The bankruptcy tide threatening Spain's recovery

Stratfor.com

The Spanish National Statistics Institute issued a warning on the state of the Spanish economy August 7, when it revealed that 5069 companies had filed for bankruptcy during the first half of 2013, a 22.5 per cent increase from the first half of 2012 and the highest number since the statistical series began in 2004. The construction sector has been hurt the most by the crisis; roughly 27 per cent of all the bankruptcies filed between January and June involved construction companies. Other sectors, such as retail (which accounted for 17.7 per cent of the bankruptcies) and industry and energy (17.3 per cent), were also particularly affected by the economic crisis in the eurozone's fourth-largest economy.

The Spanish crisis has resulted not only in the loss of a significant number of jobs but also in the closure of thousands of companies. According to Spain's Ministry of Employment and Social Security, between December 2007 and June 2013, a total of 219,000 companies shut down – a 15.5 per cent decrease in the total number of companies in the country.

On average, most of the companies that have closed down during the Spanish crisis have been in the construction or industrial sectors and have been small or midsized. In the aftermath of Spain's real estate bubble, construction was the sector by far most affected by the crisis. In June 2013 there were 53.3 per cent fewer construction companies than in December 2007. By comparison, there were 24.6 per cent fewer industrial companies during the same period.

Regarding size, small and medium companies were particularly affected by the crisis. The total number of companies with 26-49 employees fell by 32.9 per cent between 2007 and 2013, and the total number of companies with 50-249 employees fell by 27.7 per cent. In contrast, the total number of companies with more than 1000 employees has only declined by 8.3 per cent in the past six years. Of all the companies in Spain, two-thirds have less than 49 employees, something that highlights the importance of small and mid-sized companies in the Spanish economy.

In 2008, construction accounted for 13 per cent of total employment in Spain – because of the crisis, the sector's participation in employment is currently 6 per cent. In 2008, there were 2.6 million people working in construction in Spain, while today there are only 1 million workers in the sector. During the same period, the industry sector's share in total employment fell from 16.2 per cent to 13.7 per cent, and the total number of workers in the sector fell from 3.3 million to 2.2 million. The services sector (which includes a range of activities, including banking and tourism) has suffered less during the crisis: The number of employees in the sector fell from 13.5 million to only 12.6 million between 2008 and 2013.

Limited room for action

A combination of economic, legal and financial factors explains the high number of failing companies in Spain. First, the Spanish economy has been contracting almost continuously since 2009 – its 0.4 per cent growth in 2011 is the only exception – and unemployment went from 8 per cent in the second quarter of 2007 to 26.4 per cent in the second quarter of 2013. The closure of companies is significantly hurting employment, which in turn weakens domestic consumption of goods and services.

Legal issues also explain the high number of companies closing down. In its latest report on the Spanish economy, the International Monetary Fund warned about Spain's strict and inefficient bankruptcy laws. According to the International Monetary Fund, Spanish companies generally file for bankruptcy when it is too late, Spanish courts are overwhelmed with work, processes are lengthy and the system is inefficient. Moreover, according to the International Monetary Fund, Spain needs to change the rules of the game, as the majorities needed for approving a restructuring of debt (sometimes consensus of all creditors) prevent companies from surviving after filing for bankruptcy.

In addition, the financial crisis in Europe considerably weakened credit conditions in Spain, severely limiting small- and medium-sized enterprises' access to bank loans. On August 8, the European Central Bank said in its monthly report that it will keep interest rates low (currently at 0.5 per cent) for an extended period, a further signal to banks that they should increase lending to companies and consumers. But while the European Central Bank has played a crucial role in avoiding the breakup of Europe's financial system and currency union through extensive liquidity provision for banks and promises to intervene in sovereign bond markets, it has largely failed to stimulate lending and consumption in the real economy.

The European Central Bank's limitations are a result of the eurozone structure as well as the depth of the consumer crisis. The European Central Bank's sole target is inflation, and under its current charter it is significantly constrained in its purchase of government or corporate debt to fuel growth and drive down unemployment, like the Federal Reserve or the Bank of England can do and have done.

The 17 different banking systems in the eurozone are another structural problem. While capital still flows freely in Europe (apart from temporary restrictions in Cyprus), the divergence in terms of financial and economic stability across the eurozone makes it more difficult to implement a monetary policy that is beneficial to all countries. In Germany, households and companies profit from the European Central Bank's low interest rates passed on by commercial banks that still lend to the real economy because of continued stability. In crisis countries like Spain or Greece, however, there is a vicious spiral. While banks can borrow money easily from the European Central Bank, they are holding back lending since there is a growing number of consumers who cannot honor their debts and companies that are struggling to survive. This means that the real economy deteriorates, further souring the balance sheets of banks and reducing their desire to lend.

This negative cycle is more of a problem in Europe than in the United States because of the importance the banking system plays as a lending channel to the real economy, particularly to small- and medium-sized companies that generate the majority of jobs and output in Europe. According to the European Banking Federation, about 75 per cent of European corporate financing comes from banks, compared to 30 per cent in the United States.

The European Central Bank has little power to break this cycle and target a specific region in the eurozone with monetary policy tools, since encouraging banks to take more risk by lending to struggling economies goes against efforts to stabilise the banking sectors and reduce governments' risk of having to bail out banks with taxpayer money. While the central bank can quickly stabilise banks and keep them operational through additional liquidity, it faces far greater difficulties in reviving the real economy in numerous countries where high unemployment and bankruptcies have decimated large parts of the consumer base and wealth-generating economy.

Modern economic history shows that recessions often enable an economy to recover efficiency, since less efficient firms tend to be the first to disappear. But Spain is currently at risk of the prolonged economic crisis destroying essential parts of its production sector (not only from a material perspective, but also because the technical expertise of workers will degrade due to prolonged unemployment), limiting the country's ability to absorb economic stimulus and restore sustainable growth. In this context, the European Central Bank has only limited room for targeted action to help Spain. In the coming months, as the European debate moves away from its original fixation with fiscal consolidation and focuses on how to create jobs (and particularly after the German elections remove the European Union from its current cautious state), the role of the European Central Bank and proposals to strengthen the banking union in the eurozone will return to center stage.

Stratfor.com Republished with permission of STRATFOR.