Conquest by convergence
Spain's drive towards the single currency has produced a virtuous circle of increasing economic activity and falling inflation and interest rates. John Lappin reports
Exponents of EMU convergence criteria as a means to discipline countries for entry into the single currency can look on Spain as a resounding example of success.
In the past year and half, the investment climate in Spain has been dominated by one overriding factor: the increasingly strong belief that Spain will qualify for the first round of the single currency.
There is one major issue, convergence to EMU, which has been supported by a marked improvement in the fundamentals of the economy and has brought about a very sharp decline in interest rates in the last three years," says Diego Prado, head of research at Schroders in Madrid.
Ignacio Gomez Montejo, head of equity research at Merrill Lynch in Madrid adds: "Spain is now considered to have a 99% chance of joining in the first round. On its inflation and deficit performance, Spain has surprised the rest of the world by correcting its imbalances faster than expected."
The major theme for the market has been the shift in domestic money from fixed interest - most commonly Spanish government debt - into mostly domestic equity with international investors taking a back seat.
Angel Sanz, director of equity at BBV Gestinova in Madrid, says that Spanish investors in mutual funds have increased equity holdings from 4% to 13% in the first nine months of this year using straight equity investments, guaranteed equity portfolios and balanced equity portfolios.
He continues: "This investment climate will continue. Basically if you look at countries with similar rates, the US, the UK, Germany, France, the Netherlands, they have more than 33% of their investment funds in equity or balanced equity. I predict that Spanish mutual funds will grow to these levels."
On the economic front, a revival of exports in Spain has been accompanied by a revival in consumer confidence, suggesting that its recovery may be more deep seated than in other European centres.
Cecilia Planiol, chief economist at Santander Investment in Madrid, says: "That is the main difference between Spain and other European countries. They have growth in exports, but in our case growth in internal consumption is also very strong."
Planiol expects GDP growth of around 3.3% this year, above the long-term figure of 2.6%, so Spain is "clearly in the recovery phase". With private consumption estimated at 3.2% for this year and predicted to increase to 3.7% next year, this has raised some inflation pressures - although not enough to put Maastricht off course.
Addressing another aspect of Spain's virtuous EMU circle, Planiol predicts that the increasing economic activity coupled to fiscal restraint brought in in last month's budget should see the budget deficit come below 2.4% while the current account is in surplus.
In terms of the market, analysts are confident for the long term. "The exchange risk is going to disappear and Spain is going to be considered less of a high risk peripheral economy and is going to integrate itself into the mainstream European market. Valuations should improve dramatically," says Prado.
Gomez Montejo, who expects company profits of 12% this year, believes that Spain should remain competitive post-EMU. He points to the devaluation of 1992-93, where the competitive advantage has not been lost because costs have not increased as they had following previous devaluations. "By 1992, employers and employees had learnt what it means to be integrated in a single market. They suffered because the peseta was linked to the Deutschmark for a long period while Spain had four points more inflation. In my view, although the risk is still there, we will not see the cost inflation situation repeated."
Gomez Montejo continues: "EMU is a good thing for Spanish companies with the loss of currency risk. Multinationals will feel more comfortable about increasing their activities in Spain, helped by the lower cost base, although there is a risk that this may not continue forever."
Montejo has some concerns about Spanish manufacturing though this does not extend to one of the most important Spanish sectors.
"The Spanish banks are possibly the strongest in continental Europe. Big Spanish banks such as BBV and Santander have little to fear from consolidation. If there is consolidation with our neighbours, with Portugal, France, Italy, even Germany, I think the Spanish banks should emerge as victors rather than losers."
Prado believes that even without EMU, change has been fundamental. As with all other analysts he identifies difficulties surrounding EMU as the major risk, but he has a proviso. "Bond yields would rise and the yield spread would increase but it would be moderate. The decline in interest rates in the last few years is not only driven by the EMU anchor but by a sharp improvement in the economic fundamentals," he says.
For the short to medium term, Montejo is more cautious. "From now it is much more difficult to give a forecast of the future," he says.
He explains that the government has been able to profit from the demand-driven market by privatising Telefonica and Repsol.
"The total amount of primary supply is going to be Pta1 trillion, seven, eight billion dollars in just three years. This clearly exceeds capacity," he says.
Montejo adds that the foreign investors will have to come back to take up some of this demand. However he and other analysts suggest that a greater equilibrium between supply and demand will be established in Spain following EMU.
Domestic flows have nevertheless been spectacular although the growing pension funds - both second and third pillar - despite increasing assets by 30% each year are as yet a minor influence.
Angel Martinez, a director of research at Inverco, the collective investments and pension funds association says: "In Spain today, the investment funds have a bigger presence. Pension funds have Pta3.1bn but in the investment fund we have nearly Pta25 trillion."
Sanz of BBV adds: "The question is which instrument are the Spanish going to use for their retirement: investment funds or pension funds."
He continues: "Investment funds have a very good tax treatment. Investors will only pay 20% of capital gains over two years. This is a very important factor in why Spain is very well developed in terms of the ratio of mutual funds to GDP while in pension funds we remain underdeveloped. We think that there needs to be some change in the fiscal treatment of pension funds if they are to grow as fast."
What is clear, however, is that both types have increased their holdings of equities with mutual funds, according to Sanz, holding 13% while pension funds are holding 15-25%.
However, the move to into equity has not been restricted to the domestic market. Sanz adds: "Spanish investors are realising that the world is very big and Spain is very small in terms of equity at 1.1% of the world equity market and they are increasing exposure. BBV's asset management company has seen investors put as much money into international equity investments as in domestic equity investments in the last three months."
To meet this demand, foreign players have been entering the market either by setting up directly, using joint ventures or by running assets from London or New York for local loyalty funds. Of the domestic players, the larger banks, while facing not just demand for overseas investments but also the prospect of a huge domestic market seem up to the challenge and are developing and buying in their own domestic and international expertise.
According to analysts, the long-term result of Spain's increasing integration into world markets, with its own large pool of domestic money should be an increasing balance between supply and demand in the Spanish market.
Both BBV and Santander have also been involved in another major theme of the Spanish market: the economic exploitation of cultural links with Latin America. Although analysts such as Planiol are keen to stress that such links are not a new development, major investments have been made in Latin America by other large cap companies such as Telefonica (with investments now valued at $10bn), Repsol and most recently a $4bn investment in Peru and Columbia by Endesa.
Analysts have credited this with producing significant value from what are either mature sectors or, in the case of Telefonica, one where liberalisation should keep down domestic profit margins.
"I think Spanish companies have a very clear competitive advantage because they understand the culture and the economic situation. Latin America is in a very similar position to what Spain was in several years ago," says Prado. Analysts admit that such investments have increased risk but not to a significant extent.
Gomez Montejo adds that the banks have been the best investors but that all the Spanish companies have proven competence: "It is amazing how Telefonica have been able to create value by improving an old state-run operation by cutting costs, improving service and increasing revenues very quickly."
Within Spain itself there are some significant market events: the most notable being the privatisation of Endesa.
In terms of other reforms the government is expected to continue to increase the fiscal incentives for pensions while the Telecoms sector should see increased competition from the entry into the market of two new players by next year to compete with Telefonica, followed by gas liberalisation, which will initially see the opening up the business end of the market. Analysts also expect some restructuring at Argentaria, a major bank where the government retains a significant share but that should begin a reform process instigated by its new management team.
While these themes are important, the most significant changes come on the macro-economic front. Planiol concludes: "In future we think the Bank of Spain will be obliged to maintain low rates because of the convegence with Europe.""