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Jul 28th 2012 | from the print edition
IF SPAIN were a patient, the mood in the hospital ward would be tense. Every
attempt by local specialists advised by renowned European consultants to treat
the sickness brings no more than temporary relief. Even more worrying, the
relapses after each dose are happening sooner and sooner. Spain s chances of
avoiding intensive care a full bail-out are receding to near vanishing-point.
The symptoms of Spanish sickness are manifest in ten-year government bond
yields touching 7.75% on July 25th; previous bail-outs of Greece, Ireland and
Portugal occurred not long after rates had surpassed 7%. Even more perturbing,
two-year yields also briefly went above 7%, in effect foreclosing the
government s ability to borrow at anything but short maturities.
No isolation ward is possible in the financially integrated euro area and Spain
s sickness quickly infected other countries. The Italian ten-year bond yield
went above 6.5%, its highest since January. European stockmarkets retreated and
Italy s fell to a euro-era low. Sentiment was further soured by a report from
Moody s, a ratings agency, saying that Germany, Luxembourg and the Netherlands
might lose their cherished triple-A status. The prognosis was based in part on
fears about the public-debt burden that northern countries might have to assume
if bail-outs spread.
The market funk was the more troubling since a Spanish government with a lot
going for it had appeared to be getting a grip. Public debt is rising fast, but
at 69% of GDP last year was far lower than Italy s 120% and less even than
Germany s 81%. The budget deficit is high (8.9% of GDP in 2011), but only a
week before the market panic Mariano Rajoy, the prime minister, announced more
tough austerity measures. And on July 20th European finance ministers
sanctioned the first tranche of a partial bail-out worth up to 100 billion
($121 billion) for Spanish banks.
So why are investors in such a cold sweat about Spain? One reason is that Mr
Rajoy flunked hard choices at the outset, notably the cleansing of the banks.
Despite a low starting-point for public debt, deficit overshoots have revealed
insufficient central control over the 17 regions that are responsible for a big
chunk of spending. Investors fret that more regions may follow Valencia, which
applied for aid on July 20th. They are in any case sceptical that Spain can
meet its targets for cutting the deficit in the teeth of a recession that is
harsher than expected.
The biggest worry is Spain s external debt. Spain ran hefty current-account
deficits in the first decade of the euro. As a result, its liabilities to
foreign investors exceeded the assets that its residents own abroad by 92% of
GDP last year, among the highest in the euro area. The problem for Spain is
that foreign capital has been fleeing over the past year. That has weakened the
banks and the economy and left the Spanish government shunned by foreign
investors for its own financing needs.
The European summit in late June offered a flicker of hope but it is guttering.
Euro-area leaders agreed that the European Stability Mechanism (ESM), their new
permanent rescue fund, would be able to inject funds directly into banks rather
than via loans to the government. That perked markets up since it promised to
sever the link between weak banks and weak sovereigns. But before long the deal
looked less solid: the ESM cannot come into force until September, when Germany
s constitutional court will rule on its legality. Assuming it passes that
test, the ESM cannot be used for direct bank recapitalisation until a European
supervisor is put in charge.
Spain may yet be able to fend off a bail-out for some time. It has some cash
reserves and can still borrow at short maturities. The euro area also has its
temporary rescue fund, which will lend the Spanish government the initial sum
of money for the banks. But even if Spain survives a hot summer, the markets
are signalling that it will need a full bail-out later this year.
That would be a nightmare, and not just for Spain. The Spanish government must
borrow 385 billion until the end of 2014 to cover its budget deficit and other
needs such as bond redemptions, according to economists at Credit Suisse. Even
if the IMF chips in a third as in previous bail-outs, European lenders would
have to find 250 billion or so. They have already committed 100 billion to
rescuing Spanish banks, so for other emergencies they would have only 150
billion of the 500 billion now in their rescue kitties.
The course of events is eerily similar to what happened a year ago. Then
European leaders appeared to have secured their summer holidays with a
breakthrough summit. But things soon fell apart. Nerves about Italy and Spain
were calmed only when the European Central Bank (ECB) started buying their
bonds. The central bank was never keen on this and it has not been buying bonds
for several months. Even if the ECB were to resume purchases they might be less
effective than before, because its refusal to share in the pain of the Greek
debt restructuring in March frightened bondholders elsewhere.
The awkward truth is that the Spanish government is not alone in flunking hard
choices. The plight of Spain and the danger of its sickness spreading to Italy
call for a decisive countermove by Germany and the ECB. One being discussed
would be to give the ESM a banking licence, which would magnify its resources
by allowing it to borrow from the central bank. The graver the euro crisis
gets, the bigger the response has to be and the harder it is to sell to
sceptical northern electorates.
from the print edition | Finance and economics