Interest on the debt will affect the deficit, because it is a financial expense.
Behind the scenes, there are still details to be resolved regarding the debt. But I would not be surprised if they went ahead with the economic measures that are already on the table. For example, they could delay the retirement age, reduce the salaries of bureaucrats, cut the spending of the "autonomous communities" (local units of government) and privatize or close public sector enterprises in regions and town councils. In addition, they will have to increase the value-added tax because Spain’s value-added tax is very low (18%) and the government would now have a justification for doing that. This is one of the measures that [the European Commission] is going to ask from us.
Universia Knowledge at Wharton: What exactly is the problem with the Spanish financial system? Do you believe that it could be solved with these 100 billion euros?
Pampillón: It is likely that our country’s financial problems will end with this rescue. It would be added to the other problems that the country has, and that it is resolving, such as the deficit in the public-sector and overseas, and in family indebtedness.
It is also clear that two important imbalances remain to be resolved, such as the housing market and the labor market, in which the government has to try harder.
Universia Knowledge at Wharton: How will this rescue help Spain’s financial system?
Pampillón: An adjustment of the Spanish banks is indispensable, including closing offices and dismissing workers. This is something that would be indispensable, whether or not there were loans from [the EU]. The people who are providing the loans [to Spanish banks] want the banks to function well.
Universia Knowledge at Wharton: In your opinion, will this injection of capital eventually reach families and companies?
Pampillón: During times of economic deleveraging, such as at this moment, when families and companies are reducing their debts, they are not going to increase the loans that they request in net terms. However, evidently, financial institutions will have a capacity to give loans that they did not have before.
Universia Knowledge at Wharton: How do you believe the Spanish people will be affected by the rescue?
Pampillón: People who need a loan are going to find it easier to get, and the depositor will find that some of the more restructured public banks are going to handle their deposits. The people who will lose out in this entire situation will be shareholders, who will find that their ownership in these institutions is diluted.
Of course, they will also be damaged by the adjustments and new measures by the government, such as the increase in the VAT. That will affect them negatively in the short run, but with the hope that over the medium and long-term, all of these reforms can generate more employment, and the unemployed can find jobs.
Universia Knowledge at Wharton: Insofar as we can see ahead, what are your predictions for growth in 2012 and 2013?
Pampillón: This year, the economy will fall by about 2%, and there will be no growth in the GDP. There could be negative growth in the first part of the year but positive growth in the second.
Universia Knowledge at Wharton: Do you believe that the timing and depth of the reforms that Spain is committing itself to will change with the arrival of Mariano Rajoy as head of the government?
Pampillón: I believe so. The message that the government has to send now is that Europe has done [Spain] a favor by giving us credit, and we are going to have to respond now with the reforms that are needed for the growth to happen earlier [rather than later] in Spain — although these adjustments will be hard and will bring us more recession in the short run.
Universia Knowledge at Wharton: In your judgment, what signal has Europe sent concerning the strength of the euro and the future of the common currency?
Pampillón: Europe is not doing a good job in that regard. It was expected that this loan would resolve the [remaining] doubts in the markets, where there was panic regarding Spain because of the uncertainty generated by the hole in its financial system. Theoretically, the tension should have been reduced. But I am surprised that this is not happening. We will have to wait for the next meeting of the European chiefs of state at the end of June to see what happens. But on that date, they have to take major steps in [creating] common fiscal policy.
It would be very interesting if Germany were to decide to carry out a policy to increase its domestic demand with the goal of increasing imports from other countries in the eurozone. It is very important for countries that have a foreign surplus – such as Austria, Finland and Holland – to increase the volume of other countries’ exports that they pull in. This is the mechanism, and this depends on what the heads of state and governments decide.
Universia Knowledge at Wharton: How do you see the future of the EU, the euro in general and Spain in particular?
Pampillón: There needs to be progress toward a United States of Europe. In order to maintain the euro over time, we need European institutions to improve and grow. We need to create a single fiscal policy, with common taxes, with a common Ministry of Finance in all of the countries of the eurozone, so that this problem is above all of the national ministries — and with a common Treasury Department, so there are eurobonds available to finance the difference between public revenues and public spending. The solution to the problems of the eurozone involves progressing more in that sense, and it involves making the necessary structural reforms in the countries that need them in order for their economies to grow.
The European Central Bank is behaving the wrong way now. It is demanding that countries undertake the necessary reforms so that they can buy debt in the market later on. They have to intervene in the secondary debt market in order to lower the risk premiums and interest on the debt. They have to help countries on the periphery, and behave like our central bank. The markets can’t be mistreating a country like Spain, which is meeting its obligations, while [the European Central Bank] just looks the other way.