Analysis: Early days for Spain's tug of war with markets

Reuters News
Posted: Apr 19, 2012 3:48 PM
Analysis: Early days for Spain's tug of war with markets

By Alan Wheatley, Global Economics Correspondent

LONDON (Reuters) - Thursday's Spanish debt auction results have set the tone for a year of muddling through: Yields are too high to be sustainable in the long term, yet not high enough to trigger a near-term meltdown.

In the same vein, an agreement taking shape to lend the International Monetary Fund $400 billion so it could help bail out Spain (or Italy) is unlikely to be a game changer for skeptical markets.

It is not obvious why a stronger firewall should encourage anyone to enter a burning house. Only better economic fundamentals, a healthier debt profile and a better-capitalized banking system will restore confidence and lure back international investors who are shunning Spain's bonds.

As that will take time, conditions are ripe for a continuing tug of war, portending recurring volatility that will keep rattling global markets and sparking friction among euro zone policymakers.

On the one side are optimists who reckon Spain can pull through on its own, backstopped if necessary by resumed European Central Bank bond purchases in the secondary market. Confronting them are pessimists who judge Madrid will eventually go the way of Greece and call in outside help or even, as a last resort, quit the euro because of popular revulsion at endless austerity.

"My base case is that things will carry on until the government, in two years' time, has either proven that it is pursuing sufficient reforms so that the market is beginning to give it better yields or the population are out on the streets," said Charles Robertson, global chief economist at Renaissance Capital in London.


Spain had to pay a yield of 5.743 percent to sell new 10-year bonds on Thursday, up from 5.403 percent at the previous auction in January.

With a debt-to-GDP ratio of around 85 percent, Spain could live with this sort of yield for the next two years if need be, Robertson argued.

Christian Schulz, an economist with Berenberg Bank in London, also played down the immediate challenge of rising yields.

He calculated that, at current levels, Spain could roll over the 40 billion euros of bonds that still have to mature this year at a weighted average 4.9 percent, 1.3 percentage point above their placement yield. The extra cost would be 500 million euros a year, less than 0.5 percent of GDP and so "not a cause for great concern", Schulz said in a note to clients.

What is a cause for concern is Spain's deteriorating economy. Despite a boom in exports since 2010, the government is projecting that output will shrink 1.7 percent this year. Unemployment is approaching 24 percent

The risks are on the downside, in the view of most economists. That would magnify the debt-to-GDP ratio, especially if, as many forecasters expect, Spain fails to meet its budget deficit goal of 5.3 percent, The IMF, for instance, is projecting a budget gap of 6.0 percent.

Yet the Fund, the guardian of fiscal orthodoxy, warned Madrid to avoid the shock therapy of big upfront spending cuts because of the impact they would have on the economy.

"We feel that the Spanish government has struck the right balance between supporting growth and moving forward with fiscal consolidation," said Joerg Decressin, deputy director of research at the IMF.


Italy demonstrated this week that even a deeply indebted country can stretch out its timetable for deficit reduction without spooking the markets.

The difference is that Italy is led by Mario Monti, a respected technocrat, whereas new Spanish Prime Minister Mariano Rajoy has badly dented his credibility with investors since taking office in December.

Firstly, he tore up an agreement with the European Commission on this year's budget target; secondly, he waited more than three months to unveil his maiden budget and, when he did so, failed in the eyes of a number of economists to chart a convincing medium-term strategy for reducing the red ink.

Central bank governor Miguel Angel Fernandez Ordonez compounded the uncertainty by acknowledging that Spanish banks, weakened by a sinking property market, would need extra capital if the economy deteriorated.

Jacob Funk Kirkegaard, who tracks the euro zone for the Peterson Institute for International Economics in Washington, said a sense of drift seemed to be emerging in Madrid. "Or are they really just clueless?" he asked in a blog post.

But Kirkegaard said another interpretation of Spain's recent policy statements was possible. In announcing an extra 10 billion euros in healthcare-related spending cuts, Spain must have known it would raise fresh doubts in the markets about the outlook for growth and hence debt sustainability.

However, Kirkegaard speculated that Madrid's intended audience was not the markets but the ECB, which has been insistent in its demands for fiscal austerity and structural reforms in return for help in financing the economic adjustments needed on the euro zone periphery.

As such, ECB Executive Board member Benoit Coeure's public reminder that the central bank's bond-buying program still existed was no accident.

"Even if the markets won't reward Spain for more austerity, the ECB probably will," Kirkegaard said.

Given Spain's poor economic outlook, Kirkegaard said Madrid might well turn to the euro zone's rescue fund for a loan to recapitalize its ailing banks.

But he said a scenario whereby Spain would have to restructure its debt, like Greece has, remained far off.

"It is essentially inconceivable that Spain would be allowed to default. In the end the ECB would bail it out," he said.

A Reuters poll published on Thursday showed only a one in four chance that Spain would need an international rescue.

The inference is that Rajoy will keep muddling through, striving to strike the right balance between growth and austerity that will placate markets and voters alike.

"I would have thought the population won't throw the government out until they've had a fair chance to make a difference," said Robertson at Renaissance Capital.

He acknowledged the risk that markets could lose patience and precipitate a crisis, but added: "Spain can survive if they push through the right reforms in the next couple of years."

(Editing by Hugh Lawson)