Ignacio de la Torre. Professor. IE Business School
10 October 2012
Spain is addressing its current account imbalance, labor costs, and surplus credit growth, bringing an opportunity for brave investors.
In the spring of 2008 Spain’s Ministry of Finance paid for a two-page ad in the Wall Street Journal, with a heading that proclaimed that the Spanish Economy was set for recovery. The calamitous Pedro Solbes, now an “independent” consultant for Enel, could be seen smiling in a photo designed to prompt the idea that public spending would bring about the recovery of the Spanish economy in the very near future.
Just another two pages and another photo for Spain’s history of horrors.
Let’s take a look at the two years leading up to that point. In spite of a growth rate of almost 4%, in 2006 the Spanish economy was falling off a cliff. Ten out of every €100 of GDP were financed by foreign savings, making Spain’s current account deficit the world’s second largest in absolute terms. The Ministry of Finance insisted that the foreign deficit did not matter.
Moreover, the annual increases in credit were over the 25% mark. That is to say, just one true point of GDP growth required over six nominal points. In other words, it was a classic asset inflation time bomb that could only culminate in a banking and economic crisis once capital flows changed direction. The inaction of Spain’s Ministry of Finance in the face of such cataclysm serves to show us, once again, its abject lack of professionalism.
In addition to these two factors, the cost of labor in Spain had been rocketing for several years, resulting in a loss of competitiveness, and public administrations poured funds derived from irregular income generated by the real estate boom into regular flows (current expenses), which created a fiscal crisis in the lead up to the change in cycle.
Nevertheless, in 2006, nobody noticed this simple fact. Agencies gave Spanish debt a triple A rating (pity the person who bought these long-term bonds at a lower rate than that of German bonds), and the portfolio investments (stocks and bonds) that Spain attracted were at record levels in spite of historic maximum prices of shares and bonds. Private equity scrambled to buy firms at incredibly inflated prices.
Then the crisis came bringing the terrible consequences that we all know too well. But let’s take look at some promising data: at the end of 2011, the cost of an hour’s labor by a Spaniard stood at €20. The cost of an hour’s labor by a citizen of our main trading partners in the Eurozone stood at €30 (Germany ), €34 (France), and €27 (Italy). These differences in pay could be justified if, for example, a German was 50% more productive than a Spaniard, but in reality said German is only 16% more productive. In fact, productivity per hour of labor in each country is the equivalent to €37, €43, €44 and €35 respectively. This means that a Spaniard costs less than an Italian but also produces more per hour. So when cost and productivity are viewed as a whole, Spain is actually the most attractive economy in which to invest.
These figures are highly relevant because labor tends to be the most expensive element of business costs, making up two thirds of the total. Taxes are another key factor, and in practice companies domiciled in Spain pay even less tax than in Ireland (whether that is better or worse for our economy is another thing). The number of hours worked is also important. Contrary to popular belief, Spain is one of the countries where most hours are worked in the world (1,700 hours per annum), compared with just over 1,600 in Italy and less than 1,500 in France and Germany.
Internal demand in Spain will continue to be sluggish for many years, but we can aspire to become an export hub. This will require direct foreign investment. If a CEO from the US is thinking about placing a factory in Europe with a view to exporting, the best choice is probably Spain.
Meanwhile, as I have outlined in other articles of mine, the economy is adjusting its current account imbalance, and there is no longer surplus credit growth. Rather the opposite in fact, given that a purge is taking place.
Basic logic tells me that the prices of Spanish assets should actually be much more expensive today than they were in 2006, first because there are less inherent risks, and second because the cycle of profits are at an all time low. In 2006 underlying imbalances in the GDP gave every indication that it would eventually implode. Today nobody seems to take into account the far lower risk associated with Spain’s GDP, nor that it will eventually grow via exports. Nevertheless 2006 prices were far higher than now. It would be feasible to expect shifts in portfolios to correct this possible inefficiency, but the data suggests that exactly the opposite has happened. The foreign investor that bought Spanish assets en masse in 2006 sold them en masse in 2012. It is now that foreign private equity firms should be buying up assets, and selling them at 2006 prices, but they have done just the opposite. And the same thing is happening with real estate investors.
Warren Buffet says that the key to investment is to be brave when the rest are scared and scared when the rest are brave. The latest question he asked was “Who will make Money in Spain, the person who bought in 2006 or the person who buys in 2013?”
Seeing the capital flows of our economy, I am increasingly convinced that the strongest of herd instincts, also known as behavioral finance, is still far more powerful than many of us would like to admit.