Spain 2012 in Pictures

Europe Equity Research
12 January 2012
Spain in Pictures
A monthly view of Spanish economic indicators
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 wholesale markets, deleveraging and a recessionary environment are likely to weigh for some time. A clean-up of real estate assets should be the main priority for the new government in our view, potentially very positive for the economy as credit markets would have a chance of reopening. In the meantime, Santander, BBVA and Caixabank should continue to benefit from 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
8 6 4 2 0 -2 -4 -6 99 00 01 02 03
GDP YoY (%) LHS
European Banks Jaime Becerril

AC
(44-20) 7742-6449 jaime.becerril@jpmorgan.com
Axel J Finsterbusch
(44-20) 7325 9021 axel.j.finsterbusch@jpmorgan.com J.P. Morgan Securities Ltd.
ECBs December LTRO was a large one

25 20
LTRO Borrowing bn
20
15
15 11 11 8 5 4 4
10
Source: Companies, J.P. Morgan estimates
Austerity measures are growing again

60% 50% 40% 40% 30% 30% 20% 10% 0% 17,707 33,007 53,407 120,000 Starting Tax Base Withholding Additional 175,000 300,000 24% 28% 24.75% 0.75% 37% 2% 43% 44% 45% 45% 3%
Spanish Income Tax (%)

47% 4% 49% 5% 51% 6% 52% 7%
Spanish PMI Composive vs GDP YoY %
70 65 60 55 50 45 40 35 30 25 08 09
PMI=50
Source: Spanish Government
04
05
06
07
10
11
PMI Manufacturing RHS
Source: Bank of Spain, Markit (Latest=December 2011)
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 that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. www.morganmarkets.com
Jaime Becerril (44-20) 7742-6449 jaime.becerril@jpmorgan.com
Europe Equity Research 12 January 2012
Table of Contents
Spanish government expects recession in 2012 ..................................................3 Austerity 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 ..........................34 Valuation data......................................................................................................35 Relative evolution of Spanish vs European banks .............................................36 Timeline of next events in Spain/Europe.............................................................37 Recently published research...............................................................................38
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 government suggest 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 by economic sentiment and PMI indicators, still well below 50
8 6 4 2 0 -2 -4 -6 99 00 01 02 03 04 05 06 07 08 09 10 11
GDP YoY (%) LHS PMI Manuf RHS PMI=50
Figure 2: Economic sentiment deteriorated again in December in Spain, pointing to a negative GDP in 2011
120 115 110 105 100 95 90 85 80 75 70 Spanish EC Economic Sentiment Indicator & GDP 8 6 4 2 0 -2 -4 -6 91929394 95969798 99000102 03040506 07080910 11
EC Ec. Sentiment 3M avg GDP YoY (%) LHS
Spanish PMI Composive vs GDP YoY %
70 65 60 55 50 45 40 35 30 25
Figure 3: The new government is yet to publish its official GDP forecasts 2012 and 2013. An adjustment to official forecasts is likely Spain GDP forecasts (%)
3.0 2.5 2.0 1.5 1.0 0.5 0.0 -0.5 -1.0 -1.5 2.3 1.1 0.7 0.3 -0.2 -1.1 2012
Government IMF EU Comm
Previous Gov forecast
2.4 1.8 1.4
1.0
2013
Bloomberg Consensus JPM
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
De Guindos: Espaa volver a entrar en recesin en 2012 (Expansin, 26 December 2011)

3
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 tax brackets by up to 7% on 30 December increasing the maximum above 50% rate until 2012-13 (at least)
60% 50% 40% 40% 30% 30% 20% 10% 0% 17,707 33,007 53,407 120,000 Starting Tax Base Withholding Additional 175,000 300,000 24% 28% 24.75% 0.75% 37% 2% 43% 44% 45% 45% 3%
Figure 5: Dealing with Regions debt has become a priority as the government plans to introduce spending limits
18x 16x 14x 12x 10x 8x 6x 4x 2x 0x 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10
Catalonia C. Mancha Vale ncia
Figure 6: The Spanish Standard VAT rate is one of Europes lowest at 18%, something other EU countries are aware of
26 24 22 20 18 16 14 12
Denmark Hungary Sw eden Romania Greece Poland Portugal Finland Latv ia Belgium Ireland Czech Rep Italy Austria UK France Germany Netherlands Spain Malta Cy prus Lux embourg
Spanish Income Tax (%)

47% 4% 49% 5% 51% 6% 52% 7%
Spain Regional Debt Evolution (rebased)
Standard VAT Rate %

Sustainable?
10
Source: Spanish Government
Source: Bank of Spain, J.P. Morgan estimates
Source: EU Commission Taxation and Customs Union, rates as of July 2011
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 (for borrowers) 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, as individuals and companies prepare for eventual problems in the industry. This was the case already in Ireland or Greece and Spain 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 Spain since 2009, where ING Direct remains surprisingly resilient
30 25 20 15 10 5 0 ING Direct Jan 09 Barclays Dec 09 Dec 10 Deutsche Bank Oct 11
Current Accounts
Source: Companies, Spanish Banking Association Source: Bank of Spain, ECB
Figure 8: Spanish banks have seen their deposits fall over the past few months, as happened in 2008
40% 35% 30% 25% 20% 15% 10% 5% 0% -5% -10%
Figure 9: Nationalized institutions have had a larger outflow of deposits in 2011 than their peers
60,000 50,000 40,000 30,000 20,000 10,000 0 CatalunyaCaixa NovaCaixaGalicia Dec 10 Jun 11 Sep 11 CAM Oct 11 UNNIM
Foreign Banks' Deposits in Spain 2008-2011 bn
Spanish Deposit Evolution YoY %
Spanish Savings Banks Customer Deposits mn
Savings Accounts
Time Deposits
Source: Companies
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 (<12-month) stabilized since the end of 2010 but are not falling yet, despite the drop in the reference rate (mainly 12-month Euribor) since then. Spanish 12-month deposits have been weakening over the past few months as rates are still surpassed by Greece, Portugal and Ireland in the EU. While the gap between some of these in Europe is very high, expensive wholesale funding costs are clearly having an impact and will be reflected in all banks balance sheets. Corporate deposits have been falling across the weakest European regions, a major trigger being the Irish bailout. Spanish corporate deposits were falling in November on a YoY basis, where implementation of new liquidity requirements is likely to maintain pressure as deposit growth is close to zero, if growing at all. The Central Bank of Portugal introduced new measures in October to try and control the high deposit prices paid by banks. Peripheral countries banks continue to fight for time deposits, where weaker/smaller banks are being less successful.
Figure 10: Deposit rates for NEW 12M deposits have been more stable in Spain than in other peripheral" countries
6.00 5.00 4.00 3.00 2.00 1.00 0.00
Figure 11: Spanish household deposits are weakening again (12-month deposits below)
70% 60% 50% 40% 30% 20% 10% 0% -10% -20% Dec 03 May 04 Oct 04 Mar 05 Aug 05 Jan 06 Jun 06 Nov 06 Apr 07 Sep 07 Feb 08 Jul 08 Dec 08 May 09 Oct 09 Mar 10 Aug 10 Jan 11 Jun 11 Nov 11
Figure 12: Deposit wars are not something unique about Spain, while corporate deposits are falling faster
80% 60% 40% 20% 0% -20% -40% -60%
Deposit Rates <12 months (%)
GIIPS Household Deposits YoY (%)
GIIPS Corporate Deposits YoY (%)
Spain
Greece
Italy
Portugal
Spain
Greece
Ireland
Portugal
Source: ECB, Central Banks
Source: ECB
Source: ECB, Central Banks
Dec 03 May 04 Oct 04 Mar 05 Aug 05 Jan 06 Jun 06 Nov 06 Apr 07 Sep 07 Feb 08 Jul 08 Dec 08 May 09 Oct 09 Mar 10 Aug 10 Jan 11 Jun 11 Nov 11
Spain Greece Ireland Portugal
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 and La 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 in October as in 2010. Higher deposit yields and lower base rates could have an impact on banks' NIM in 4Q11
100 50 0 -50
3,000
Figure 14: Banks increased the commercialization of commercial paper (pagars) to cope with higher legal requirements on time deposits
6,000 5,000 4,000
Figure 15: Lower deposit rates are having an impact on volumes as deposits are shrinking once again 2% YoY
30% 25% 20% 15% Spanish Deposits Evolution YoY %
Spread new Deposits vs 3M Euribor (bp)
Commercial Paper Issued 2011 mn

4,9194,778 3,766
-100 -150 -200

2,000 1,000 <12M 12-24M
1,9771,839 1,515 1,0271,000 832 809 754 721
10% 5% 0% -5% 65 67 69 71 73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 07 09 11
Source: Bank of Spain, EBF, Bloomberg, J.P. Morgan estimates
Source: Banks, AIAF
Source: Bank of Spain (last = October 2011)
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 a referendum on the EU bailout and dropped after comments from German chancellor Merkel that the EU would take steps towards fiscal 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 very high. 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 German sovereign debt has fallen from Euro-area records in November
500 450 400 350 300 250 200 150 100 50 0
8 June 2010* 9 January 2011
Table 1: Wholesale funding has remained almost stagnant for Spanish banks and companies since last April
Issuer BBVA SAN Bankinter Popular Unicaja Banesto BBVA Caixa SAN Popular* Sabadell* BBVA** La Caixa* Date Term Yield Spread (bp) 5Y CDS Volume mn 04-Jan 3 4.12% 225 262 1,500 05-Jan 5 4.62% 225 255 1,000 14-Jan 2 4.87% 315 456 500 26-Jan 2 4.85% 270 486 650 23-Mar 5 5.50% 257 n/a 500 30-Mar 4 4.63% 178 n/a 600 30-Mar 4 4.25% 140 205 2,000 27-Apr 5 5.13% 206 269 1,250 21-Jun 5 4.63% 195 231 1,000 20-Jul 8 8.00% 494 645 200 14-Sep 2 4.25% 275 700 300 28-Oct 1.5 4.00% 350 257 750 21-Nov 5.1 7.50% 500 255 1,500
Figure 17: CDS spreads for Spanish banks are well above the levels reached at the peak of the June 2010 turmoil
5 year senior CDS spreads (bp) 950 900 850 800 750 700 650 600 550 500 450 400 350 300 250 200 150 100 50
Spread Spain 10Y Gov Bond vs German 10Y Bunds (bp)
344
Source: Bloomberg as of 11 January 2012
Source: Bloomberg, Companies *Subordinated retail debt. **Senior Debt. All others are covered bonds
Source: Bloomberg, CMA
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 3Y LTRO auction (JPM estimates by bank below)
25 20
Figure 19: Spanish borrowing from ECB increased to 98bn or 25% of overall as of November, as funding turmoil remains
200 175 150 Spain ECB + Guaranteed Funding bn
Figure 20: Reliance on ECB funding has increased across Europe as sovereign pressures returned
225 200 175 150 125 100 75 50 25 0 Greece* Ireland* Spain* Portugal Italy Belgium France
Nov-11 Dec-11
LTRO Borrowing bn
ECB Funding bn
20
15
15 11 11 8 5 4 4
125 100 75 50 25 0
10
0
SPAIN (LHS) Spain Government Guarante ed Debt
Dec-08
Dec-09
Dec-10
Aug-11
Sep-11
Source: Companies, J.P. Morgan estimates *Santander estimate 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)
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 rated countries 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 to German Bunds, close to record low levels
7.5 6.5 5.5 4.5 3.5 2.5 1.5 Government Debt 10Y Government Bonds Yields (%)
Figure 22: Spain has managed to escape the final contagion whilst Italy and France are having their own problems now
Figure 23: Government debt issues could reach just under 200bn in 2012, similar to 2011
225 200 Spanish Sovereign Debt Issuance 2010 vs 2011 bn
10Y Bond Spreads vs German Bunds (bp)

4,000 3,500 3,000 2,500 2,000 1,500 1,000 500 1,095 632 513 344 3,356
175 150 125 100 75 50 25
134
20 UK
0 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec 2010 2011
Spain
Source: Bloomberg; Data as of 5 January 2011
Germany
0 Greece PortugalIreland Italy

Source: Bloomberg; Data as of 5 January 2011
Spain France
Source: Spanish Treasury, J.P. Morgan estimates
10
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 and Germany 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 fallen significantly since the end of 2010
50% 48% 46% 44% 42% 40% 38% 36%
France Asia, Africa Benelux Other EU Germany Italy Other
Figure 25: France remains the main foreign investor in Spanish Government debt
Spanish Foreign Debtholders
100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 2000 2005 2008 2009 2010 August 2011 20% 8% 21% 13% 23% 17% 4% 12% 19% 18% 21% 16% 28% 21% 5% 6% 13% 8% 9% 8% 15% 15% 6% 6% 7% 13% 6% 6% 8% 17% 13% 6% 5% 9% 15% 14%
Figure 26: ECB SMP purchases have helped Spain contain its sovereign debt yields since they started in August
35 30 25 20
24%
Spanish Debt Foreign Bondholders (%)
ECB SMP Weekly Purchases bn 29 30
20 14 15 9 4 10 5 3 Nov 11 Spain Dec 11 1 0
26%
15 10 5 -
22%
25%
24%
28%
Aug 11
Sep 11
Oct 11 Italy
Jan 12
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
11
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 or Catalonia. 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 town halls 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 them have 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 greatest in Castilla La Mancha, Murcia and Valencia
-6 -5 -4 -3.0 -3 -2 -1 -0.1 0 1 0.6 -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 -1.2 3Q11 Deficit as % of Regional GDP -4.8
Figure 28: Valencia, Catalonia and Castilla La Mancha are still some of the most problematic regions in Spain (3Q 2011)
23% 22% 21% 20% 19% 18% 17% 16% 15% 14% 13% 12% 11% 10% 9% 8% 7% 6% 5% 5 10
Figure 29: Regional Governments in Spain reached a record high debt of 135bn in September, 13% of Spanish GDP
140 130 120 110 100 90 80 70 60 50 40 30 20 10 0 Total Regional Debt Spain by type of borrowing bn
Catalonia Valencia Balearic I.
Regional Debt/GDP (%)
C. La Mancha Galicia
Aragon Madrid
Andalusia
15 20 25 Regional Unemployment (%)
30
35
95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 Bonds Loans
Source: Spanish Finance Ministry
Source: INE, Bank of Spain (last = June 2011)
Source: INE; Size of bubble= 2010 Regional GDP mn
12
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 for 2011 by over 2% according to the new government
4% 2% 0% -2% -4% -6% -8% -10% -12% 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Slippage is not a good sign
10 Keeps falling 0
Figure 31: Speculation about a potential increase in Spanish VAT from 18% to 20% increased recently
60 50 40 30 20 Tax Hikes Work Spanish Tax Revenues 12M Rolling bn
Figure 32: The impact of incentive schemes introduced by the Government in 2008-10 should now be reversed
220,000 200,000 180,000 160,000 140,000 120,000 100,000 80,000 60,000 40,000 20,000 0 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 Non Financial Income Non Financial Expenses Spain Cash Surplus/Deficit 12M Rolling mn
Spain Government Budget Deficitt as % of GDP
Spain Government surplus/deficit as % of GDP
Expected Deviation
Corporate Tax
Source: AEAT, IGAE
VAT
Source: IGAE, Spanish Finance Ministry (last = November 2011)
Source: Spanish Treasury, Eurostat; shadowed = forecasts (red = Gov forecasts)
13
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 we wouldnt 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 already been downgraded by rating agencies, with Moody's going one step further (so far)
Spain L/T Sovereign Debt Ratings
Aaa Aaa Aaa Aa1 AAA AAA AA+ AA AA-* A1 AAAAA AAA AAA AA+
Aa3 Aa3 A1 A1 A1 A1 A1 A1 A1 A2 A2 Baa1 Baa2 Ba1 Ba2
Figure 34: Regional Governments debt rating is under pressure from rating agencies
Aa1
Regional Governments' L/T Debt Rating*

Non-Inv. Grade
Figure 35: Banks debt ratings are also under pressure from rating agencies AA- AAS&P Long Term Debt rating
A+ A BBB+ BBB+BBB+ BBB BBB BB+**BB+*BB
Moody's 07 08
S&P 09 10 11
Fitch
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
14
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 it may 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 economy as deleverage is underway accelerated by funding pressures
35% 30% 25% 20% 15% 10% 5% 0% -5% -10% 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11
Corporates Households Government
Spanish Lending evolution by borrower YoY (%)
Figure 37: Lending to the construction sector suffered the largest drop between 2009 and 2010 after growing strongly for decades
60% 50% 40% 30% 20% Spain: Loan Growth YoY (%)
Figure 38: Mortgage demand and production continues to reach new lows as banks are unable to get long-term funding.
550,000 500,000 450,000 400,000 350,000
Spanish quarterly new mortgages 3M rolling (units)
10% 0% -10% -20% 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11
300,000 250,000 200,000 150,000

Corporate Housing Developer Construction
100,000 03
Source: Bank of Spain (last = October 2011) Source: Bank of Spain (last = September 2011)
04
05
06
07
08
09
10
11
Source: Spanish Property Registrars (last = October 2011)
15
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 of strong growth. Still the adjustment looks low
35% 30% 25% 20% 15% 10%
Figure 40: Credit demand is falling again in Spain from large corporate and SMEs as they adjust to a low growth scenario
60 40 20 0 -20 -40 -60 -80 Expected demand forr corporate loans YoY Change (%)
Figure 41: Public debt as a percentage of GDP will grow for Spain in 2011-12 but is still below other "peripheral countries
200 180 160 140 120 100 80 60 40 20 0 Greece Ireland 2011 Italy 2012 Portugal 2013 2014 Belgium Spain
Spain Lending YoY (%)
Government gross debt projections
5% 0% -5% 65 67 69 71 73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 07 09 11
-100
SMEs
Large Corporates
Source: Bank of Spain
Source: Countries' Stability and Growth Programs, J.P. Morgan estimates
16
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 no sector 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 but volumes keep falling so the effect is limited
200,000 180,000 160,000 140,000 120,000 100,000 80,000 60,000 40,000 20,000 0 Spanish banks new production Mortgages spreads vs volumes 250
1,100
Figure 43: Large corporates are suffering a larger adjustment than SMEs since the start of the turmoil but no one is safe
Spain Outstanding Corporate Loans bn 1,000 900 800 700 600 500 400 300 200 100 0
Figure 44: The rate of adjustment in the Spanish credit market accelerated at the end of 2011
35% 30% 25% 20% 15% 10% 5% 0% -5% -10% 96 96 97 98 99 99 00 01 02 02 03 04 05 05 06 07 08 08 09 10 11
Spain Credit Growth YoY %
200 150 100 50 0
Mortgage Volumes 12M rolling mn LHS
Mortgage Spreads RHS
Corporates <1mn
Corporates >1mn
Corporate Loans
Households
Source: Bank of Spain, EBF (Spread vs. 12M Euribor)
17
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 exports are 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
Spain Exports per country June 2011
Africa, 6% Asia, 5% China, 2% Japan, 1% America (other), 6% US, 4% Germany , 10% Other, 5% France, 18%
Figure 46: Exports are starting to show some weakness in Spain and could deteriorate further as PMI figures anticipate
20 15 10 5 0 -5 -10 -15 -20 -25 Spanish ex ports vs PMI Maunfact. YoY 3M rolling % 60 55 50 45 40 35 30 25
Figure 47:Spain is one of the worlds largest producers of products such as olive oil, pigmeat, grapes or tomatoes
7,000 6,000 5,000 4,000 3,000 2,000 1,000 -
Spain Top 10 commodities value 2009 $mn
Portugal, 8% Europe (other), 21% Italy , 8% UK, 6%
Exports YoY LHS
PMI Manufacturing RHS
PMI=50
Source: ICEX, Datacomex
Source: AEAT, Markit (last=December 2011)
Source: Food and Agricultural Organization
18
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 industrial production was the worst in decades
20%
Figure 49: Spanish PMI Output indicator dropped to a 2Y low in November

15% 10% Spanish Industrial Production vs Manufacturing PMI 70 65 60 55 50 45 40 35 30 25 20 99 00 01 02 03 04 05 06 07 08 09 10 11
Figure 50: The Spanish consumer goods industry is negative again following higher taxes and the end of public subsidies
10% 5% 0% -5% -10% -15% -20% -25% -30% -35% Industrial Production YoY 3M Rolling %
Industrial Production YoY 3M Rolling %
10%
5% 0%
0%
-5% -10% -15%
-10%
-20% -25%
-20%
-30% -35%
-30%
-40%
-40% 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11
Source: INE (last = November 2011)
I.P. Durable Cons YoY %
PMI Manuf RHS
PMI=50
Durable Cons Goods

Source: INE
Non Durable Goods
Source: INE, Markit
19
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 companies like 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 low levels of 2009 but are weakening especially at home
20 15 10 5 0 -5 -10 -15 -20 -25
-15% -5% -10% 5% 0%
Figure 52: Smaller retailers are suffering a greater adjustment than large companies since the start of the turmoil
15% 10% Spanish retail sales YoY 3-month rolling
Figure 53: Economic sentiment is weakening again and retail sales usually follow
8% 6% 4% 2% 0% -2% -4% -6% -8% -10% -12% 05 06 07 08 09 10 11 Spanish retail sales vs Cons Confidence YoY 3-month roll 110 105 100 95 90 85 80 75 70
Spanish domestic sales & exports YoY %
Single Retail
Domestic Sales Exports YoY LHS
Small chain
Large chain stores

EU Ec. Sentiment RHS Retail Sales LHS
Source: AEAT
Source: INE
Source: INE, EU Commission. Latest = December 2011
Las rebajas llegan con descuentos ms agresivos (El Pais, 7 January 2012)
20
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 with 50bp spread
Monthly payment on a 375K mortgage w. 50bp spread () 2,000 1,800 1,600 1,400 1,200 1,000 800 600 400 200 07 08 09 10 11 12 742 1,883
Figure 55: Savings rate dropped to 12% in 3Q11 once again as borrowers have to draw on their savings
20% 18%
Figure 56: There were 197bn savings accounts in Spain as of October, almost 20% of GDP non-interest-bearing
Spanish Household savings rate 4Q rolling

18.5%
-60%
16% 14% 12% 12.0% 10% 8%
30% 28% 26% 24% 22% 20% 18% 16% 14% 12% 10%
Spanish Savings Accounts/GDP (%)
71 73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 07 09 11
Source: Bank of Spain, INE, J.P. Morgan estimates
Source: EBF, Bloomberg, J.P. Morgan estimates
Source: INE
21
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 the early 1990s in 2011
1,800 1,700 1,600 1,500 1,400 1,300 1,200 1,100 1,000 900 800 700 600 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11
Source: INE, ANFAC (last = October 2011) Source: INE, ANFAC
Figure 58: The SEAT Ibiza was the best selling car in Spain last month, when 202 Porsches were also sold, not too bad
2,800 2,600 2,400 2,200 2,000 1,800 1,600 1,400 1,200 1,000 800 600 400 200 196 8 3 3 1 2,591 2,148 1,765 1,568 1,469 1,333
Figure 59: Car sales have recently taken a negative turn not only in Spain but also in countries like Germany or France
60% 40% 20%
Spanish Car Registrations 12M rolling (000 units)
Top Cars sold in Spain December2011
New Car registrations 3M Rolling YoY %
1,231 1,009
0% -20% -40% -60%
Spain
UK
Germany
Italy
Source: ACEA, ANFAC, FAMA, FMVO, ANFIA
22
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 have weakened more over the past few months and cheques have become a residual form of payment, unlike in countries like the UK. 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 the turmoil a positive sign
1,200 1,000 800 600 400 200 -
Figure 61: A higher number of transactions is taking place but at lower amounts for the moment
2,000 1,800 1,600 1,400 1,200 1,000 800 600 400 200 -
Spain money transactions (mn)
Spain money transactions amount mn
Figure 62: Spanish banks have increased their maintenance fees on almost every product to try to offset their higher funding costs. Savings products are no different
55 50 45 40 35 30
Annual Maintenance Fees
Transfers
Cheques
Debits
Transfers
Cheques
Debit s
Source: Bank of Spain, Iberpay, (last = November 2011)
Source: Bank of Spain, Iberpay, (last = November 2011)
Source: Bank of Spain, Spanish banks
Apr 05 Sep 05 Feb 06 Jul 06 Dec 06 May 07 Oct 07 Mar 08 Aug 08 Jan 09 Jun 09 Nov 09 Apr 10 Sep 10 Feb 11 Jul 11 Dec 11
Current Accounts Sav ings Accounts
23
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 measures introduced 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 is still a large oversupply of properties in Spain
900 800 700 600 500 400 300 200 100 0 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13
-35%
Housing starts (Y+2) Completed Housing
Figure 64: Its difficult to know exactly how much the market has dropped in Spain but clearly not enough
Spanish house prices evolution YoY (%) Dec 2007- Dec 2011 0% -5% -10% -15%
Figure 65: Housing transactions remain at depressed levels in Spain, reaching lower levels almost every quarter
200 175 150 125 100 75 Spain Housing Transactions 3M rolling
Spanish housing starts vs. completions (000 units)
-20% -25% -30%
-18%
50
-25% -27% -27% -30% Housing Ministry TINSA Idealista Fotocasa CBRE -30% A&N
25 0
Housing free promotion
Housing subsidised
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
24
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 private companies 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, not surprising given the status of the local economy
60 40 20 0 -20 -40 -60 -80 -100 -120 Expected demand for Spanish residential mortgages (%) End housing incentives
Figure 67: Wages are picking up again in Spain, driven by growing CPI and contracts with collective agreements
7 6 5 4 3 2 1 0 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11
Wages Spain (Gross) Collective Agreements
Figure 68: The Spanish population is getting older and set to decline for the next decade... Wholl pay? Kids?
Spain Population Pyramid 3Q11 >70 65-69 60-64 55-59 50-54 45-49 40-44 35-39 30-34 25-29 20-24 16-19 <15 -4,000 -2,000 Male Female 2,000
Wages Spain average YoY Growth (%)
Prepared to pay?
4,000
Source: INE, Spanish Surveyors College, J.P. Morgan estimates
Source: AEAT, Bank of Spain
Source: INE Active Population Survey
25
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 Japan suffered 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, the largest figures since the mid 1990s and growing
30% 25% 20% 15% 10% 5% 0% 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 07 09 11
20-24 25-54 >55
Spain Unemployment Rate (%)
Figure 70: Younger unemployment (<25) was stable at 46% in September, victims of the turmoil and a rigid labour market where more efforts are required
45% 40% SPAIN: Unemployment rate by age (%)
Figure 71: Immigrants were still worse off as of 3Q, an added problem for the housing market where they should normally be the main potential buyers
35% 30% 25% 20% 15% 10% 5% 0% Spain unemployment rate by origin (%)
22.9%
35% 30% 25% 20% 15% 10% 5% 0%
Spanish
Foreign
Source: INE Active Population Survey (last = December 2011)
Source: INE Active Population Survey (last = September 2011)
26
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 increases the 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
6,000 5,000 4,000 3,000 2,000 1,000 0 Spain unemployed by origin 000
Figure 73: Services and construction represent 67% of total unemployment in Spain, where austerity measures won't help
Spanish unemployment December 2011 Agriculture First job 3% 9% Industry 11%
Figure 74: Spanish unemployment is very seasonal due to the high amount of temporary workers in Spain.
150,000 100,000 50,000 0 -50,000 -100,000 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec AVERAGE 1996-2011 2011 Av erage 1996-2010 Spanish unemployed MoM increase
Construct 18%
Serv ices 59%
Spanish
Foreign: TOTAL
Source: Spanish Labour Ministry Source: Spanish Labour Ministry
27
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 lax control 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 unemployed as of September 2011, with big differences across regions
20 17.7 18 16.9 15.9 15.4 16 14 12 10 8 6 4 2 0 13.012.7 12.6 11.010.9 % of families with all members unemployed
Figure 76: Andalusia remains the main drag for Spain with 31% unemployment and the largest population
35% Spain regional unemployment vs Civil servants 3Q11 Andalusia 30% C. Islands Valencia Castilla Leon 20% Catalonia Madrid 15% C. Mancha Extremad ura
Figure 77: There still is no unemployment in the public sector in Spain while the private sector is adjusting
16,000 14,000 12,000 10,000 8,000 6,000
Spanish employed private vs public sector 000
3,300 3,100 2,900 2,700 2,500 2,300 2,100 1,900 1,700 1,500
25%
9.5 9.3 8.8 8.8
8.0 8.0
7.5 7.1 7.1
6.3 6.2
Unemployment
10%
4,000
5% 10% 15% 20% 25% 30% 35% Civil Servants as % of Total employees
89
91
93
95
97
99
01
03
05
07
09
11
Private Sec LHS
Public Sec RHS
Source: INE Active Population Survey
Source: INE Active Population Survey (size of bubble = population)
28
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 working environment 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, well above Eastern European and peripheral countries
25% Unemployment % (Eurostat)
Figure 79: Young unemployment in Spain is highest in the EU, well above Eastern European countries
50%
Figure 80: Spain has one of the lowest minimum salaries in Europe, below countries like Greece or Ireland
2,000 1,800 1,600 1,400 1,200 1,000 800 600 400 200
EU unemployment rates <25 (%) September 2011
Minimum Wage 2011
20%
45% 40%
15%
35% 30%
10%
25% 20% 15% 10% 5% Spain Greece* Lithuania* Slovakia Latvia* Ireland Italy Portugal Bulgaria France Poland Hungary Romania* Sweden Estonia* Eurozone UK* Finland Czech Rep Belgium Denmark Slovenia Germany* Norway* Netherla Austria 0%
Spain Greece Ireland Portugal Italy
5%
0%
Source: Eurostat *Latest available
Source: Eurostat *Latest available
Source: Eurostat
29
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 charts below), 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 for different products.
Spanish CPI evolution YoY (%) 8 6
Figure 82: Wages are usually linked to CPI evolution in Spain, introducing great seasonality in the system
7 6 5 Spanish Wage growth rate YoY (%)
Figure 83: Core inflation remained at 1.7% as of October after running negative for some time in 2010
Spanish Core CPI evolution YoY (%)

6% 5% 4% 3% 2% 1% 0%
4 2 0 -2 -4
4 3 2 1 0 -1 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11
General Food and non-alcoholic beverages
-1% 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11
Source: INE (last = November 2011)
Wages Spain
CPI SPAIN
Source: INE
Source: INE, AEAT (last = November 2011)
30
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 troubled companies. 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 is likely to keep non-performing loans and credit losses high for some time
30%
Figure 85: Corporate bankruptcies have stabilised at very high levels. The new insolvency law to be introduced could have a further impact as NPLs are very correlated.
7,000 6,000 5,000 4,000 3,000 2,000 1,000 0 81 83 85 87 89 91 93 95 97 99 01 03 05 07 09 11 Corp. Bankruptcies LHS Bank NPLs RHS Spain annual corporate bankruptcies vs NPLs YoY (%) 10.0% 9.0% 8.0% 7.0% 6.0% 5.0% 4.0% 3.0% 2.0% 1.0% 0.0%
Figure 86: Unpaid bills have dropped since their peak in 2008 in line with the lower business activity
7.0% 6.5% 6.0% 5.5% 5.0% 4.5% 4.0% 3.5% 3.0% 2.5% 2.0%
Spanish Banks' NPLs vs Unemployment (%)
10% 9%
Unpaid bills % of total bills outstanding
25%
8% 7% 6%
20%
15%
5% 4%
10%
3% 2% 1%
5%
0% 71 74 77 80 83 86 89 92 95 98 01 04 07 10 13E
0%
Unemployment LHS
Banks NPL RHS
Source: Bank of Spain, INE Active Population Survey
Source: INE, Mercantile Courts, Bank of Spain
Source: INE
31
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 show how repossessions have been growing for Spanish banks since 2009 BBVA RMBS 1-10 repossessed properties(units) 4,000
3,500 3,000 2,500 2,000 1,500 1,000 500 0
Figure 88: Shorter term arrears are usually good indicators of where credit quality is heading
7% 6% Santander SME & Corporate MBS average NPLs <90D (%)
Figure 89: Increased deterioration across assets is taking place across the whole sector since the end of 2010
18% 16% Caja Madrid RMBS >90D Due + Foreclosure
5% 4% 3% 2% 1% Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 Jan 10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 Jul-11 Nov -11 0%
14% 12% 10% 8% 6%

15-30 D 30-60 D 60-90 D
Delinquencies picking up
Source: BBVA, EdT
Source: Santander Titulizacion
Source: Caja Madrid, Bloomberg
32
Mar-09 May -09 Jul-09 Sep-09 Nov -09 Jan-10 Mar-10 May -10 Jul-10 Sep-10 Nov -10 Jan-11 Mar-11 May -11 Jul-11 Sep-11 Nov -11
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 sentiment expectations 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
120 110 100 90 80 70 60 50 40 30 Feb 07 May 07 Aug 07 Nov 07 Feb 08 May 08 Aug 08 Nov 08 Feb 09 May 09 Aug 09 Nov 09 Feb 10 May 10 Aug 10 Nov 10 Feb 11 May 11 Aug 11 Nov 11 20
Figure 91: Consumer confidence is one of the main drivers of retail sales in Spain
8% 6% 4% 2% 0% -2% -4% -6% -8% -10% -12% 05 06 07 08 09 10 11 Spanish retail sales vs Cons Confidence YoY 3-month roll 110.0 105.0 100.0 95.0 90.0 85.0 80.0 75.0 70.0
Figure 92: Unemployment and the economy were by far the main concerns for Spanish citizens as of December
90 80 70 60 50 40 30 20 10 0
Spain consumer confidence (ICO)
Main concerns for Spanish citizens
Cons. Confidence
Current
Future
EU Ec. Sentiment RHS
Retail Sales LHS
Dec 2009
Dec 2010
Dec 11
Source: ICO Confidence Indicator
Source: INE, EC Commission
Source: CIS Barometer
33
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 recovered significantly 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 total tourism in Spain. It looks like tourism is now clearly on a recovery path
20% 15% 10%
UK v isitors (mn)
Figure 94: UK tourists (main source of tourism) reported a 10Y low visitors figures in December 10 and has been increasing since despite the weak sterling
17.0 16.5 16.0 15.5 15.0 14.5 14.0 13.5 13.0 12.5
May 02 Nov 02 May 03 Nov 03 May 04 Nov 04 May 05 Nov 05 May 06 Nov 06 May 07 Nov 07 May 08 Nov 08 May 09 Nov 09 May 10 Nov 10 May 11 Nov 11
Figure 95: German tourism was in October again above its long-term average, showing encouraging signs.
1,200 1,000 German tourism to Spain 2001-2011 (000)
Foreign v isitors to Spain YoY 3M Rolling (%)
UK Visitors to Spain 12M rolling (mn) vs /
1.70 1.60
/ Ex change Rate
1.50 1.40 1.30 1.20 1.10 1.00
800 600 400 200 0 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Av erage monthly tourism (2001-2010) 000 2011
5% 0% -5% -10% -15% -20%
12.0
UK
UK
Germany
France
Source: Frontur
Source: Frontur, Bloomberg
Source: Frontur
34
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
18%
16% BBVA 14% DNB Sydbank 12% CASA BNP Paribas France Erste Deutsche Bank Raiffeisen Mediobanca Societe Generale 8% Postal Savings Bank 6% Commerzbank UniCredito Banco Popolare UBI Lloyds TSB Pastor Popular Intesa Sanpaolo Banesto Barclays Danske Bank Caixa Morgan Stanley Sabadell BPI Goldman Sachs Credit Suisse UBS Santander
Swedbank
Standard Chartered Nordea HSBC Nordics
RoNAV 12E
10%
Bankinter
4%
BES Banca Popolare di Milano Royal Bank of Scotland
2%
0% 0.0x
0.2x
0.4x
0.6x
0.8x
1.0x SEB
1.2x
1.4x
1.6x
Price/Tangible Book Value (P/NAV) 2012E

Source: Bloomberg, J.P. Morgan estimates; Values as of 11 January 2012
35
Relative evolution of Spanish vs European banks

Spanish banks were amongst the best performing banks in Europe in 2011, outperforming European banks (DJ Stoxx Index) since the start of 2011, even with the sovereign funding pressures suffered during the year. Spanish banks did underperform however the main index (SX7P) in November as Spanish bond yields reached new highs. Smaller domestic banks also performed relatively better than other European peers in 2011, despite the multiple troubles they are still facing. We expect 2012 will be yet another complicated year for the Spanish domestic banking sector.
Figure 97: Santander and BBVA were two of the best performing banks in Europe in 2011 and have started well in 2012, on a relative basis Figure 98: Domestic Spanish banks also evolved relatively better than European banks in 2011, where Caixabanks performance is particularly good
140 130 120 110 100
SAN/BBVA relative to DJ Eurostoxx Banks
340 290 240 190 140 90
Spanish Domestic Banks relative to DJ Eurostoxx Banks
90
40
80
SAN
BBVA
Popular
Bankin ter
Sabadell
Caixabank
Source: Bloomberg, J.P. Morgan estimates
Source: Bloomberg, J.P. Morgan estimates
36
Timeline of next events in Spain/Europe

Below is a table of what we consider have been the main events regarding the Spanish economy over the past few months and we believe will be those to follow over the next few weeks.
Table 2: Timeline of recent and future events affecting Spain
Date 25 Mar 2010 3 May 2010 7 May 2010 12 May 2010 28 May 2010 10 Nov 2010 28 Nov 2010 24 Jan 2011 10 Mar 2011 1 Apr 2011 3 May 2011 8 Aug 2011 7 Oct 2011 8 Nov 2011 20 Nov 2011 2 Dec 2011 6 Dec 2011 8 Dec 2011 8-9 Dec 2011 13 Dec 2011 21 Dec 2011 22 Dec 2011 30 Dec 2011 12 Jan 2012 12 Jan 2012 12 Jan 2012 13 Jan 2012 16 Jan 2012 17 Jan 2012 19 Jan 2012 20 Jan 2012 24 Jan 2012 28 Feb 2012 Event Trichet says that the ECB w ill continue to accept bonds rated as low as BBB- as collateral. EU summit agrees to principles behind a Greek bailout The ECB says it w ill indefinitely accept Greek collateral regardless of the country s credit rating In Spain, Government and main opposition party reach agreement over mergers between cajas and the need of savings-bank regulation reform Spain announces public-w age cuts and a pension freeze Fitch cuts Spains AAA rating one level to AA+ LCH.Clearnet increases haircuts for Irish bonds Ireland gets 85bn bailout. European leaders scale back proposals to inflict losses on bondholders in future EU bailouts Spain announces new capital requirements for banks Bank of Spain announces 15bn capital shortfalls in national bank stress tests ECB agrees to drop its ratings requirement on Irish-backed paper at its tender operations Portugal reaches agreement on a 78bn aid package ECB starts buying Italian and Spanish debt in its SMP purchase program Fitch cuts Spain rating to AA- and Italy rating to A+ LCH.clearnet increases margin requirements on Italian paper by 3.5-5.0% points across the curv e Popular Party wins Spanish elections with a record majority Angela Merkel announces steps towards fiscal union S&P announces potential downgrades of 15 European countries, including Germany and France between them ECB meeting European Council Meeting in Brussels will discuss about the economic situation in Europe Spain issues 12M and 18M bills ECB 3Y LTRO with full allotment - 489bn demand Popular Party takes office in Spain and names new government and economic team Spanish Government announces new austerity measures, including higher income tax and an increase in property tax WHAT TO FOLLOW OVER THE COMING WEEKS Spain issues 3-4Y bonds expected 4bn (top of range at 5bn) Governing Council meeting of the ECB in Frankfurt European Union Meeting in Copenhagen. UK decides on QE expansion Italy issues 5Y bonds EU, ECB, IMF inspectors visit Greece to assess evolution of reforms Spain issues 12M and 18M bills G20 Meeting in Mexico City Meeting Angela Merkel, Sarkozy and Mario Monti in Italy ECOFIN meeting ECB 3Y LTRO with full allotment
Source: J.P. Morgan economic team, press clippings, Bloomberg, Reuters
37
Recently published research

Below is a table with the main research published over the past few weeks, which could, in our view, help investors to gain a better idea of what are the main challenges faced by Spanish banks and companies in the near term. We also included what we considered the most relevant documents for the Spanish economy from our economists, fixed income teams and strategists.
Table 3: Key research published by the JPM European Banks Team and economic team
Date 9/01/2012 7/01/2012 3/01/2012 16/12/2011 15/12/2011 7/12/2011 3/12/2011 3/12/2011 30/11/2011 28/11/2011 24/11/2011 22/11/2011 22/11/2011 22/11/2011 4/11/2011 3/11/2011 30/09/2011 14/11/2011 24/07/2011 19/07/2011 Company Santander JPM Fixed Income Economic Team Caixabank Portuguese Banks Spain in Pictures Santander Sabadell Santander European Banks Interest Rates Strategy BBVA European Banks JPM Fixed Income Economic Research Spanish Banks & Other European Banks Spanish Domestic Banks Santander, BBVA European Banks Description Santander: Reaches EBA's 9% Core Tier I as 10% is the next step Global Fixed Income Markets Weekly Worrying fiscal slippage in Spain CaixaBank: Debt Exchange could close capital shortfall Portuguese Banks: Capital issues remain Spain in Pictures: A monthly view of Spanish economic indicators Santander: Exchanges 2.0bn preferred shares for equity- 4% EPS dilution but cheap capital Banco Sabadell: 870mn debt securities exchange still expensive with 5% EPS dilution Santander: Finding the right funding is the key to outperforming European Banking Outlook: Funding Issues Unresolved: Remain Cautious and Defensive Global Fixed Income Markets 2012 Outlook BBVA: Issues 3.5bn convertible bonds - 13% EPS dilution but very valuable capital European Banks : Deleveraging: E2tr asset achievable, but 14x leverage needs further improvement: Remain Cautious European Credit Outlook & Strategy 2012: A First Cut GDW: Euro area: fiscal slippage and an even deeper recession Spain in Pictures: A monthly view of Spanish economic indicators European Banks: Euro TARP macro sensitivity analysis Spanish Banks: Time to cleanup, recapitalize and merge Santander & BBVA: Not just Spanish but suffering from it European Banks: The Stress Test converted into JPM Acid Test: Capital raising inevitable
Source: J.P. Morgan European Banks Team
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Spain 2012 in Pictures

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Spain 2012 in Pictures

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Europe Equity Research

European Banks Jaime Becerril

(44-20) 7742-6449 jaime.becerril@jpmorgan.com

ECBs December LTRO was a large one

Source: Companies, J.P. Morgan estimates

Austerity measures are growing again

Spanish Income Tax (%)

Spanish PMI Composive vs GDP YoY %

Source: Spanish Government

PMI Manufacturing RHS

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

Jaime Becerril (44-20) 7742-6449 jaime.becerril@jpmorgan.com

Europe Equity Research 12 January 2012

Jaime Becerril (44-20) 7742-6449 jaime.becerril@jpmorgan.com

Europe Equity Research 12 January 2012

Spanish government expects recession in 2012

Spanish PMI Composive vs GDP YoY %

Previous Gov forecast

2.4 1.8 1.4

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

Source: EU Commission, Bank of Spain, Bloomberg

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

Jaime Becerril (44-20) 7742-6449 jaime.becerril@jpmorgan.com

Europe Equity Research 12 January 2012

Austerity measures will increase pressure on weak growth

Spanish Income Tax (%)

Spain Regional Debt Evolution (rebased)

Standard VAT Rate %

Source: Spanish Government

Source: Bank of Spain, J.P. Morgan estimates

Source: EU Commission Taxation and Customs Union, rates as of July 2011

Jaime Becerril (44-20) 7742-6449 jaime.becerril@jpmorgan.com

Europe Equity Research 12 January 2012

Deposit outflows are still small, mostly amongst weaker banks

Foreign Banks' Deposits in Spain 2008-2011 bn

Spanish Deposit Evolution YoY %

Spanish Savings Banks Customer Deposits mn

Jaime Becerril (44-20) 7742-6449 jaime.becerril@jpmorgan.com

Europe Equity Research 12 January 2012

Other European countries are having issues with their deposits

Deposit Rates <12 months (%)

GIIPS Household Deposits YoY (%)

GIIPS Corporate Deposits YoY (%)

Source: ECB, Central Banks

Source: ECB, Central Banks

Jaime Becerril (44-20) 7742-6449 jaime.becerril@jpmorgan.com

Europe Equity Research 12 January 2012

Competition for deposits was still strong at the end of 2011

Spread new Deposits vs 3M Euribor (bp)

Commercial Paper Issued 2011 mn

-100 -150 -200

1,9771,839 1,515 1,0271,000 832 809 754 721

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

Source: Banks, AIAF

Source: Bank of Spain (last = October 2011)

Jaime Becerril (44-20) 7742-6449 jaime.becerril@jpmorgan.com

Europe Equity Research 12 January 2012

Wholesale funding pressures remain high for Spanish companies

Spread Spain 10Y Gov Bond vs German 10Y Bunds (bp)

Source: Bloomberg as of 11 January 2012

Source: Bloomberg, CMA

Jaime Becerril (44-20) 7742-6449 jaime.becerril@jpmorgan.com

Europe Equity Research 12 January 2012