The problem for Spain, part 2

Both Malaysia and Thailand (as well as Korea and the Philippines for that matter) operated exchange rate targets rather than explicit currency unions but Hong Kong runs a currency board and may offer a better precedent for the current Euro / Spain Crisis.

Hong Kong was an initial beneficiary of the Asian crisis in terms of receiving capital inflows in mid 1997 but as local credit availability surged, so there began a shift up in local property prices. Then as the regional crisis deepened in 1998, so funds left the region and investors began to short the Hong Kong dollar and the country’s balance of payments moved into deficit. The data suggest that Hong Kong’s overall balance of payments deficit moved towards 20% of its GDP, and under the terms of the Pegged Exchange Rate System, the Hong Kong Monetary Authority (HKMA) had no choice but to address the balance of payments deficit with a sharp tightening in domestic liquidity conditions and a substantial hike in real interest rates. Nominal interest rates soared into the high twenties, although intraday rates occasionally hit three figures and the local property market fell by nearly two thirds from its peak and a third from the level prevailing in 1996, prior to the inflow of funds which had supported the expansion of credit.

The contraction of Hong Kong’s economy that followed involved outright deflation with the consumer price index (CPI) falling by around 15% from peak to trough over the next five years. There were popular protests, but with no democracy, austerity was maintained and Hong Kong regained some of its competitiveness with falls in property prices, wages and consumer prices. That said, the authorities did recognise the pain, with intervention in the equity market and opening a discount window at the HKMA.

In contrast to king Kong, Spain is an open democracy with a heavily unionised work force and a generous social security safety net that prevents meaningful wage deflation by in effect setting a high minimum nominal wage. Perhaps more directly, Spain’s electorate can simply vote for a change in policy direction.

As the Federalists have long recognised, if the government of Spain was in fact Euroland, selected by a full Euroland populace, then sustained austerity could be forced upon the Spanish people. But Euroland politics is in effect unfinished business, and the single currency and monetary system does not have a match in the setting of fiscal priorities and arrangements, and by extension politics. As a consequence the Spanish people can force a change of direction, and a policy option that must be considered will include return to an independent currency regime.

The immediate problem is that as Spain’s problems intensify, so its people will vocally and visibly demand more action, and this will generate further capital flight, with continued worsening of the balance of payments crisis, and more pressure on the economy in what is a harsh and vicious spiral.

Politics lies at the heart of the problem through the construct of the single currency, the absence of integrated politics and fiscal policy, and the brinkmanship that is involved when sectional interests, which are practically determined through the ballot box, control what actually happens. No elected government will exhibit an appetite to concede apparent benefits that accrued hand in hand with the extraordinary excesses associated with the prolonged and extended build of financial leverage.

Markets recognise and seek to price the challenge that absent vigorous political will to address the challenges on a pan-Euroland basis, Spain’s problems will only become more pressing, and its voters will force change. Some of the immediate issues are considered in the next paper.

The problem for Spain, part 1
The problem for Spain, part 3

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla

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The Local Authority Treasurers’ Investment Forum September 25th, 2012, London Stock Exchange
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