Chart of the Week: Spain’s bad loans rise with unemployment

January 22nd, 2013 by

Nonperforming loans at Spanish banks continued to rise in November, reaching a record high of €192bn, or 11.4% of all outstanding loans. Spanish lenders have faced the dual threat of slumping house prices and widespread unemployment. With joblessness set to rise further this year, they would be wise to brace themselves for a further increase in bad loans over the coming months.

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The level of toxic assets in the Spanish banking system rose to a new record high in November. Non-performing loans increased by €2bn to €192bn, and now make up 11.4% of total bank assets, or almost 20% of GDP. Many of these bad loans are concentrated in the real estate sector. Spanish house prices have fallen by more than a quarter since peaking in 2008, leaving a substantial debt overhang. The weak real estate market has been compounded by an unemployment rate above 25%. With joblessness set to rise further in the coming months, there is little reason to expect a sharp turnaround in non-performing assets.

Bad bank assets today can be seen as the sovereign’s liabilities of tomorrow. Recent evidence in Spain gives credence to this view. Over the past few years, the government’s borrowing costs have tended to rise in sync with the perceived safety of its domestic banking system, and vice-versa. This is a pattern that can be seen across the Euro Area. In Ireland, an insolvent banking system ended up bankrupting the sovereign. For Greece, it was the opposite. In both countries, the two were inextricably linked.

European leaders appeared to have recognized this unhealthy relationship, and pledged last June to break the ‘vicious circle between banks and sovereigns’. However, words are cheap, and bank recapitalizations are costly. Since then, politicians have backtracked from the spirit of that statement. Finance ministers from the ‘core’ northern economies, who would bear a disproportionate burden of any pan-European bank bailout, have since said that legacy debt should not be covered by the ESM. Furthermore, they have indicated that the cost of any bank bailout should first be borne by its host sovereign. Far from breaking the bond between banks and their domestic hosts, this would appear to be codifying it.

All of this does not bode well for Spain. Having already borrowed €40bn to pump into its ailing lenders, Madrid’s debt-to-GDP ratio is forecast to rise to 96% this year. With a fiscal deficit approaching 9% of GDP in 2012, and something close to 7% penciled in for this year, the government has little room for maneuver. For the moment, financial markets, buoyed by the ECB’s OMT backstop, have been willing to lend to Madrid at favorable rates. But should Spain’s banks be forced to come cap-in-hand for more money that could quickly change.