April 18, 2011 / 4:36 PM / 8 years ago

Analysis - Spain still unable to decouple from euro periphery

MADRID (Reuters) - A renewed rise in Spanish debt yields is bad news for the euro zone, since it shows Spain is still failing to set itself apart from the zone’s weakest states in the eyes of the markets.

In January, Spain’s 10-year government bond yield came off its highs and stabilised, even as yields for Greece, Ireland and Portugal continued climbing because of worries they might eventually have to restructure their debt.

The divergence raised hopes that Spain might have “decoupled” from the most indebted countries on the euro zone periphery, giving it time to push through economic reforms without facing an attack from bond markets.

But a jump in Spanish yields over the past several days suggests those hopes were premature. The yield reached 5.60 percent on Monday, its highest level since a euro lifetime high of 5.75 percent hit last November 30; it has climbed 40 basis points since April 12 — more slowly than yields in the weakest states, but fast enough to suggest Spain remains vulnerable to panic dumping of its bonds.

“The key driver here is peripheral contagion,” said Michael Leister, strategist at WestLB in Duesseldorf.

Spain’s 10-year yield is still well below the 7 percent level which some investors believe signals the possibility that a country might have to seek an international bailout. In contrast to the weakest states, its yield curve retains a normal, upward slope.

But the rise in the yield is threatening partly because of Spain’s size. The international bailouts extended to Greece and Ireland last year, and one now being negotiated by Portugal, are expected to total roughly 275 billion euros.

Analysts estimate that if Spain does eventually lose its ability to borrow from the markets at affordable rates, it could need over 350 billion euros. Taken together, the four bailouts could strain the capacity of the euro zone’s 440 billion euro bailout fund, even with financial support from the International Monetary Fund, which has contributed a third of past bailouts.

The timing is also uncomfortable. Public opposition to contributing to bailouts is rising in some rich euro zone states, as illustrated by gains made by the eurosceptic True Finns party in Finnish elections on Sunday. So it is not certain that Europe could summon the political will to expand its bailout fund if Spain did need a rescue.


The case to view Spain as different from the three weak states has not changed since January. The IMF projects Spain will have a public debt to gross domestic product ratio of 64 percent this year, about 20 percentage points below the euro zone average and far below 152 percent for Greece, 114 percent for Ireland and 90 percent for Portugal.

The government’s projected budget deficit is 6.2 percent of GDP against 10.8 percent for Ireland, 7.4 percent for Greece and 5.6 percent for Portugal.

Market sentiment towards Spain began to improve in January partly because the government pushed ahead with reforms including unpopular austerity measures, such as pay cuts for civil servants and a freezing of some welfare payments, and structural changes to the labour and pension systems.

These reforms, which look unlikely to be derailed by the approach of elections next year, have allowed officials to claim Spain is very different from, for example, Portugal, which is still struggling to implement reforms.

“We’re talking about completely different cases. Policy action has been taken in the case of Spain,” Jose Vinals, director of the IMF’s Monetary and Capital Markets Department, said in mid-April.

The big risk in many investors’ eyes is the impact on the banking system of Spain’s sagging property market. Property prices have sunk around 17 percent since a housing bubble burst in 2008, and given an estimated overhang of over a million unsold new homes, values may have further to fall, analysts say.

This puts state finances on the hook; though banks have been ordered to boost their capital ratios by seeking private sector funds, the government has pledged that if banks cannot find enough cash, it will intervene through partial nationalisation. While the Spanish government estimates banks may have a capital shortfall of around 15 billion euros, some private sector estimates are far higher, as much as 120 billion euros.

Even here, however, the maths do not appear disastrous for Spain. Even if the government had to take on an additional 100 billion euros in debt to recapitalise banks, that would add about 10 percentage points to its debt/GDP ratio, which would stay below the euro zone average. By contrast, Ireland’s estimated bill for bailing out its banks is near half of GDP.


What has changed since January, however, is worries that the weakest euro zone states may end up restructuring their debts because the economic burden on them is simply too heavy, and since the political will to push through new austerity measures in those countries may be weakening.

The Greek government and most euro zone officials have repeatedly denied any restructuring is on the cards, but German government sources told Reuters privately in Berlin on Monday that they did not believe Greece would make it through the summer without restructuring.

A Greek restructuring could worsen the outlook for Spain in two ways. Although Spanish banks do not have much exposure to Greek debt, a restructuring in Greece might eventually encourage Portugal to follow suit, and Spanish banks had over $80 billion of exposure to Portugal as of late last year, according to the Bank for International Settlements.

Secondly, by hurting investors’ willingness to take risks on euro zone sovereign debt in general, a Greek restructuring could make it more difficult and expensive for Spain to raise any additional funds that it requires to recapitalise its banks.

So to decouple from the periphery, Spain may need to announce a clearer and more aggressive plan for how it would rescue its banks in a worst-case scenario.

“We recognise that in order to assuage market concerns “once and for all,” a “shock and awe” strategy might be recommended and gauging the recapitalisation needs on a more severe, if unlikely scenario, may make sense,” wrote Deutsche Bank economist Gilles Moec.

It is not clear, however, whether Spain can come up with such a plan. It has given banks until September to raise fresh capital from the private sector, and speeding up this timetable would be difficult; raising the government’s estimate of capital needs would be politically sensitive.

And Spain may only fully decouple when it returns to solid economic growth of at least, say, 2 percent — a process that could take several years.

“When we get in to a growing path, everyone will be happy, because we’ll be generating enough resources to pay what we owe and the worry will disappear. But until that day we’ll be in the eye of the hurricane,” said Pablo Vazquez, head of Madrid-based think tank Fedea.

The government projects GDP growth of 1.3 percent this year, rising to 2.6 percent by 2014, but most private analysts think that is too optimistic. The IMF predicts growth of just 0.8 percent this year and 1.6 percent next year.

Additional reporting by William James in London; Editing by Andrew Torchia

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