Spain rues the day it joined the euro

Spain's economy is less competitive than ever, the house price slide continues and its current account deficit has mushroomed to the world's second-largest. And there's very little the authorities can do.

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The numpties at the Banco de Espana must be rueing the day they joined the euro. They have three reasons for regret. The country's housing bubble has burst, the economy is less competitive than ever and the current account deficit has mushroomed to the world's second largest.

And there's little to nothing they can do about it. Except, of course, look on helplessly...

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It didn't have to be like this. Before euro membership, the Spanish economy was motoring on nicely. Economic growth at just over 3% was complemented by interest rates at 15% and almost normal levels of household debt. Then came the euro, and with it interest rates set across the board by the European Central Bank.

And while that may be good news for an economy such as Germany, which by itself represents one third of the eurozone economy, for tiddlers like Spain it's the last thing that they needed.

Interest rates promptly dropped below 3%, and before Spain knew it, its economy turned red hot. Cheap money flooded the market, which in turn stoked a housing bubble. Spanish house prices have jumped 270% in just a decade. Spaniards suddenly found themselves riding a housing beast that could lose control at anytime.

And now it has. So many houses and apartments have been built in the past year, that there's a huge surplus. In fact 40% more than required. 750,000 houses and apartments were built last year, says the country's Finance Ministry. Annual demand ran at only about 60% of that.

But if sellers are now fretting over how they're going to unload their properties, they really have only themselves to blame.

As far back as January, the OECD warned that prices were overvalued by at least 30%. That's a figure in line with estimates from analysts at Ahorro Corporacion. They say that in order for demand and supply to strike a balance, construction of new apartments and houses would have to drop to 400,00-450,000 a year. So there's a long way to fall yet.

Which implies there's a lot more pain to go around. Fewer houses being built means fewer workers in the housing industry. Ahorro Corporacion says 200,000 people are facing the dole queue.

In a country where housing accounts for almost a fifth of GDP and for a third of economic growth, that spells trouble. About 18% of Spanish GDP is accounted for by housing, twice the EU average, meaning economic growth is set for a trimming as fewer houses are built and unemployment increases. In a May 18 report, IMF economist Julio Escolano said a 30% drop would result in a 0.4%-0.7% cut in economic growth a year. Deutsche Bank put the cut in growth closer to a worrying 1.8%.

So the economy is slowing. In the good old days before they joined the Euro and had rates set for them by the ECB, the Spanish Central Bank would simply have devalued the currency, thus making goods cheaper and boosting the export sector.

Of course it can't, which means a slowing Spanish economy, and a widening trade deficit. Already, Spain boasts the second largest current account deficit in the world with more than $100 billion outstanding. (The US has the largest, with a gargantuan $862 billion outstanding).

"The current account is completely out of control,' said Alberto Mattelan, an economist at Inverseguros in Madrid told the Daily Telegraph. 'We have the worst deficit in our history and worse than any other country in the western world. It has not yet become a 'street concern', but I can assure you that it is of great concern to us economists. This will turn bad over the next 18 months,' he said."

What should the central bank do? Because it's tied to the Euro, it has only one option. Bite its lip and deflate. As Jamie Dannhauser says in a report, The End is Nigh from Lombard Street Research, 'Pain seems to be on Spain's doorstep'.

Turning to the stock markets...

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In London, the FTSE 100 soared 90 points higher yesterday, closing at 6,649, as mining issues continued to climb and the strong start on Wall Street gave stocks a boost. Bradford & Bingley was the day's stand-out performer, jumping over 5% after broker Credit Suisse said that the mortgage bank's recent decline was coming to an end. For a full market report, see: London market close

On the Continent, the Paris CAC-40 added 112 points to end the day at 6,047. And the Frankfurt DAX-30 was 168 points higher, at 7,752.

Across the Atlantic, stocks rallied again yesterday as ongoing stability in the bond market cheered investors. The Dow Jones added 71 points to close at 13,553. The tech-heavy Nasdaq was 17 points higher, at 2,599. And the S&P 500 gained 7 points to end the day at 1,522.

In Asia, the Nikkei closed up 129 points at 17,971 as the yen weakened further against the dollar. In Hong Kong, the Hang Seng was 168 points higher, at 21,035.

Crude oil futures rallied 2% yesterday and were trading at $67.62 today. In London, Brent spot was at $71.16.

Spot gold had fallen to $650.50 from $651.20 in New York late last night.

In the foreign exchange markets, the pound was at 1.9702 against the dollar and 1.4797 against the euro this morning, whilst the dollar was at 0.7509 against the euro. Meanwhile the yen hit a 15-year low of 243.10 against the pound and was trading at 123.43 against the dollar today.

And in London this morning, a survey by Industrial Relations Services showed that UK salary growth slowed in May, with median pay gains of 3% compared to 3.1% in the quarter ending in April. The survey could help assuage the Bank of England's fears that the higher cost of living will prompt workers to make bigger wage demands.

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Jody Clarke

Jody studied at the University of Limerick and was a senior writer for MoneyWeek. Jody is experienced in interviewing, for example digging into the lives of an ex-M15 agent and quirky business owners who have made millions. Jody’s other areas of expertise include advice on funds, stocks and house prices.