Spain risks crisis over vanishing FX and gold reserves

By Ambrose Evans-Pritchard
The Telegraph, London
Wednesday, May 16, 2007

Spain's foreign reserves have plummeted to wafer-thin levels, leaving the country exposed to a possible banking crisis if the property market swings from boom to bust -- despite membership in the eurozone.

The Banco de Espana's holdings of foreign currencies and gold have fallen to E13.2 billion (Β£9.02 billion), equivalent to 12 days of imports.

Over the past two months the Banco de Espana has sold off 80 tonnes of gold, flooding the world market with enough bullion to dampen the usual spring rally. The bank has reduced its holdings of US Treasuries, British gilts, and other investments at a similar rate.

Total reserves have now fallen by two thirds from E41.5 billion in early 2002. Greece and Portugal have seen a similar drop.

By contrast, the overall reserves of the eurozone system have remained stable. France (E76 billion), Germany (E86 billion), Italy (E59.5 billion) have all kept holdings at full strength since the launch of the euro.

The Banco de Espana refused to comment on the sales, leaving it unclear why reserves have fallen so low or where the money has gone.

It appears the bank has been draining the reserves to help finance the current account deficit, which has ballooned to 9.5 percent of GDP, reaching E8.6 billion in January alone.

"The current account is completely out of control," said Alberto Mattelan, an economist at Inverseguros in Madrid.

"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.

It is often assumed that reserves no longer matter once a country has joined the euro, but this ignores a crucial element in the workings of the EMU system. It is responsibility of the 13 national central banks to act as lender of last resort in a crisis, even though they have no control over interest rates.

"Where this gets serious is if there is a property collapse in Spain and the banks get into trouble," said Prof Tim Congdon, an expert on monetary policy.

The first signs of a housing slump are emerging as the ECB raises interest rates, already up seven times to 3.75 percent since December 2005. The shares of Valencia builder Astroc have fallen 77 percent since February, setting off a sharp slide across the sector, with knock-on effects on banks with mortgage exposure.

Morgan Stanley said construction accounts for 17.7 percent of GDP, even higher than the 15 percent peak reached in Germany after reunification -- a boom-bust saga that left German banks prostrate for years.

Spain's private sector has amassed $600 billion (Β£300 billion) in foreign debts. Corporate borrowing is 100 percent of GDP. The overall stock of mortgages has increased sixfold in a decade. Household debt has reached 120pc of disposable income, largely on floating rates.

Prof Congdon said Japan was able to uphold its banking system in the post-bubble slump of the 1990s because the government could guarantee deposits. "You can't do that in the eurozone because there is no government to turn to," he said.

Each country is on its own. The ECB may interevene only if the crisis spreads across the eurozone, and it is forbidden from bailing out the member states. The International Monetary Fund warns that the structure leaves EMU exposed to "systemic financial risk."

Reserves are a key defence for each state, hence the EMU quirk that national banks retain the lion's share of reserves. The ECB has a token 13 percent.

For now Spain is still looking rosy: growth was 4 percent in the first quarter; the budget surplus is 1.8 percent of GDP; and export share is holding up reasonably well.

However, the party is ending after a near tripling of house prices since 1995. In a report, "The End is Nigh," Jamie Dannhauser from Lombard Street Research said Madrid is now making matters worse with a new law to hit property speculators.

"This screams of closing the stable door after the horse has bolted. House price growth has clearly peaked and is decelerating quickly. Speculators appear to have got out already, sensing the dangers that lie ahead," he said.

The government cannot devalue its way out of trouble, so it will have to deflate. "Pain seems to be on Spain's doorstep," he said.

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