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Europe Equity Research12 January 2012

Spain in PicturesA monthly view of Spanish economic indicators

European Banks

Jaime BecerrilAC

(44-20) 7742-6449

[email protected]

Axel J Finsterbusch

(44-20) 7325 9021

[email protected]

J.P. Morgan Securities Ltd.

See page 39 for analyst certification and important disclosures, including non-US analyst disclosures.J.P. Morgan does and seeks to do business with companies covered in its research reports. As a result, investors should be aware ththe firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a singfactor in making their investment decision.

The end of 2011 was mixed for Spain, with bond yields falling and the

newly elected government announcing austerity measures which could

already reach 40bn (4% of GDP), while more growth initiatives will

be necessary to avoid a deep recession. This month, unfortunately,

challenges for the economy once again outweigh the positive signs we

could find in the period.

We remain cautious on Spanish banks, where lack of access to wholesalemarkets, deleveraging and a recessionary environment are likely to weighfor some time. A clean-up of real estate assets should be the main priorityfor the new government in our view, potentially very positive for theeconomy as credit markets would have a chance of reopening. In the

meantime, Santander, BBVA and Caixabank should continue to benefitfrom their relatively stronger balance sheets and access to funding.

The positive signs this month:

Government bond yields dropped substantially since November (p.8,11)

ECB intervention should reduce refinancing risks in 2012 (p.9)

Deposit wars have shifted to other products (p.5-7)

Low interest rates are giving consumers some relief(p.21)

Tourism is still in a recovery trend, especially from Germany (p.34)

The negative signs this month:

Economic indicators show recession is almost inevitable in 2012 (p.3-19) Austerity measures will increase the pressure on a weak economy (p.4)

Spanish 2011 budget deficit could miss the 6% target by over 2% (p.13)

Retail sales are showing renewed weakness (p. 20-22)

There are still no signs of recovery in the housing market (p. 24-25)

Unemployment close to 23% is still our main concern (p. 26-29)

Recession seems inevitable for Spain in 1Q 2012 as most economic indicators suggest

Source: Bank of Spain, Markit (Latest=December 2011)

25

30

35

4045

50

55

60

65

70

-6

-4

-20

2

4

6

8

99 00 01 02 03 04 05 06 07 08 09 10 11

Spanish PMI Composive vs GDP YoY %

GDP YoY (%) LHS PMI Manufacturing RHS PMI=50

ECBs December LTRO was a large on

Source: Companies, J.P. Morgan estimates

Austerity measures are growing again

Source: Spanish Government

20

15

11 11

8

54

0

5

10

15

20

25 LTRO Borrowing bn

24%28%

37%43% 44% 45% 4

0.75%

2%

3%

4%5%

6% 7

24.75%

30%

40%

47%49%

51% 5

0%

10%

20%

30%

40%

50%

60%

- 17,707 33,007 53,407 120,000 175,000 300

Starting Tax Base

Spanish Income Tax (%)

Withholding Additional


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2

Europe Equity Research

12 January 2012Jaime Becerril(44-20) [email protected]

Table of Contents

Spanish government expects recession in 2012 ............ ............. ............. ............3Austerity measures will increase pressure on weak growth ............. .............. .....4

Deposit outflows are still small, mostly amongst weaker banks.............. ............5

Other European countries are having issues with their deposits ............ ............6

Competition for deposits was still strong at the end of 2011............ .............. .....7

Wholesale funding pressures remain high for Spanish companies.....................8

Spanish banks ECB funding is close to record high levels.......... ............. ..........9

Government bond yields dropped but pressures remain high...........................10

Spanish Government debt is still favoured by SMP purchases ............. ............ 11

Spanish Regional Governments debt is still a major concern...........................12

Spanish 2011 budget deficit could go well above its 6% target ............. ............ 13

Rating agencies are keeping a close eye on Spain........................ ............. ........14

Credit continues to shrink in Spain as mortgage demand tanks........................15

Debt and leverage: Spain needs to de-lever further ............. ............. .............. ...16

Deleveraging is already taking place, as the economy adjusts............ ............. .17

Spanish trade balance: exports are showing some weakness...........................18

Industrial production drop is signaling recession..... ............. .............. ............. .19

Retail sales could pick up a bit in the sales season............. ............. .............. ...20

Lower rates are a positive for consumption ............ ............. .............. ............. ...21

Car sales are taking another dip as the turmoil continues........ ............. ............ 22

Card consumption is weakening as banks fees keep growing..........................23

Real estate prices are still far from recovery ............. ............. .............. ............. .24

The outlook for mortgage demand is still weak......... ............. .............. ............. .25

Spanish Unemployment: younger generation is the main concern ..... ............. .26

Labor reforms are needed to solve the unemployment problem........................27

Unemployment remains more problematic in the South ............. ............. ..........28

Spain is still at the top in Europe in unemployment....................... .............. ...29

Inflation growth is relaxing, as commodities prices drop............ ............. ..........30

Credit quality deterioration continues ............ ............. .............. ............. ............ 31

Credit quality indicators (continued)................. .............. ............. ............. ..........32

Consumer confidence remains very low in Spain ............ ............. ............. ........33

Tourism is the bright spot, benefiting from turmoil elsewhere ............ ............. .34Valuation data......................................................................................................35

Relative evolution of Spanish vs European banks ............. ............. .............. .....36

Timeline of next events in Spain/Europe.................. ............. ............. .............. ...37

Recently published research...............................................................................38


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3



Spanish government expects recession in 2012

The Bank of Spain announced 4Q11 GDP could drop QoQ from being flat in 3Q11, increasing the odds of Spain entering

recession in 2Q12 as consensus estimates (Bloomberg) dropped to 0.2% for 2012 (previously 0.6%). PMI figures released 2

January reflected a drop in December to 43.7 vs 43.8 in November, usually a good proxy of GDP evolution.

Household spending is still the main driver of Spanish GDP (65% of total). Comments from the newly elected governmentsuggest they could take further austerity and unpopular measures (already increased income tax substantially) likely to apply

downward pressure to consumption, something banks and retailers are already warning.

The new Spanish Government is yet to release its official GDP forecasts, currently standing at 0.8% in 2011, 2.3% for 2012

and 2.4% in 2013, which the new Finance Minister already warned could be too high (right chart below).

Spains new Finance Minister Luis de Guindos announced on 26 December that the Government expects Spain to return to

recession in 1Q12, making official 2.3% forecasts look extremely optimistic for 20121.

JPM downgraded Spains GDP forecast on 4 November 2011 (GDW: Euro area: fiscal slippage and an even deeper recession)

Figure 1: The Spanish economy is weakening as reported byeconomic sentiment and PMI indicators, still well below 50

Figure 2: Economic sentiment deteriorated again in Decemberin Spain, pointing to a negative GDP in 2011

Figure 3: The new government is yet to publish its officialGDP forecasts 2012 and 2013. An adjustment to officialforecasts is likely

Source: Bank of Spain, Markit (Latest=December 2011) Source: EU Commission, Bank of Spain, Bloomberg Source: Spanish Finance Ministry, Bloomberg, IMF, EU, J.P. Morgan estimates

1

De Guindos: Espaa volver a entrar en recesin en 2012 (Expansin, 26 December 2011)

25

30

35

40

45

5055

60

65

70

-6

-4

-2

0

2

4

6

8

99 00 01 02 03 04 05 06 07 08 09 10 11

Spanish PMI Composive vs GDP YoY %

GDP YoY (%) LHS PMI Manuf RHS PMI=50

-6

-4

-2

0

2

4

6

8

70

75

80

85

90

95

100

105

110

115

120

919293949596979899000102030405060708091011

Spanish EC Economic Sentiment Indicator & GDP

EC Ec. Sentiment 3M avg GDP YoY (%) LHS

2.3 2.4

1.1

1.8

0.7

1.4

0.3

1.0

-1.1

-0.2

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.52.0

2.5

3.0

2012 2013

Spain GDP forecasts (%)

Gove rn me nt I M F E U C om m Blo o mb erg Co nse ns us J PM

Previous Govforecast
https://mm.jpmorgan.com/PubServlet?action=open&doc=GPS-717108-0.pdfhttps://mm.jpmorgan.com/PubServlet?action=open&doc=GPS-717108-0.pdfhttps://mm.jpmorgan.com/PubServlet?action=open&doc=GPS-717108-0.pdfhttps://mm.jpmorgan.com/PubServlet?action=open&doc=GPS-717108-0.pdf


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4



Austerity measures will increase pressure on weak growth

The new Government announced a series of austerity measures on 30 December, including an increase in taxes that they

previously said they wouldnt do. These measures will be applicable for 2012-13 (for now), most of which were deeply

unpopular, justified due to the worse than expected condition of the official accounts. Some of these measures were:

Increase Income Tax for all earners, from 1% to 7% on the state taxable base (left table below).

Increase in real estate tax (IBI) from 4% to 10%, depending on the age of the propertys valuation.

The new Government announced plans to introduce a new Labour Reform to deal with over 5mn reported unemployed in

Spain as well as spending limits for the regions to control their budget deficit, a problem for the overall economy.

The Spanish PM (Rajoy) confirmed on 10 January they have no plans to raise VAT or create a bad bank as the Finance

Minister said banks will have to provision 50bn to adjust asset valuations to more realistic levels ("Madrid targets regions

in austerity drive, FT, 4 January 2012). The risks of creating a further credit squeeze are very obvious in our view.

Figure 4: The Spanish Government increased the income taxbrackets by up to 7% on 30 December increasing themaximum above 50% rate until 2012-13 (at least)

Figure 5: Dealing with Regions debt has become a priority asthe government plans to introduce spending limits

Figure 6: The Spanish Standard VAT rate is one of Europeslowest at 18%, something other EU countries are aware of

Source: Spanish Government Source: Bank of Spain, J.P. Morgan estimates Source: EU Commission Taxation and Customs Union, rates as of July 2011

24%28%

37%43% 44% 45% 45%

0.75%

2%

3%

4%5%

6% 7%

24.75%

30%

40%

47%49%

51% 52%

0%

10%

20%

30%

40%

50%

60%

- 17,707 33,007 53,407 120,000 175,000 300,000

Starting Tax Base

Spanish Income Tax (%)

Withholding Addit ional

0x

2x

4x

6x

8x

10x

12x

14x

16x

18x

94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10

Spain Regional Debt Evolution (rebased)

Catalonia C. Mancha Valencia

10

12

14

16

18

20

22

24

26

Denmark

Hungary

Sweden

Romania

Greece

Poland

Portugal

Finland

Latvia

Belgium

Ireland

CzechRep

Italy

AustriaUK

France

Germany

Netherlands

Spain

Malta

Cyprus

Luxembourg

Standard VAT Rate %

Sustainable?


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5



Deposit outflows are still small, mostly amongst weaker banks

Foreign banks have been losing deposits in their local subsidiaries since 2009, where Barclays stands out (left chart below).

Customers have been moving cash from mutual funds and non-interest bearing current accounts to more profitable (forborrowers) time deposits, as the risk of cross-contamination and clients getting smarter with their money is becoming obvious.

There has been much speculation about whether European countries have been losing deposits over the past few months, asindividuals and companies prepare for eventual problems in the industry. This was the case already in Ireland or Greece andSpain is also experiencing this, although at much lower rates.

Nationalized institutions have had a larger outflow of deposits in 2011 than their domestic peers, a trend which in our view

will continue over the coming months, benefiting larger banks perceived as safer.

Foreign banks have been losing deposits in their local subsidiaries since 2009.

Figure 7: Foreign banks have been losing deposits in Spainsince 2009, where ING Direct remains surprisingly resilient

Figure 8: Spanish banks have seen their deposits fall over thepast few months, as happened in 2008

Figure 9: Nationalized institutions have had a larger outflowof deposits in 2011 than their peers

Source: Companies, Spanish Banking Association Source: Bank of Spain, ECB Source: Companies

0

5

10

15

20

25

30

ING Direct Barclays Deutsche Bank

Foreign Banks' Deposits in Spain 2008-2011 bn

Jan 09 Dec 09 Dec 10 Oct 11

-10%

-5%

0%

5%10%

15%

20%

25%

30%

35%

40% Spanish Deposit Evolution YoY %

C urr en t A cco un ts S avin gs Acco unt s Ti me De po si ts

0

10,000

20,000

30,000

40,000

50,000

60,000

CatalunyaCaixa N ovaCaixaGalicia CAM UNNIM

Spanish Savings Banks Customer Deposits mn

Dec 10 Jun 11 Sep 11 Oct 11


6/41

6



Other European countries are having issues with their deposits

Deposit rates for 12M deposits have been increasing in Spain as in other peripheral" countries (left chart below). Spanish

short-term deposit rates (


7/41

7



Competition for deposits was still strong at the end of 2011

The Spanish deposits war returned once again in November, despite regulatory measures implemented to try to control

competition in the market. A number of institutions were offering deposits above 4%, which will have an impact on spreads and

which larger banks could be dragged into if they start losing deposits. The falling yield curve will not help margins either.

Banks are still selling new products to circumvent regulations such as commercial paper or retail bonds. Popular, Sabadell andLa Caixa have already issued debt to retail clients at very high rates (POP 8%, SAB 4.25%, Caixa 7.5%). All these are an

added competitor to the Regional and Central Government debt, still to enter the market over the near term.

Lower deposit rates and the economic slowdown are having an impact on volumes, as deposits were falling close to 3% YoY

as of November, falling more in weaker economic areas.

Spanish Treasury Bonds at 5% have become a significant competitor for banks retail deposits in 2011.

The ECBs LTRO on 21 December should release some pressure from Spanish banks deposit competition in 2012.

Figure 13: The Spanish deposits war has returned inOctober as in 2010. Higher deposit yields and lower baserates could have an impact on banks' NIM in 4Q11

Figure 14: Banks increased the commercialization ofcommercial paper (pagars) to cope with higher legalrequirements on time deposits

Figure 15: Lower deposit rates are having an impact onvolumes as deposits are shrinking once again 2% YoY

Source: Bank of Spain, EBF, Bloomberg, J.P. Morgan estimates Source: Banks, AIAF Source: Bank of Spain (last = October 2011)

-200

-150

-100

-50

0

50

100 Spread new Deposits vs 3M Euribor (bp)


8/41

8



Wholesale funding pressures remain high for Spanish companies

Spains risk premium (spread between its 10-Y bonds and German 10Y bunds) record a Euro-era high of 469bp on 22 November

as the sovereign turmoil accelerated. Spreads between Spanish and German debt spiked early November after Greece announced

referendum on the EU bailout and dropped after comments from German chancellor Merkel that the EU would take steps towardfiscal integration over the coming weeks and later as the ECB implemented longer term LTRO auctions.

Wholesale funding remains largely unavailable for Spanish banks since last April 2011. Only a few banks (SAN, BBVA,

Caixa) have issued debt since then, usually via private placements or at huge premiums, as funding pressures are still veryhigh. Banks have become more dependent on retail placements as not even the covered bonds markets are available.

CDS spreads dropped sharply for Spanish banks after the EU announced steps towards fiscal harmonization in Europe.

Spanish banks have issued over 10bn of commercial paper in September-December, with Santander and BBVA on top.

La Caixa issued 1.5bn subordinated debt to retail clients at 7.5% in November, a huge premium to place these bonds.

Figure 16: The spread between Spanish and Germansovereign debt has fallen from Euro-area records inNovember

Table 1: Wholesale funding has remained almost stagnant forSpanish banks and companies since last April

Issuer Dat e Term Yi eld S pread (bp) 5Y CDS Vol ume mn

BBVA 04-Jan 3 4.12% 225 262 1,500SAN 05-Jan 5 4.62% 225 255 1,000Bankinter 14-Jan 2 4.87% 315 456 500

Popular 26-Jan 2 4.85% 270 486 650Unicaja 23-Mar 5 5.50% 257 n/a 500Banesto 30-Mar 4 4.63% 178 n/a 600

BBVA 30-Mar 4 4.25% 140 205 2,000Caixa 27-Apr 5 5.13% 206 269 1,250SAN 21-Jun 5 4.63% 195 231 1,000Popular* 20-Jul 8 8.00% 494 645 200Sabadell* 14-Sep 2 4.25% 275 700 300BBVA** 28-Oct 1.5 4.00% 350 257 750La Caixa* 21-Nov 5.1 7 .50% 500 255 1,500

Figure 17: CDS spreads for Spanish banks are well above thelevels reached at the peak of the June 2010 turmoil

Source: Bloomberg as of 11 January 2012 Source: Bloomberg, C ompanies *Subordinated retail debt. **Senior Debt. All others

are covered bonds

Source: Bloomberg, CMA

344

0

50

100

150

200

250

300

350

400

450

500 Spread Sp ain 10Y Gov Bond vs German 10Y Bunds (bp)

50100150200250300350400450500550

600650700750800850900950

5 year senio r CDS spreads (bp)

8 June 2010* 9 January 2011


9/41

9



Spanish banks ECB funding is close to record high levels

The ECB's 13-months LTRO auction held on 21 December attracted a total 523 banks borrowing a record 489bn, with

Spanish banks reportedly borrowing amongst most in Europe, together with Italian banks, not a surprise given wholesale

markets remain largely unavailable for them. The auction had a fixed rate (1%) and full allotment and there will be a second

one on 28 February when we expect banks could borrow again to cover their LT debt maturities for 2012-13. Spanish banks funding reliance on ECB increased to 98bn in November (10% of GDP) and should be well above 100bn in

December. European clearinghouses (LCH Clearnet, Eurex) are still available but more expensive, which Spanish banks are

using extensively. The bulk of ECB borrowing is still coming from Greece, Ireland, Italy, Portugal and Spain, while other

European banks may have to resort to it again.

Funding from the ECB increased most in December for Italy and France. Italy has become Europes largest ECB borrower at

210bn as of December, growing from 85bn in August. France also saw a significant increase in its ECB borrowing, growing

to 101bn in November from 21bn in July, as French banks suffered the turmoil in the markets.

We expect the rollover of repos over the coming weeks to increase pressure in the interbank markets to find alternatives.

Figure 18: Spanish banks funding from 21 December 3YLTRO auction (JPM estimates by bank below)

Figure 19: Spanish borrowing from ECB increased to 98bnor 25% of overall as of November, as funding turmoil remains

Figure 20: Reliance on ECB funding has increased acrossEurope as sovereign pressures returned

Source: Companies, J.P. Morgan estimates *Santander e stimate from relative weight

of its balance sheet similar to its domestic peers

Source: Bank of Spain, ECB Source: Central Banks, ECB *December not available (estimated)

20

15

11 11

8

54 4

0

5

10

15

20

25 LTRO Borrowing bn

0

25

50

75

100

125

150

175

200 Spain ECB + Guaranteed Funding bn

SPAIN (LHS) Spain Government Guaranteed Debt

0

25

50

75

100

125

150

175

200

225

Greece* I re land* Spain* Por tuga l I ta ly Be lg ium F rance

ECB Funding bn

D ec-08 Dec-09 D ec-10 Aug -1 1 Se p-1 1 Nov-11 D ec-11


10/41

10



Government bond yields dropped but pressures remain high

The spread between 10-year Spanish Government bonds and German bunds dropped from a 15-Y high in November following

the ECBs purchase of Spanish and Italian bonds and the speculation about further fiscal integration in the Eurozone. The gap

remains however very large between both countries.

Spanish Government bond yields are still far from Italian, Greek, Irish or Portuguese bonds but well above AAA ratedcountries like Germany, France or the UK. With Spanish 10Y bond yields at around 5.0% and the spread vs 10Y German

Bunds close to 300bp, we think the risk of further deterioration is still there.

Government debt issuance for Spain in 2012 could reach just under 200bn, similar to 2011. On top of this 2012 is a year with

a very large amount of debt maturities (over 100bn) in the private sector. Higher bond yields are a problem for the Spanish

economy, especially if more austerity measures are implemented or a deep recapitalization of the Banking sector is carried out

with public money, without help from the EU or IMF.

The approval of the EFSF expansion in October was not as effective at lowering bond yields as some expected.

The 3M Bills auction on 20 December attracted a record 10.6bn demand at just 1.735% as banks prepared the carry trade.

Figure 21: Spanish government bonds are still high relative toGerman Bunds, close to record low levels

Figure 22: Spain has managed to escape the final contagionwhilst Italy and France are having their own problems now

Figure 23: Government debt issues could reach just under200bn in 2012, similar to 2011

Source: Bloomberg; Data as of 5 January 2011 Source: Bloomberg; Data as of 5 January 2011 Source: Spanish Treasury, J.P. Morgan estimates

1.5

2.5

3.5

4.5

5.5

6.5

7.5Governmen t Debt 10Y Government Bonds Yields (%)

Spain Germany

3,356

1,095

632513

344134 20

0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

GreeceP ortuga lIre land It al y Spain Fr anc e UK

10Y Bond Spreads vs German Bunds (bp)

0

25

50

75

100

125

150

175

200

225

Jan F eb M ar Apr M ay Jun Jul Aug Sep Oct Nov Dec

Spanish Sovereign Debt Issuance 2010 vs 2011 bn

2010 2011


11/41

11



Spanish Government debt is still favoured by SMP purchases

Spain increased its government debt to 592bn in 2011 from 533bn in 2010 and 472bn in 2009. In 3Q11 the Government

managed to place over 56bn of bonds and treasury bills, a good achievement in this environment. The next sovereign debt

issue will be 3-4Y bonds on 12 January for a maximum 5bn.

Foreign investors own around 38% of Spanish Government debt, having fallen from almost 50% in 2008. France, China andGermany remain the main holders while Japan has fallen to around 6% of total vs 11% in 2007. Local banks owned 33% of

total as of August, up from 25% in 2008. The remainder is owned by a variety of holders, including investment and pension

funds, public institutions and individuals.

The ECBs Securities Market Program (SMP) has helped keep Spanish government debt under control and will probably

affect the composition of debt holders over the coming months. The ECB purchased 30.5bn Spanish and Italian bonds in

November as the sovereign turmoil accelerated (chart below), where we assume 2/3 were Italian bonds and 1/3 were Spanish

ones (ECB gives no split).

Figure 24: Foreign holders of Spanish debt have fallensignificantly since the end of 2010

Figure 25: France remains the main foreign investor inSpanish Government debt

Figure 26: ECB SMP purchases have helped Spain contain itssovereign debt yields since they started in August

Source: Spanish Treasury Source: Spanish Treasury Source: ECB, J.P. Morgan estimates assuming 2/3 of purchases of Italian debt and

1/3 of Spanish debt

36%

38%

40%

42%

44%

46%

48%

50%Spanish Debt Foreign Bondholders (%)

21% 23% 22% 25% 24%28%

8%13%

21%28% 26%

24%20%

21%16%

15%

13%14%18%

19% 15%

13% 17% 15%12%

13%8%

7% 8% 9%4%

6%9%

6% 6% 5%17%5% 8% 6% 6% 6%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

2000 2005 2008 2009 2010 August 2011

Spanish Foreign Debtholders

France As ia, Africa Benelux Other EU Germany Italy Other

2930

9

20

5

1

14 15

4

10

30

-

5

10

15

20

25

30

35

Aug 11 Sep 11 Oct 11 Nov 11 Dec 11 Jan 12

ECB SMP Weekly Purchases bn

I ta ly Sp ain


12/41

12



Spanish Regional Governments debt is still a major concern Regions revealed an accumulated budget deficit of 1.19% as of September. While Castilla La Mancha continues to have the

largest imbalances (-4.84% deficit as of 3Q11), other regions are more relevant in terms of GDP, such as Valencia orCatalonia. This is likely to keep generating political turmoil for some time, and further downgrades from rating agencies.

Valencia, Catalonia and Balearic Islands are the regions with the highest debt/GDP ratios in Spain. Madrid and Valencia townhalls are the two most indebted in Spain, as both have been told they wont be able to increase their debt further.Coincidentally both areas are in regions not under the control of the current Governments local party.

Regional Governments in Spain reached a record high debt of 132bn in June, 13% of Spanish GDP. The figures show how

little is being done so far in reducing debt levels in regions suffering from lack of access to wholesale markets. A few of themhave announced tax increases and cost cutting programs which in our view will have to increase.

Castilla La Mancha announced on 29 October it could end 2011 with a 9% budget deficit vs a 1.3% target.

The Popular Party announced early January it would cut up to 450 regional institutions to reach its budget targets.

Figure 27: Regional Government budget deficits are greatestin Castilla La Mancha, Murcia and Valencia

Figure 28: Valencia, Catalonia and Castilla La Mancha are stillsome of the most problematic regions in Spain (3Q 2011)

Figure 29: Regional Governments in Spain reached a recordhigh debt of 135bn in September, 13% of Spanish GDP

Source: INE, Bank of Spain (last = June 2011) Source: INE; Size of bubble= 2010 Regional GDP mn Source: Spanish Finance Ministry

0.6

-0.1-0.5-0.5-0.5-0.6

-0.8-1.0-1.2-1.3-1.3

-1.6-2.0-2.0

-2.3

-3.0

-4.8

-1.2

-6

-5

-4

-3

-2

-1

0

1

3Q11 Deficit as % of Regional GDP

AndalusiaAragon

Balearic I.C. La

Mancha

Catalonia

Galicia

Madrid

Valencia

5%6%7%8%9%

10%11%12%13%14%15%16%

17%18%19%20%21%22%23%

5 10 15 20 25 30 35

RegionalDebt/GDP(%)

Regional Unemployment (%)

0

10

20

30

40

50

60

70

8090

100

110

120

130

140

95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11

Total Regional Debt Spain by type of borrowing bn

Bonds Loans


13/41

13



Spanish 2011 budget deficit could go well above its 6% target

The Bank of Spain warned Spain could miss its 6% budget deficit target for 2011, where regional government debt will add

pressure, having posted a 1.2% deficit at the end of September, vs a 1.3% target for the year. On top of this, the Spanish

Deputy Prime Minister announced on 5 January the Social Security had a 0.06% deficit in 2011 vs 0.40% surplus target.

The main boost for Spanish Government revenues continues to be VAT, after the increase in 2010 from 16% to 18%,increasing the odds of a further increase in VAT from 18% to 20%, something local politicians have already been indicating to

the media (later denying), which could come from EU guidelines. Corporate tax collection is simply poor, whilst there is also

talk that further tax breaks could be progressively removed.

The drop in revenues since 2008 is increasing the pressure on the budget deficit. This is likely to have a negative effect on the

economys growth in the near term. The opposition party supports the need for further public expenditure cuts over the next

few years, and public companies are likely to be the main target.

The Popular Party announced early January the final deficit for 2011 could reach 8.2%, well above the 6% target for the year.

Moodys announced on 9 January missing the budget deficit would represent a credit negative" for Spain.

Figure 30: Spain could miss the 6% budget deficit target for2011 by over 2% according to the new government

Figure 31: Speculation about a potential increase in SpanishVAT from 18% to 20% increased recently

Figure 32: The impact of incentive schemes introduced by theGovernment in 2008-10 should now be reversed

Source: Spanish Treasury, Eurostat; shadowed = forecasts (red = Gov forecasts) Source:AEAT, IGAE Source: IGAE, Spanish Finance Ministry (last = November 2011)

-12%

-10%

-8%

-6%

-4%

-2%

0%

2%

4%

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

Spain Government Budget Deficitt as % of G DP

Spain Government surplus/deficit as % of GDP Expected Deviation

Slippage is not a good sign

0

10

20

30

40

50

60 Spanish T ax Revenues 12M Rolling bn

Corporate Tax VAT

Tax HikesWork

Keeps falling0

20,000

40,000

60,000

80,000

100,000

120,000

140,000160,000

180,000

200,000

220,000

8687888990919293949596979899000102030405060708091011

Spain Cash Surplus/Deficit 12M Rolling mn

Non Financ ia l Income Non F inancial Expenses


14/41

14



Rating agencies are keeping a close eye on Spain

General Governments debt rating was already downgraded in 2011 by all 3 main rating agencies, where Moody's has gone

one step beyond the rest (so far), leaving the Spanish sovereign L/T debt rating at A1, losing its "high-grade" status.

Regional Governments debt ratings have been under more pressure lately, especially concerning excessive leverage and lack

of payments to suppliers (i.e. Castilla La Mancha, Valencia). All these regions are currently under negative outlook so wewouldnt be surprised to see more downgrades coming through over the coming months, as recently seen in Valencia.

Banks debt ratings have also come under recent pressure from rating agencies, with S&P lowering its ratings for a number of

them at the end of November. Despite the downgrade, Santander, BBVA and Caixabank have some of the highest debt ratings

for European banks at the moment.

On 15 December 2011, S&P downgraded its credit ratings for a few domestic banks, including Popular, Bankia, Caixabank.

On 4 January 2012 Fitch maintained its negative outlook on all Spanish domestic banks, as further downgrades could follow.

Figure 33: General Governments debt rating has alreadybeen downgraded by rating agencies, with Moody's going onestep further (so far)

Figure 34: Regional Governments debt rating is underpressure from rating agencies

Figure 35: Banks debt ratingsare also under pressure fromrating agencies

Source: Bloomberg, Moodys, S&P, Fitch *Under review negative outlook Source: Bloomberg, Moodys, S&P, Fitch *Lowest rating of those available Source: Bloomberg, S&P *Fitch equivalent, **Moodys equivalent

Aaa AAA AAAAaa AAA AAAAaa

AA+

AAA

Aa1

AA

AA+

A1

AA-* AA-

Moody's S&P Fitch

Spain L/T Sovereign Debt Ratings

07 08 09 10 11

Aa1

Aa3 Aa3

A1 A1 A1 A1 A1 A1 A1

A2 A2

Baa1

Baa2

Ba1

Ba2

Regional Governments' L/T Debt Rating*

Non-Inv.Grade

AA- AA-

A+

A

BBB+BBB+BBB+

BBB BBB

BB+**BB+*-

BB

S&P Long Term Debt rating


15/41

15



Credit continues to shrink in Spain as mortgage demand tanks

Bank loans are not yet reaching the real economy as lending to less risky official institutions and the local Government is

also losing pace. This evolution reflects how deleveraging in the private sector has already started and should continue for

some time as the economy grows at a slower pace.

Lending to the construction sector suffered the largest drop between 2009 and 2010 after growing strongly for decades, but itmay now be stabilising. Banks reported in their 3Q11 results a slight drop in their lending to construction and real estate

sectors which should probably continue in the near term.

Mortgage demand slowdown keeps reaching new lows. Banks are still holding large amounts of real estate in their books and

are unable to obtain long-term funding in the markets, as potential buyers expect prices to weaken further. In this situation

obtaining a mortgage for a new property has become a difficult task and we expect regulators to do something about it.

Figure 36: Bank loans are not yet reaching the real economyas deleverage is underway accelerated by funding pressures

Figure 37: Lending to the construction sector suffered thelargest drop between 2009 and 2010 after growing stronglyfor decades

Figure 38: Mortgage demand and production continues toreach new lows as banks are unable to get long-term funding.

Source: Bank of Spain (last = October 2011) Source: Bank of Spain (last = September 2011) Source: Spanish Property Registrars (last = October 2011)

-10%

-5%

0%

5%

10%

15%

20%

25%

30%

35%

96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11

Spanish Lending evolution by borrower YoY (%)

Corporates Households Government

-20%

-10%

0%

10%

20%

30%

40%

50%

60%

94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11

Spain: Loan Growth YoY (%)

Corporate Housing Developer Construction

100,000

150,000

200,000

250,000

300,000

350,000

400,000

450,000

500,000

550,000

03 04 05 06 07 08 09 10 11

Spanish quarterly new mortgages 3M rolling (units)


16/41

16



Debt and leverage: Spain needs to de-lever further

Corporate leverage in Spain has barely dropped from record high levels in 2009, although lending is finally adjusting, as the

sovereign turmoil continues. We think deleveraging must follow for the economy to recover and become competitive again.

So far, regulators have been unconvincing at accelerating the necessary deleveraging of the system, where bank restructuring

is delaying the process. Credit demand is falling again in Spain from large corporates and SMEs as they adjust to a low growth scenario. This will add

pressure to banks suffering from no access to wholesale markets, competing in a market with few growth opportunities.

Public debt as a percentage of GDP is expected (Gov forecast) to grow in Spain from 64% in 2010 to 75% by the end of 2012.

This will imply issuing around 170bn long and short-term debt in 2012 (Government expects to issue 86bn gross LT debt in

2012), where sovereign spreads should be a focus for the Government. The level of debt/GDP is still however below other EU

countries, giving some room to manoeuvre.

EBA stress tests revealed a 26bn capital deficit in Spain, where all banks involved declared they didnt plan to raise capital

and opt instead to delever or RWA optimization. The debt exchanges carried out in December were also linked to closing

this large capital gap.

Figure 39: Lending is falling YoY in Spain after a decade ofstrong growth. Still the adjustment looks low

Figure 40: Credit demand is falling again in Spain from largecorporate and SMEs as they adjust to a low growth scenario

Figure 41: Public debt as a percentage of GDP will grow forSpain in 2011-12 but is still below other "peripheral countries

Source: Bank of Spain Source: Bank of Spain Source: Countries' Stability and Growth Programs, J.P. Morgan estimates

-5%

0%

5%

10%

15%

20%

25%

30%

35%

65 67 69 71 73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 07 09 11

Spain Lending YoY (%)

-100

-80

-60

-40

-20

0

20

40

60 Expected demand forr corporateloans YoY Change (%)

SMEs Large Corporates

0

20

40

60

80

100

120

140

160

180

200

Greece Ireland Italy Portugal Belgium Spain

Government gross debt projections

2011 2012 2013 2014


17/41

17



Deleveraging is already taking place, as the economy adjusts

Banks have been shrinking their loan books in Spain since the start of the turmoil in 2007, although at a slow pace, which now

we expect should pick up. Longer term loans, like residential mortgages and large corporate loans, are suffering the bulk of the

adjustment as a result of the real estate downturn and wholesale markets freezing.

We expect that most of the deleveraging in Spain will come from residential mortgages and large corporates, although nosector is safe from this adjustment. Large corporates are still able to issue debt in the wholesale markets at a cheaper rate than

that demanded by banks on corporate loans, something already visible in the UK or the US for instance.

The trend of new corporate loans is looking very negative since the end of 2009, with no clear easing in sight. This should

help the adjustment of the credit sector, although it will be a painful one for the economy.

The latest Bank of Spain lending survey revealed how credit demand was falling.

Figure 42: Mortgage spreads are increasing for new loans butvolumes keep falling so the effect is limited

Figure 43: Large corporates are suffering a larger adjustmentthan SMEs since the start of the turmoil but no one is safe

Figure 44: The rate of adjustment in the Spanishcredit marketaccelerated at the end of 2011

Source: Bank of Spain, EBF (Spread vs. 12M Euribor) Source: Bank of Spain Source: Bank of Spain

0

50

100

150

200

250

0

20,000

40,00060,000

80,000

100,000

120,000

140,000

160,000

180,000

200,000 Spanish banks new production Mortgages spreads vs volumes

Mortgage Volumes 12Mrolling mn LHS Mortgage Spreads RHS

0

100

200

300

400

500

600

700

800

900

1,000

1,100

Spain Outstanding Corporate Loans bn

Corporates 1m n

-10%

-5%

0%

5%10%

15%

20%

25%

30%

35%

9696979899 99000102 02 03 040505 0607080809 10 11

Spain Credit Growth YoY %

Corporate L oans Households


18/41

18



Spanish trade balance: exports are showing some weakness

The Spanish trade balance has weakened since the start of 2010. The austerity measures implemented across the board and

strong Euro haven't helped the industry recover. While politicians expect imports to be an important way out of the crisis for

Spain, we need to see some effective policies being implemented here.

Exports are starting to show some weakness in Spain and could deteriorate further as PMI figures anticipate. Spanish exportsare still largely dependent on EU consumption. A recovery in Germany, France, UK and other EU members is crucial. The

latest PMI Output indicator increased in December to 42.1 in Spain, still well below the 50 break-even mark.

Spain is one of the worlds largest producers of products such as olive oil, pigmeat, grapes or tomatoes. Considering some of

these are part of the Mediterranean diet and others (i.e. pigmeat) could be very popular in Asia, we consider there is still

much to do for Spain, where investing in better marketing would be a first step. As an example, Bertolli olive oil (major olive

oil seller worldwide) includes a large part of Spanish olive oil (above 50%) in its own oil.

Figure 45: Spain is a major exporter of products in Europe,including ham and olive oil

Figure 46: Exports are starting to show some weakness inSpain and could deteriorate further as PMI figures anticipate

Figure 47:Spain is one of the worlds largest producers ofproducts such as olive oil, pigmeat, grapes or tomatoes

Source: ICEX, Datacomex Source: AEAT, Markit (last=December 2011) Source: Food and Agricultural Organization

France, 18%

Germany,10%

Portugal, 8%

Italy , 8%

UK, 6%

Europe(other), 21%

US, 4%

America

(other), 6%

Japan, 1%China, 2%

Asia, 5%Africa, 6%

Other, 5%

Spain Exports per country June 2011

25

30

35

40

45

50

55

60

-25

-20

-15

-10-5

0

5

10

15

20 Spanish exports vs PMI Maunfact. YoY 3M rolling %

Exports YoY LHS PMI Manufacturing RHS PMI=50

-

1,000

2,000

3,000

4,000

5,000

6,000

7,000 Spain Top 10 commodities value 2009 $mn


19/41

19



Industrial production drop is signaling recession

Industrial production growth dropped in November 7% YoY vs. 5.4% drop expected by Bloomberg consensus, confirming

risks of recession. Austerity measures in areas such as construction and infrastructure are generating some weakness, set to

increase as the Popular Party announces the new austerity measures to be implemented in 2012. The latest Purchasing

Managers Indicator for December supports a more negative outlook for 2012, still well below 50, at levels last seen in 2009. The Spanish PMI manufacturing indicator for December dropped to a 24-month low of 43.7, not very promising for the

industrial sector, where intense sovereign pressures are certainly not helping. The removal of incentives and weaker retail

sales are also likely to affect it for some time as companies adjust their manufacturing plans.

The Spanish consumer goods industry has once again turned negative following higher taxes and the end of public subsidies.

A cut in consumer spending is consistent with the trends seen in the evolution of savings and comments by main retailers in

Spain. Energy was one of most negative sectors in October, showing manufacturers adjusting their capacity.

Figure 48: The recent downturn in Spanish industrialproduction was the worst in decades

Figure 49: Spanish PMI Output indicator dropped to a 2Y lowin November

Figure 50: The Spanish consumer goods industry is negativeagain following higher taxes and the end of public subsidies

Source: INE (last = November 2011) Source: INE, Markit Source: INE

-40%

-30%

-20%

-10%

0%

10%

20%

94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11

Industrial Production YoY 3M Rolling %

20

25

30

35

40

45

50

55

60

65

70

-40%

-35%

-30%

-25%

-20%

-15%

-10%

-5%

0%

5%

10%

15%

99 00 01 02 03 04 05 06 07 08 09 10 11

Spanish Industrial Production vs Manufacturing PMI

I.P. Durable Cons YoY % PMI Manuf RHS PMI=50

-35%

-30%

-25%

-20%

-15%

-10%

-5%

0%

5%

10% Industrial Production YoY 3M Rolling %

Durabl e C ons Goods N on D urable Goods


20/41

20



Retail sales could pick up a bit in the sales season

Retail sales have recovered since the record low levels of 2009, although the impact of budget cuts and tax increases over the

coming months is already having a negative impact on consumption. Domestic sales have clearly evolved much weaker than

exports, where a cheaper currency would help.

Larger retailers are weakening, most likely as a result of the worsening of the economic environment. While large companieslike Inditex can still take advantage of better financing conditions and higher bargaining power with suppliers, they too have

suffered from consumers weakness in Spain. Smaller businesses appear to be having a tougher time though.

Economic sentiment is key to retail sales recovery, dragged by unemployment and uncertain economic outlook. Retail sales

should normally remain weak, something retailers and banks are generally expecting for 2012.

Spanish retailers reported a Christmas season worse than expected as they try to offset the decline with the sales season2.

Figure 51: Retail sales have recovered since the record lowlevels of 2009 but are weakening especially at home

Figure 52: Smaller retailers are suffering a greater adjustmentthan large companies since the start of the turmoil

Figure 53: Economic sentiment is weakening again and retailsales usually follow

Source:AEAT Source: INE Source: INE, EU Commission. Latest = December 2011

2

Las rebajas llegan con descuentos ms agresivos (El Pais, 7 January 2012)

-25

-20

-15

-10

-5

0

5

10

15

20 Spanish domestic sales & ex ports YoY %

Domestic Sales Exports YoY LHS

-15%

-10%

-5%

0%

5%

10%

15%Spanish retail sales YoY 3-month rolling

Single Retail Small chain Large chain stores

-12%

-10%

-8%

-6%

-4%

-2%

0%

2%

4%

6%

8%

70

75

80

85

90

95

100

105

110

05 06 07 08 09 10 11

Spanish retail sales vs Cons Confidence YoY 3-month roll

EU Ec. Sentiment RHS Retail Sales LHS


21/41

21



Lower rates are a positive for consumption

The drop in interbank rates will be a positive for consumption. Considering 98% of Spanish mortgages are floating, usually

linked to the 12-month Euribor, a drop in this rate should at least give mortgagees some relief. This has been a vital issue since

the start of the turmoil, luckily for Spain. The drop in the base rate is not so good news however for some banks, especially

those with a large portion of residential mortgages in their book, as their revenues will fall again in 2012. Savings rate dropped to 12% in 3Q11 once again as borrowers have to draw on their savings. This is however still above the

savings ratios of other countries in the world, partly explained by the widespread grey economy and the lack of a

sophisticated investment market.

Spanish families still have accumulated wealth they could draw on if needed. There were almost 197bn savings accounts in

Spain as of October, having fallen slightly since the start of the year but still representing 20% of total GDP. This is surprising,

given most of these accounts are non-interest bearing. The risk for banks is customers demanding more return for this money.

Figure 54: Monthly repayment on a 375K mortgage with50bp spread

Figure 55: Savings rate dropped to 12% in 3Q11 once againas borrowers have to draw on their savings

Figure 56: There were 197bn savings accounts in Spain asof October, almost 20% of GDP non-interest-bearing

Source: EBF, Bloomberg, J.P. Morgan estimates Source: INE Source: Bank of Spain, INE, J.P. Morgan estimates

1,883

742

-

200

400

600

800

1,000

1,200

1,400

1,600

1,800

2,000

07 08 09 10 11 12

Monthly payment on a 375K mortgage w. 50bp spread()

-60%

18.5%

12.0%

8%

10%

12%

14%

16%

18%

20% Spanish Household savings rate 4Q rolling

10%

12%

14%

16%

18%20%

22%

24%

26%

28%

30%

71 73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 07 09 11

Spanish Savings Accounts/GDP ( % )


22/41

22



Car sales are taking another dip as the turmoil continues

Car registrations increased 3% YoY in December 2011 to 38,739 units, still at depressed levels, despite discounts offered by a

large number of vendors. The drop in sales has been consistent after tax incentives and direct subsidies were removed by the

Government in 2010. Further austerity measures (VAT increases are likely) are unlikely to be positive for this sector.

The SEAT Ibiza was once again the best-selling car in Spain last month, with the Renault Megane and SEAT Leon following,as the VW Group remains at the top of car sales in Spain. Interestingly, 196 Porsches were also sold during this month (202 in

November), as well as a few Maseratis, Ferraris and Bentleys, showing the crisis doesnt affect everyone at the same level.

Spain is experiencing a slower recovery in car sales than other EU countries, largely due to later removal of incentive schemes

and weaker economic growth. Since the summer however, all countries are showing some renewed weakness.

The chairman of car-dealer association GANVAM. Described 2011 as a year to forget, while Spains car manufacturers

association ANFAC said it expects car sales to remain weak this year (WSJ, 3 January 2012).

Figure 57: Car registrations reached its worst levels since theearly 1990s in 2011

Figure 58: The SEAT Ibiza was the best selling car in Spainlast month, when 202 Porsches were also sold, not too bad

Figure 59: Car sales have recently taken a negative turn notonly in Spain but also in countries like Germany or France

Source: INE, ANFAC (last = October 2011) Source: INE, ANFAC Source: ACEA, ANFAC, FAMA, FMVO, ANFIA

600

700

800

900

1,000

1,100

1,200

1,300

1,400

1,500

1,600

1,700

1,800

9192939495969798 9900010203040506 07 08091011

Spanish Car Registrations 12M rol ling (000 units) 2,591

2,148

1,765

1,5681,469

1,333 1,231

1,009

196

8 3 3 1-

200

400

600

800

1,000

1,200

1,400

1,600

1,800

2,000

2,200

2,400

2,600

2,800 Top Cars sold in Spain December2011

-60%

-40%

-20%

0%

20%

40%

60% New Car re gistrations 3M Rolling YoY %

Spain UK Germany Italy


23/41

23



Card consumption is weakening as banks fees keep growing

Card usage remains relatively strong in Spain despite the turmoil, where debit cards are still growing while transfers haveweakened more over the past few months and cheques have become a residual form of payment, unlike in countries like theUK. This trend is in our view linked to the modernisation of the banking system and rapid pace of growth in internet payments,

an opportunity long term. Card usage has evolved positively in 2011, although its clearly not immune to the state of the economy. According to some

local banks, the black economy has much to do with this, as well as the record low interest rates for 99% of loans in Spain.

While the number of transactions increased from 2010, the amounts have declined substantially from the peak in 2007.

Spanish banks have been increasing fees applied on almost every product as funding costs remain high and credit activity has

plummeted. This applies to card, current accounts or maintenance fees, where commissions have increased over 70% since

2005 to a new record high. Similar trends have been seen across all products banks offer (right chart below).

Amazon started offering Spanish e-books in the last few weeks and continues to grow after opening www.amazon.es last

September.

Online sales of the Spanish Lottery increased over 30% YoY, showing how new channels are helping consumption.

Figure 60: Card usage remains relatively strong despite theturmoil a positive sign

Figure 61: A higher number of transactions is taking placebut at lower amounts for the moment

Figure 62: Spanish banks have increased their maintenancefees on almost every product to try to offset their higherfunding costs. Savings products are no different

Source: Bank of Spain, Iberpay, (last = November 2011) Source: Bank of Spain, Iberpay, (last = November 2011) Source: Bank of Spain, Spanish banks

-

200

400

600

800

1,000

1,200 Spain money transactions (mn )

Transfers Cheques Debits

-

200

400

600

800

1,000

1,200

1,4001,600

1,800

2,000 Spain money transactions amount mn

Tra ns fe rs C h eq u es D eb it s

30

35

40

45

50

55

Apr05

Sep05

Feb06

Jul06

Dec06

May07

Oct07

Mar08

Aug08

Jan09

Jun09

Nov09

Apr10

Sep10

Feb11

Jul11

Dec11

Annual Maintenance Fees

C urrent Acc ounts Sav ings Accounts


24/41

24



Real estate prices are still far from recovery

Housing starts have fallen below the levels of the early 1990s, although there are still over one million new properties that

could reach the market in 2012, without taking into account properties repossessed by banks; these will likely put further

pressure on pricing. This should be a key focus for the new Spanish government.

House prices have fallen in Spain but its hard to know how much due to the lack of reliable indicators. New measuresintroduced by the new government (i.e. reinstating tax deductions on property acquisitions) are also expected to fall short of

being effective and high economic uncertainty will tame demand.

A lack of housing transactions is showing the extent of the turmoil. There are no official figures as to how many transactions

are linked to repossessed properties, but some banks point out this figure could be around 70% and larger for some. All in all

they (chart below) dipped even lower over the last few months, reflecting the end of tax incentives in 2010.

The Government reintroduced on 30 December 2011 the tax deduction on property acquisition, removed in January 2011.

Figure 63: Housing starts vs completions show there isstill a large oversupply of properties in Spain

Figure 64: Its difficult to know exactly how much themarket has dropped in Spain but clearly not enough

Figure 65: Housing transactions remain at depressedlevels in Spain, reaching lower levelsalmost every quarter

Source: Ministry of Development, Spanish Surveyors College, J.P. Morgan estimates Source: INE, companies reports, press clippings, shaded official statistics Source: INE, Spanish Surveyors College

0

100

200

300

400

500

600

700

800

900

939495969798990001 02030405060708091011 12 13

Spanish housing starts vs. completions (000 units)

Housing starts (Y+2) Completed Housing

-18%

-25%

-27% -27%

-30% -30%

-35%

-30%

-25%

-20%

-15%

-10%

-5%

0%

HousingMinistry

TINSA Idealista Fotocasa CBRE A&N

Spanish house prices e volution YoY (%) Dec 2007-Dec 2011

0

25

50

75

100

125

150

175

200 Spain Housing Transactions 3M rolling

H ousing fr ee pr om ot ion H ousing subs id is ed


25/41

25



The outlook for mortgage demand is still weak

The Bank of Spains lending survey published late October revealed how credit demand remains weak in Spain, both for small

and large corporates and residential loans. The end of housing incentives and economic turmoil are having an impact, as well

as the general economic situation.

Wages are falling in Spain, although they are more expensive for those contracts with collective agreements. As privatecompanies continue to moderate salary increases in Spain, the public sector will have to adjust after the 5% pay cut in 2010.

The collective agreements are generally considered one of the main obstacles to a more flexible labour market in Spain.

The Spanish population is getting older and the pension system will have to adjust to it. On top of this, the population is set to

decline over the next decade, as the National Statistics Institute (INE) published last 7 October, the first such decline on record.

This should be another reason why housing prices look set to decline long term and why the younger population could suffer

an increase in taxes over the long term.

The Popular Party will have to detail its plans to reactivate the housing market, including lower taxes, more deductions for

buyers and tenants and changing the bankruptcy law, amongst other measures.

Figure 66: Mortgage demand remains weak in Spain, notsurprising given the status of the local economy

Figure 67: Wages are picking up again in Spain, driven bygrowing CPI and contracts with collective agreements

Figure 68: The Spanish population is getting older and set todecline for the next decade... Wholl pay? Kids?

Source: INE, Spanish Surveyors College, J.P. Morgan estimates Source: AEAT, Bank of Spain Source: INE Active Population Survey

-120

-100

-80

-60

-40

-20

0

20

40

60 Expected demand for Spanish residential mortgages (%) End housingincentives

0

1

2

3

4

5

6

7

97 98 99 00 01 02 03 04 05 06 07 08 09 10 11

Wages Spain average YoYGrowth (%)

W ag es S pa in (Gro ss) C ol le ct iv e Ag reem ents

-4,000 -2,000 - 2,000 4,000

70

Spain Population Pyramid 3Q11

M ale Fe ma le

Preparedto pay?


26/41

26



Spanish Unemployment: younger generation is the main concern

Unemployment reached almost 23% in December 2011, staying at historically high levels and with little signs of a fast

recovery in sight. However, there have been not major adjustments in the public sector yet.

Younger people (under 25) and immigrants are still suffering the bulk of the adjustment in Spain, where it is very expensive to

lay-off long-time workers, with expensive severance payments, increasing the risks of a lost generation - such as Japansuffered in the 1990s. This is one of our main concerns and more efforts are required on labour reform, as unemployment

figures show, something Government and Opposition should be tackling sooner rather than later.

Foreign workers in Spain are suffering more from the downturn in the real estate sector, which will be very much affected by

the Government budget cuts in infrastructure and construction spending. Programs set up to repatriate immigrants to avoid

having a further increase in local unemployed never really worked, as public figures showed.

On 11 January, Spanish PM Rajoy declared the 4Q11 unemployment survey could show a record 5.3mn unemployed.

Figure 69: Unemployment reached 21.5% in September, thelargest figures since the mid 1990s and growing

Figure 70: Younger unemployment (55

0%

5%

10%

15%

20%

25%

30%

35% Spain unemployment rate by origin (%)

Spanish Foreign


27/41

27



Labor reforms are needed to solve the unemployment problem

Spanish unemployment reached almost 5mn in December 2011 (23% of total), after growing in December by 1,897, but still at

historically high levels and likely to increase further in January.

Services and construction industries represent 67% of total unemployment in Spain, where younger people and immigrants are

still worst placed, as it is very expensive to lay off long-time workers, which some local economists have suggested increasesthe risks of a lost generation. This is one of our main concerns and recent labour reforms dont appear to be enough.

Spanish unemployment is still very seasonal due to the large number of temporary workers in Spain, as companies usually hire

before the festive season until its over, as we can see clearly in the summer and Christmas period (right chart below).

Spanish PM Rajoy announced on 10 January the Government is still negotiating with the unions the labour reform but "if an

agreement is not met the Government will act in the best interest of the Spanish people" (Expansion, 11 January 2012)

Figure 72: Unemployment reached 5mn mark in September,the largest figure since the mid 1990s and growing

Figure 73: Services and construction represent 67% of totalunemployment in Spain, where austerity measures won't help

Figure 74: Spanish unemployment is very seasonal due to thehigh amount of temporary workers in Spain.

Source: INE Active Population Survey (last = September 2011) Source: Spanish Labour Ministry Source: Spanish Labour Ministry

0

1,000

2,000

3,000

4,000

5,000

6,000 Spain unemployed b yorigin 000

Spanish Foreign: TOTAL

Services59%Construct

18%

Industry11%

First job9%

Agriculture3%

Spanish unemployment December 2011

-100,000

-50,000

0

50,000

100,000

150,000

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

Spanish unemployed MoM increase

AVERAGE 1996-2011 2011 Average 1996-2010


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28



Unemployment remains more problematic in the South

The latest employment survey showed 11% of families had all their members unemployed as of September 2011, with large

differences across regions (Andalusia had 18% vs Madrid 7%), evidencing the large economic differences inside Spain.

Andalusia remains the main drag for the Spanish economy. This region reported a 31% unemployment rate in September 2011

(8.8% above average), despite having one of the largest proportions of public spending in Spain (centre chart below). The laxcontrol of tax authorities and the black economy in the region are usually blamed for this. Andalusia is also the most

populous state in Spain, with over 8.2 million inhabitants or 18% of the total Spanish population.

There public sector in Spain will have to be adjusted, as the number of public employees kept increasing until 3Q11. The

number of civil servants reached a record high in 3Q11 of 3.2mn, contrasting with austerity measures the Government and

regions should be implementing. This is something likely to draw the attention of Germany and other EU members asking for

further austerity measures in order to keep supporting the Spanish sovereign debt.

Figure 75: 11% of families had all their members unemployedas of September 2011, with big differences across regions

Figure 76: Andalusia remains the main drag for Spain with31% unemployment and the largest population

Figure 77: There still is no unemployment in the public sectorin Spain while the private sector is adjusting

Source: INE Active Population Survey Source: INE Active Population Survey (size of bubble = population) Source: INE Active Population Survey (last = September 2011)

17.716.9

15.915.4

13.012.712.6

11.010.9

9.5 9.3 8.8 8.88.0 8.0

7.5 7.1 7.16.3 6.2

0

2

4

6

8

10

12

14

16

18

20 % of famili es with all members unemployed

Andalusia

C. Islands

C. Mancha

Castilla

LeonCatalonia

Valencia

Madrid

5%

10%

15%

20%

25%

30%

35%

10% 15% 20% 25% 30% 35%

Unemployment

Civil Servants as % of Total employees

Spain regional unemployment vs Civil servants 3Q11

Extremadura

1,500

1,700

1,900

2,100

2,300

2,500

2,700

2,900

3,100

3,300

4,000

6,000

8,000

10,000

12,000

14,000

16,000

89 91 93 95 97 99 01 03 05 07 09 11

Spanish employed private vs public sector 000

Private Sec LHS Public Sec RH S


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29



Spain is still at the top in Europe in unemployment

Overall unemployment in Spain is the highest in Europe, close to the worlds highest at 22.9% as of November, according to

Eurostat. This figure reveals the size of the problem for Spain and how it has to become a priority for the new government to

tackle, as huge unemployment costs are a real problem for the budget.

Youth unemployment in Spain is the highest in Europe. The duality of the Spanish labour system and a very rigid workingenvironment are largely behind this number, in our view, one of the main concerns for the Spanish population, especially the

younger generations.

Spain has one of the lowest minimum salaries in Europe, below countries like Greece or Ireland. The differences between

some of these countries are surprisingly large, despite the state of their economies.

Figure 78: Unemployment in Spain is highest in the EU, wellabove Eastern European and peripheral countries

Figure 79: Young unemployment in Spain is highest in theEU, well above Eastern European countries

Figure 80: Spain has one of the lowest minimum salaries inEurope, below countries like Greece or Ireland

Source: Eurostat *Latest available Source: Eurostat *Latest available Source: Eurostat

0%

5%

10%

15%

20%

25% Unemployme nt % (Eurostat)

Spain Greece Ireland Portugal Italy

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

50%

Spain

Greece*

Lithuania*

Slovakia

Latvia*

Ireland

Italy

Portugal

Bulgaria

France

Poland

Hungary

Romania*

Sweden

Estonia*

Eurozone

UK*

Finland

CzechRep

Belgium

Denmark

Slovenia

Germany*

Norway*

Netherla

Austria

EU unemployment rates


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30



Inflation growth is relaxing, as commodities prices drop

Spanish CPI was 2.4% in December 2011; falling from 2.9% in November. Lower oil prices and stable prices of tobacco are

the main drivers behind the drop, according to the National Statistics Institute.

Wages are usually linked to CPI in Spain. This has generated a major loss of competitiveness with Europe since the 1990s and

criticism from institutions such as the IMF or ECB. Recent wage cuts are unfortunately not being too effective (see chartsbelow), but the gap with CPI should remain high over the next few months as wage indexation is targeted by new labour

reforms. December CPI (2.4%) will normally be used to update wages in Spain, an added challenge for companies suffering

from liquidity constraints.

Core inflation bounced up from negative in April 2010 to 1.65% in November 2011. Higher taxes and oil prices are keeping

general prices up in Spain, whilst economic activity remains weak.

The IFM reiterated late 2011 how in Spain The government will have to persevere with reforms to further build market

confidence and to create a new growth model that can generate jobs for the countrys millions of unemployed.

Figure 81: Inflation has evolved differently in Spain fordifferent products.

Figure 82: Wages are usually linked to CPI evolution inSpain, introducing great seasonality in the system

Figure 83: Core inflation remained at 1.7% as of October afterrunning negative for some time in 2010

Source: INE Source: INE, AEAT (last = November 2011) Source: INE (last = November 2011)

-4

-2

0

2

4

6

8

Spanish CPI evolution YoY (%)

G en er al F oo d a nd n on-a lc oho li c b ev era ge s

-1

0

1

2

3

4

5

6

7

97 98 99 00 01 02 03 04 05 06 07 08 09 10 11

Spanish Wage growth rate YoY (%)

Wages Spain CPI SPAIN

-1%

0%

1%

2%

3%

4%

5%

6%

94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11

Spanish Core CPI evolution YoY (%)


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31



Credit quality deterioration continues

High unemployment of 22.4% currently in Spain is likely to ensure non-performing loans keep growing in Spain. There are

still few encouraging signs, while an increase in interest rates could potentially be problematic as 99% of loans are floating.

Deleveraging in the banking sector should make NPL ratios increase further, not only in the real estate sector.

Corporate bankruptcies have stabilised at very high levels, with voluntary bankruptcies the preferred choice for troubledcompanies. The Insolvency Act introduced late 2011will only have a small impact however according to local law firms as

distressed transactions are yet to pick up. We analyse this in detail in our 21 July report Santander and BBVA, not only

Spanish but suffering from it.

Unpaid bills (mainly short-term commercial paper) have stabilised at low levels, as the activity in the market has dropped

dramatically since 2008. This is partly a consequence of weaker activity in the SME market in Spain as companies need for

credit has dropped significantly.

Madrid and the Mediterranean were the most active regions in bankruptcy filings in 2011, according to PWC.

Figure 84: High unemployment (currently at >20%) in Spain islikely to keep non-performing loans and credit losses high forsome time

Figure 85: Corporate bankruptcies have stabilised at veryhigh levels. The new insolvency law to be introduced couldhave a further impact as NPLs are very correlated.

Figure 86: Unpaid bills have dropped since their peak in 2008in line with the lower business activity

Source: Bank of Spain, INE Active Population Survey Source: INE, Mercantile Courts, Bank of Spain Source: INE

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

0%

5%

10%

15%

20%

25%

30%

71 74 77 80 83 86 89 92 95 98 01 04 07 10 13E

Spanish Banks' NPLs vs Unemployment (%)

Unemployment LHS Banks NPL RHS

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

8.0%

9.0%

10.0%

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

81 83 85 87 89 91 93 95 97 99 01 03 05 07 09 11

Spain annual corporate bankruptcies vs NPLs YoY (%)

Co rp . B an kr up tcies LHS B an k N PL s R HS2.0%

2.5%

3.0%

3.5%

4.0%

4.5%

5.0%5.5%

6.0%

6.5%

7.0% Unpaid bills % of total bills outstanding


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32



Credit quality indicators (continued)

Fixed income instruments such as RMBS show how repossessions have been growing for Spanish banks since 2009.

Mortgages written between 2004 and 2008 (not the whole book) are responsible for most of the issues, while no covered bond

has (so far) defaulted. Some vehicles are showing an acceleration in repossessions which shows how the turmoil is still far

from over in the sector (left chart below). Shorter term arrears are usually good indicators of where credit quality is heading, as these are not affected by the usual

refinancing process followed by banks. Some banks usually securitized the riskiest part of their loan books at the peak of the

housing cycle to diversify risk from their balance sheet, which could prove valuable if they eventually do default.

Increased deterioration across assets is taking place across the whole sector since the end of 2010. This is something banks

have been talking about since mid 2011, as the credit markets shut down, having a negative impact on the Spanish economy.

S&P and Moodys have downgraded a number of covered bonds and securitizations, leaving others under negative watch due

to increased asset deterioration in the portfolios of these products.

Figure 87: Fixed income instruments such as RMBS showhow repossessions have been growing for Spanish bankssince 2009

Figure 88: Shorter term arrears are usually good indicators ofwhere credit quality is heading

Figure 89: Increased deterioration across assets is takingplace across the whole sector since the end of 2010

Source: BBVA, EdT Source: Santander Titulizacion Source: Caja Madrid, Bloomberg

0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000 BBVA RMBS 1-10 repossessed properties(units)

0%

1%

2%

3%

4%

5%

6%

7%

Jan-07

Apr-07

Jul-07

Oct-07

Jan-08

Apr-08

Jul-08

Oct-08

Jan-09

Apr-09

Jul-09

Oct-09

Jan10

Apr-10

Jul-10

Oct-10

Jan-11

Apr-11

Jul-11

Nov-11

Santander SME & Corporate MBS average NPLs 90D Due + Foreclosure

Delinquenciespicking up


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33



Consumer confidence remains very low in Spain

Consumer confidence indicators have been very unstable in Spain since 2009, showing little sign of recovery, although the

latest figures released in November show a bit more optimism. We expect, however, as soon as the Popular Party starts

announcing further austerity measures in 2012, confidence could be affected.

Consumer confidence is one of the main drivers of retail sales in Spain. The expected downturn indicated by sentimentexpectations is potentially negative for the retail sector. The two have been very closely linked over the past few years so

finding a way to make Spaniards more confident could be vital for retailers.

Unemployment and the economy were by far the main concerns for Spanish citizens as of November 2011. Also worth noting

is again the decline in terrorism as a concern, probably linked to the ceasefire announced by ETA in October.

Figure 90: Consumer confidence dropped again in December,after a very unstable 2010

Figure 91: Consumer confidence is one of the main drivers ofretail sales in Spain

Figure 92: Unemployment and the economy were by far themain concerns for Spanish citizens as of December

Source: ICO Confidence Indicator Source: INE, EC Commission Source: CIS Barometer

20

30

40

50

60

70

80

90

100

110

120

Feb07

May07

Aug07

Nov07

Feb08

May08

Aug08

Nov08

Feb09

May09

Aug09

Nov09

Feb10

May10

Aug10

Nov10

Feb11

May11

Aug11

Nov11

Spain consumer confidence (I CO)

Cons. Confidence Current Future

-12%

-10%

-8%-6%

-4%

-2%

0%

2%

4%

6%

8%

70.0

75.0

80.0

85.0

90.0

95.0

100.0

105.0

110.0

05 06 07 08 09 10 11

Spanish retail sales vs Cons Confidence YoY 3-month roll

EU Ec. Sentiment RHS Retail Sales LHS

0

10

20

30

40

50

60

70

80

90 Main concerns for Spanish citizens

Dec 2009 Dec 2010 Dec 11


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34



Tourism is the bright spot, benefiting from turmoil elsewhere

The UK, Germany and France represent around 50% of total tourism in Spain. It appears tourism has gradually recovered

since mid 2010, reflected in recent figures from tourism associations and positive feedback from the summer season in regions

like the Balearic Islands and the Canary Islands.

UK tourists (number one source of tourism) reported the worst month on record in December 2010 and have since recoveredsignificantly on a 12M rolling basis. This is a surprise given the weak evolution of Sterling vs the Euro, where discounts

applied by hotel chains and turmoil in other Mediterranean destinations are also having a positive effect according to Spanish

travel agents.

German tourism (second largest source of tourism in Spain) in July reached a similar level of tourists as that of 2010. While

it's still far below its long-term average, locations such as Mallorca or Ibiza were almost at full capacity in July and August, a

positive sign for their local economies.

Low cost airlines (Easyjet, Ryanair) are still reporting good traffic figures in Spain, definitely helping some recovery here.

Figure 93: UK, Germany and France represent 50% of totaltourism in Spain. It looks like tourism is now clearly on arecovery path

Figure 94: UK tourists (main source of tourism) reported a10Y low visitors figures in December 10 and has beenincreasing since despite the weak sterling

Figure 95: German tourism was in October again above itslong-term average, showing encouraging signs.

Source: Frontur Source: Frontur, Bloomberg Source: Frontur

-20%

-15%

-10%

-5%

0%

5%

10%

15%

20%Foreign v isitors to Spain YoY 3M Rolling (%)

UK Germany France

1.00

1.10

1.20

1.30

1.40

1.50

1.60

1.70

12.0

12.5

13.0

13.5

14.0

14.5

15.0

15.5

16.0

16.5

17.0

May02

Nov02

May03

Nov03

May04

Nov04

May05

Nov05

May06

Nov06

May07

Nov07

May08

Nov08

May09

Nov09

May10

Nov10

May11

Nov11

/ExchangeR

ate

UKvisitors(mn)

UK Visitors to Spain 12M rolling (mn) vs /

UK /

0

200

400

600

800

1,000

1,200

J an Feb Mar Apr May J un Jul Aug Sep Oct N ov Dec

German tourism to Spain 2001-2011 (000)

Average monthly tourism (2001-2010) 000 2011


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35



Valuation data

Spanish banks are generally trading on low Price/Earnings multiples but are expensive on Price/Tangible Book Value ratios.

This suggests investors are concerned about the value of goodwill (nil) plus the unrealised losses banks may be holding in

their domestic portfolios.

Figure 96: Price/Tangible Book Value vs Expected ROE for main European banks

Source: Bloomberg, J.P. Morgan estimates; Values as of 11 January 2012

Barclays

HSBC

Royal Bank of Scotland

Standard Chartered

France

BNP Paribas

CASA

Societe Generale

Banesto

Bankinter

BBVA

Popular

Sabadell

Santander

Pastor

Intesa Sanpaolo

UBI

Mediobanca

UniCredito Banco Popolare

Banca Popolare di Milano

Credit Suisse

UBSDeutsche Bank

Goldman Sachs

Morgan StanleyCommerzbank

Nordics

Danske Bank

DNBNordea

SEB

Swedbank

Sydbank

Erste

Raiffeisen

Lloyds TSB

Postal Savings Bank

BES

BPI

Caixa

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

0.0x 0.2x 0.4x 0.6x 0.8x 1.0x 1.2x 1.4x 1.6x

RoNAV12E

Price/Tangible Book Value (P/NAV) 2012E


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36


12 January 2012Jaime Becerril(