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Cablegate: Housing Market Finally Cooling, but The

VZCZCXRO0779
PP RUEHAG RUEHDF RUEHIK RUEHLZ RUEHROV
DE RUEHMD #1511/01 2151452
ZNR UUUUU ZZH
P 031452Z AUG 07
FM AMEMBASSY MADRID
TO RUEHC/SECSTATE WASHDC PRIORITY 3143
INFO RUCNMEM/EU MEMBER STATES COLLECTIVE PRIORITY
RUEHLA/AMCONSUL BARCELONA 2968

UNCLAS SECTION 01 OF 03 MADRID 001511

SIPDIS

SIPDIS

E.O. 12958: N/A
TAGS: ECON SP PREL
SUBJECT: HOUSING MARKET FINALLY COOLING, BUT THE
CONVENTIONAL WISDOM STILL SUGGESTS A SOFT LANDING FOR SPAIN

REF: 06 MADRID 01750

MADRID 00001511 001.2 OF 003


1. SUMMARY: As the Spanish economy pushes forward toward
matching wealthier EU members, it continues to face
challenges. Spain must increase its competitiveness across
the board, especially in its labor markets, energy utilities
and telecoms. What has been of most immediate concern lately,
however, has been the housing and construction situation.
The housing market is cooling off. Mortgage rates have risen
from 3.4% in June of 2006 to 4.49% in June 2007. Home sales
have fallen by 11.5% over the last year, with a 15.9% fall in
the sale of new homes. New home prices rose by 7.4% during
Q1 2007 compared to 12.7% over the same period the year
before. During the May-July 2007 timeframe, apartment prices
in Madrid and Barcelona actually went down by about 5%
according to the Ministry of Housing. This is of concern
because the Spanish economy is significantly dependent on
construction, which contributes up to 18% of GDP (roughly
twice the Euro zone average); and accounts for a quarter of
all economic growth. Despite increasing risks however, there
are enough offsetting factors suggesting a soft landing for
Spain's economy. END SUMMARY.

RISING INTEREST RATES
SPARK FEARS FOR HOUSING
MARKET

2. Cheap credit through low interest rates has been a driving
factor in the construction/housing led boom following the
introduction of the Euro. Interest rate hikes therefore are
at the heart of fears of a sharp economic slowdown. The
potential chain reaction begins with the fact that higher
interest rates could lead to more foreclosures, making
lenders more cautious. Lenders are already moving to sell
off delinquent accounts as well as some of their current
mortgages. Spanish households, even Qthey can mostly make
the higher payments on their variable interest rate loans,
have to reduce consumption, thereby at some point lowering
demand, although this is being offset somewhat by more
investment. The effect on Spanish households' consumption
patterns is probably more macroeconomically significant than
the risk of foreclosures as getting a mortgage loan is much
harder in Spain than in the U.S. so, overall, most borrowers
in Spain are a fair credit risk.

VARIABLE RATE MORTGAGES
BECOMING A PROBLEM

3. Currently many Spaniards are spending over 40% of their
gross income on their mortgage. In order to be able to
afford the soaring prices of the recent housing boom,
Spaniards have been forced to take on very large, variable
rate mortgages with exceptionally long terms of up to forty
and fifty years. The average monthly mortgage in April 2007
was 7% higher than the year before and had an average term of
26 years. Furthermore, of all the mortgages granted in April
2007, 97.7% were of the variable rate variety with almost 90%
of those being fixed to the Euribor. This continues the
trend of Spanish families becoming more overextended
financially and exposed to interest rate rises.

OTHER POTENTIAL NEGATIVE
ECONOMIC FACTORS

4. Many Spanish households will likely cut back on
consumption to keep current on their mortgage payments,
further slowing the economy. Joint decreases in construction
and consumption should increase unemployment. Spain has seen
its advantages in competitiveness among major EU nations
erode as productivity is low and inflation is higher than
average in the eurozone. Spain suffers from a low
productivity growth rate of .8%, behind even Portugal among
top EU nations, and is furthermore losing its wage advantage
to Eastern Europe and Asia. European Union (EU) subsidies
will also be phased out; although, the effect will not be
felt in the immediate future as Spain will not become a net
contributor until 2013. The significance of construction and
housing to the Spanish economy suggests a cumulative effect
from the drop in housing demand causing a significant
downturn.

BUT, THE SOFT LANDING
SCENARIO HAS SUBSTANCE

5. Despite the hovering dark clouds, there is another side to
Spain's overall housing picture. First, the demand declines
in the overbuilt suburbs and coasts mask continued strong
demand for housing and office space in major cities. Sources
of continued demand are expected to be continued immigration,
split couples as divorce has become more common, and the
strong demand for housing among young people (Ref 06 Madrid

MADRID 00001511 002.2 OF 003


01750). Also, there is the potential that slackening
northern European demand for vacation homes might pick up or
perhaps emerging EU nations such as Poland will take up the
slack. Finally, ECB interest rate rises may in fact turn out
to be a stabilizer by reigning in spending by overextended
Spanish consumers and businesses and encouraging more savings
and the paying down of debt.

MAJOR REAL ESTATE GROUPS
DIVERSIFYING

6. On the construction/real estate company side, although
speculators and the extraordinarily large number of small
time firms are likely to get hit, all the largest players
have taken the opportunity of the boom years to diversify by
buying into Spanish energy utilities, water treatment plants,
airport management firms, and toll roads; as well as
investing overseas to tap emerging markets. Spanish
construction firms also seek to take advantage of new
building and infrastructure projects in Eastern Europe.
There the Spaniards expect to leverage their experience with
contracting and managing projects built under EU funds.
Furthermore, the Spanish government itself is expected to
increase its already high spending on infrastructure.
Spain's budget surplus gives the government some room for
maneuver to use fiscal policy as a stabilizer.

R&D INVESTMENT AND
CAPITAL GOODS SPENDING
TRENDING UPWARDS

7. R D in Spain is currently low, but R D spending is a
government priority, mostly to help improve Spain's low
productivity rates. While government spending on R D is
budgeted at 6.5 billion Euros in 2007, a 35% yearly increase,
Spain's total R D spending is still only 1.03% of GDP, half
the EU average. However, the government has fairly credible
plans to raise this number to 2% by 2010, and increase the
private sector's share from 46% to 55% of total R D. Spain
plans to increase private R D spending through better
incentives for private sector innovation and patent
registration, as well as through improved links between
business and government sponsored research bodies. (Note: It
is pretty clear that R&D spending will go up, although it is
not clear whether providing the extra money will actually
have the impact on productivity the government wants.)
Moreover, capital goods investment increases are expected to
continue as Spanish industrial firms increase their
production capacity to meet demand emanating from a resurgent
German economy. Capital goods spending is already up 7.2%
this year and is expected to continue well into double digits
this year and remain strong thereafter. Capital goods
spending is expected to be an economic driver for Spain and
in combination with increased R D could help improve
productivity, although no observers believe Spain is on the
verge of becoming an innovation driven economy.

SOFT LANDING STILL
SEEMS LIKELY

8. The safe bet on the direction of the Spanish economy is
still the soft landing. This is because it appears that
major banks and corporations have protected the better part
of their boom profits, and new opportunities for growth in
the construction sector are expected. Demographic and social
trends also suggest continued robust housing demand. Given
that the percentage of all homes and apartments that are
rentals in Spain was 11.4% last year compared to an EU
average of 38%, high prices, strong demand, and perhaps (in
the future) more balanced landlord/tenant laws might lead to
more of a rental market. Currently, average Spanish mortgage
holders, small time developers, and speculators appear to be
most vulnerable to weaknesses in the housing market. Overall
though, Spain looks set to weather the storm despite the
troubles in the housing market. This Embassy analysis tracks
largely with the conclusions of the IMF's latest Article IV
consultations with Spain, although both the Fund and the
Embassy are cognizant that while the soft landing scenario is
likely, it is by no means guaranteed. A May 2007 Morgan
Stanley analysis is consistent with this view as well,
although it does not discount the possibility of a recession
in 2009. The conservative PP opposition party linked
economic/business consultancy, Montoro y Asociados Asesores
concludes: "in Spain the slight slackening in economic growth
which might happen in the coming months does not put into
risk the maintenance of rates of growth of over 3% with
considerable employment generation". Most analysts are
optimistic for the short-term, despite Madrid stock exchange
volatility and reports of greater difficulties for big
corporate borrowers. The bottom line: it appears that the
government will meet the electorate (parliamentary elections

MADRID 00001511 003.2 OF 003


must be held by March 2008 at the latest) with the economy
still growing strongly.
AGUIRRE

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