Saturday, 8 September 2007

Immigration? Yes! But Let's Be Smart About It

One of the social and economic issues facing Spanish society today is that we like to enjoy ourselves...maybe too much. We are not having enough children to replace populations in our societies. On the other hand, we also live in a society where there is relative economic and political freedom, and, as a result, there has been a tendency to "import" people from more populous countries who come to our own looking for the economic freedom which they lack.

However, I believe that Spain and many other developed countries are going the wrong way around this problem, and, through flawed immigration policies, are importing not only people, but also the social problems from their countries of origin.

In Spain, for example, most immigrants are unskilled workers who come to do jobs that Spaniards will not do at the price that Spanish entrepreneurs are willing to pay, mostly in the services industry. What does that mean?

In my opinion, all this means is that Spanish entrepreneurs have found a class of worker who is willing to work for a wage that Spaniards will not work for, though there are plenty of available Spanish workers. Immigrants work longer hours, have less social benefits, and pose less problems than a "first world worker". The argument in favour of this state of affairs goes that if we did not engage in importing unskilled workers surely Spain would suffer given competition from lower wage countries.

This argument is manifestly flawed. The industries that cheap unskilled workers are involved in are eminently non-tradable, primarily construction and tourism. You cannot trade a coffee in a bar in Majorca or a block of flats in the coast of Spain with China. Therefore, the benefit of cheap labour accrues mainly to the entrepreneur...notice the boom in wealth derived from residential construction and the service industry in Spain.

On the other hand, Spanish society has to bear the costs implicit in paying people a wage which is below what local or European citizens would work for. Remember we are talking about unskilled workers from emerging markets. In general this are people with little education, few democratic or liberal values, fundamentalist religious beliefs, no family connections in their host countries and, in many cases, imported health burdens. These costs have to be borne by Spanish and European welfare systems. Take a walk around a public hospital or school if you don't believe me...

So, first message: when we import unskilled workers to serve in non-tradable sectors of the economy, we are also importing the social problems of their countries of origin. The benefits accrue to the entrepreneurs in these sectors while the costs are spread across society.

At the same time, however, it is incredibly difficult for skilled workers to obtain legal permits to work in Spain. I read a case in Expansion newspaper two days ago of two Japanese biotech researchers who, in view of the long delay in obtaining their visas, and under encouragement from the Spanish subsidiary of a Japanese company, worked in Spain under a tourist visa, only for them to be fined by the tax authorities for fraud. They eventually got their visas, ten months after the request, and some months after they had returned to Japan. This type of immigration benefits tradable sectors of the Spanish economy and society as a whole, yet because these immigrants traditionally respect immigration laws, they often find it next to impossible to come and work in Spain.

To conclude, unskilled workers are coming in droves, ignoring the legal requirements to work in the country and importing their social problems while benefitting a minority of the Spanish population. On the other hand, skilled workers, who usually respect the legal requirements to work, find it increasingly hard to work in Spain where they would work in tradable sectors which would benefit Spanish society as a whole.

Are we mad or what?

Raise Your Hand If You Think Inflation Is Dead

Yes, the chickens are really coming home to roost. Yet there is one chicken we have not heard much from lately and her name is "Inflation".

Official statisticians would have us believe that inflation, as measured by CPI, has been under control for many years, but you only have to notice a few tell-tale signs to predict that it is paving a way for a glorious re-entrée.

One of the strongest points in favour of globalisation was that it permitted the export of disinflation from low production cost countries to high production cost countries. The latter's governments have been extremely quick to take advantage of this by hitting the print button on the money machine faster than ever. Under normal circumstances "too much money chasing too few goods" would lead to an increase in the price of the latter. However, with China and India making many of those goods, the inflationary impact of an expansive monetary policy has been offset by lower production costs. Many consumer goods have experienced little inflation over the last 10 years or so.

But what about non-tradable or non-traded goods, such as real estate and local services- restaurants, housekeeping, and some agricultural products. Have they followed the same path? My hypothesis is that they have not and, in fact, asset price inflation has been on the rampage, only mitigated by the expansive monetary policy (i.e. low interest rates) which has made financing these assets historically cheap.

Thus, you have a combination of cheap consumer goods and expensive non tradable assets financed by cheap debt. It is obvious that such a combination cannot be sustained indefinitely and there are signs that the "times they are a changin' ". Disinflation from China and India seems to have run most of its course. There are limited productivity gains and increased wage pressures in both countries which will eventually lead to inflation. The maxim of "everything that China buys will go up and everything that China sells will go down" cannot hold for much longer.

The boys and girls in the central banks are not doing their job either. Faced with irate politicians that are scared of bursting the bubble, they have not increased interest rates enough and are, in fact, lowering rates as we speak. After all, inflation is a tax that is borne by many and therefore attributable to indefinite and nebulous causes. Bubbles bursting are sharp and painful and the victims loud and influential. Try guessing what the politicians choice will be.

I recommend the following article by Spanish professor Trías de Bea- a genuine gem:

My prediction is that tight trousers with bellbottoms and over-size collar shirts are back. Yes, dust off those wide ties and lacy shirts- the 1970s with their glorious stagflation will soon be back in vogue.

Ladies, gentlemen...prepare for landing.

And the chickens come home to roost- Real Estate Fiesta in Spain (II)

OK, if you've read the first blog you are probably wondering how and who is paying for the "Fiesta". After all, Spain was a relatively underdeveloped country in the 1980s and now it boasts a AAA/Aaa3 rating from the rating agencies (more about these later) while the BMWs and €500 notes are prominently in display.

The simple fact is that Spain as a country is addicted to debt. It has been running a current account deficit for years, as large in percentage terms as that of the US economy. The rest of the world, especially those countries with ageing populations, has been financing that deficit, as retirees and their trustees (pension funds and other institutional investors) look for places to invest their money. Individual Spaniards cannot, of course, borrow money from the Netherlands or Germany...this is conducted through the "oil that greases the economy"; domestic financial institutions.
The growth in assets of the Spanish banking system over the last ten years has been astonishing but more so has been the net production of loans. What do I imply by this? Not all loans, and especially mortgage loans, are kept on the balance sheet of banks. Most are packaged and on-sold to the trustees of those Dutch and German savers in the form of residential mortgage backed securities or covered bonds. In effect, Spanish financial institutions act as a mere conduit between non-resident savers and domestic borrowers. The lenders, via their trustees, are happy to buy these financial assets because the are highly rated by rating agencies- above investment grade in their jargon. This rating relies primarily on two aspects: (i) loan to value; i.e. how much debt to the appraised value of the property and (ii) debt servicing ratio; i.e. how much of the family income is consumed by the service of such debt. But, if you believe, as I do, that the "value" has been artificially inflated and that a great deal of the income of Spanish families is directly and indirectly derived from the construction and real estate sectors, themselves fuelled by cheap debt, then doubts begin to emerge about the credit quality of such financial instruments.

So why have investors not shunned Spain and taken their money while they can? For one, Spain is now within the Euro-zone. Prior to the introduction of the Euro, investors did just that on a regular basis; witness the devaluation of the peseta in 1994 after the previous real estate fiesta finished. Another important point is that the world is looking for borrowers; many countries are net savers and debt addicts such as the US and Spain are in high demand. Savings, after all, have to be invested.

Yet the chickens are coming home to roost. In the US, investors have finally realised that, as interest rates have risen, the value of the paper they were financing was not what they thought, given that an increasing amount of borrowers were now facing difficulties to service their debt. As a result, they have sold these assets and their price has come down. As the price falls, the loan to value covenants in many of the vehicles which finance these residential mortgage backed securities have triggering further selling. And so the cycle goes on. Furthermore, many of these vehicles were also funded by short term renewable money market loans also known as asset backed commercial paper. Of course, investors have also shunned this type of investment, leading to draw-downs under liquidity facilities provided by banks which were in place precisely to face this situation. But no one expected that they would be drawn all at the same time...which is what has been happening lately in financial markets.

So, remember those loans which the banks happily offloaded via securitisation? They are now back on the balance sheet of banks who had long forgotten about them. And yes, the banks need money to fund those drawn liquidity facilities. Yet, as the whole system faces increased liquidity requirements, few banks are willing to lend to each other, either because they expect to need the liquidity themselves or because they know that the assets which have been recently reacquired are not of good credit quality.

What does this mean for Spain? Well, everyone is focusing on the US and some of those German investors at the moment, but it is just a question of time before someone starts pointing a the "little US"- Spain. Unlike the much larger and monetarily independent Americans, Spain cannot devalue its currency to share the pain with its lenders (note what the US dollar has been doing lately). My prediction is that there will be a strong credit crunch in Spain over the coming years as banks try to sort out the mess implicit in those mortgage portfolios of recent vintages (aged mortgages usually have much lower LTVs). And then it will be time to pay for the fiesta, not with additional debt, but will real income...time to turn in those €500 notes and sell the BMWs.