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Another Spanish era. Another bull fighter?
Spainís new government, due to be Officially Sworn in Mid-December, will have to add new austerity measures beyond those established by the previous cabinet if it wants to regain sustainability of public finance.
Issue Date - 22/12/2011
Who would have thought just a few years back that countries in the mighty eurozone would fall like a pack of cards. But that is what is happening. First Ireland, then Greece and recently Portugal, all have been victims of the devastating sovereign debt crisis. The reason is simple. Markets have lost faith in policymakersí ability to do what it takes to carry out serious structural reform, bring down debt, and stimulate growth in their respective countries. And it is evident. After claiming two of Europeís most popular leaders Ė George Papandreou, the third member of the Papandreou family to serve as the countryís prime minister, and Silvio Berlusconi, the famous Bunga Bunga organiser who played the first fiddle in Italian politics for nearly two decades Ė itís the Spanish Prime Minister Jose Luis Rodriguez Zapatero who is the latest victim of sovereign debt crisis (Zapatero led Socialist Party lost to conservative Popular Party in an election dominated by agendas revolving around sovereign debt crisis on November 20, 2011).

After all, Spain is the 1,000-pound gorilla in the room right now. The monetary union can absorb the shock if Greece and Portugal collapse. But Spain is too large; if it defaults on its debt, the monetary union would likely collapse and all of Europe would descend into a deep recession. However, elections that brought Mariano Rajoy led Popular Party to power in Spain have not been able to restore marketsí faith in the countryís fiscal situation. On the contrary, at an auction of Spanish government debt worth Ä2.978 billion held after the election, yields reached euro-era highs. Bidders set an average rate of 5.1% for three-month debt, more than double the rate set at the previous monthís auction, while the six-month yield reached 5.2%, up from 3.3%.

No doubt, Spain, the last of the four PIGS (an acronym used by international bond analysts that refers to the faltering economies of Portugal, Ireland, Greece and Spain; the other three have already faltered), has avoided the need for external aid due to a slew of spending cuts and reforms by the socialist government so far, but then how long? Spainís recovery has been really rough so far. In fact, the eurozoneís fourth-largest economy is among the areaís laggards. While the entire monetary union saw GDP grow by 1.4% last quarter (Q3 2011), Spainís economy crawled at 0.8% in Q3 2011. At 21.52% (a 15-year high in Q3 2011), Spainís unemployment rate too is the highest in the area, and almost double of Portugalís 12.4%, the last victim of the debt crisis.

In fact, the signals sent by Spain are almost similar to the ones propelled by Greece, Ireland and Portugal just before they collapsed. Like its aggrieved Euro-partners, Spain too has a fragile public finance. Though Spainís fiscal deficit narrowed last year, it still remains at 6.2%, which is almost double the fiscal ceiling (3% of GDP) set by EU. Even the countryís public and private foreign liabilities at $2.4 trillion (of this total, about $1.2 trillion are owed to foreign holders by Spanish banks & other private financial institutions, while about $700 billion are owed by private companies and individuals. The public sector owes $450 billion to foreigners) are close to 170% of its GDP ($1.3 trillion), much higher when compared to the other three beleaguered nations. For instance, foreign liabilities of Greece stood at 87% of its GDP at the time of the collapse.

Considering this, the 10-year yields on Spanish bonds are hovering at 6.33%, and are expected to only move north. Although yields on Spanish gilts dropped 18 basis points from 6.51%, after recent government data showed Spainís deficit narrowing, they remain above the psychological 6% level and at a 14-year high, showing that uncertainty lingers. Even credit rating agency Moodyís suggests that borrowing costs above 6% could endanger the sustainability of public finances. Yields on 10-year Spanish government bonds are already 303 basis points higher than their German equivalents which give prudent investors a reason good enough to stay away from Spain. This certainly makes the situation difficult for Spain (in turn for PM-elect Rajoy), which has about $440 billion worth of debt to refinance in the next six years.

A banking sector with pockets of weakness also raises concerns, and the Rajoy government will definitely have to pump more money into the sector to restructure it. In fact, the nationís financial institutions as a group were among the worst performers in the EUís bank stress tests this year and in 2010. Along with Greek banks, they were also identified in October as the ones that need to raise the most capital by June 2012. Reason: The steep correction in the prices of real estate (property prices have fallen almost 15% from their 2008 peak and are expected to decline at least 10% more, putting more homeowners into negative equity positions), to which local banks have heavy exposure, has spurred a wave of asset write-downs among Spanish banks (according to the Bank of Spain, the nonperforming loan rate in the banking sector has surpassed 6% for the first time since 1995). While profitability of the banks has plunged due to restructuring, high credit default swap spreads (464 bps in November 2011) have raised investorsí doubts on the sectorís solvency, particularly the local savings banks, or cajas. In fact, Spanish officials estimate that the cost of recapitalising and restructuring just cajas could total $24 billion, leave aside national level banks.


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