Amid signs of increasing risk aversion in international financial markets, based in part on sovereign debt concerns in the euro area, spreads of Spanish government bonds over comparable benchmark German bunds have widened markedly in recent days, while the country’s stockmarket has also suffered. The Spanish government has been at pains to stress to investors and the wider public that its fiscal position is fundamentally different to that of Greece. Nevertheless, with the risk of further contagion likely to persist in the near term, doubts are growing that the government can succeed in bolstering investor confidence and stemming a rise in its debt-servicing costs.
Despite the IMF and euro area countries having seemingly reached agreement on a massive bailout package for Greece’s battered economy at the end of April, investor concerns over a number of other fiscally weak euro area countries’ budgetary imbalances have not been assuaged. Within the single currency zone, Portugal has come under the most pressure over the past week, but Spain, the fourth-largest member of the euro area and thus a potentially significant systemic threat to financial and economic stability across the region (and further afield), has also been affected.
The spread of ten-year Spanish government bonds to comparable benchmark German bunds has widened markedly in recent days, against a backdrop of sharply heightened risk aversion in global financial markets, climbing from around 70 basis points in late April to a decade-high of 165 basis points on May 6th. The main Madrid stockmarket has also suffered, down from 11,300 points in mid-April to a little over 9,000 on April 7th (the index has fallen by 24% since the start of the year). Share prices of the country’s two largest banks, Banco Bilbao Vizcaya Argentaria (BBVA) and Banco Santander, have also experienced significant falls.
The government has been at pains to suggest to investors and the wider public thatSpain’s fiscal position is fundamentally different to that of Greece. Although the general government budget went into deficit in 2008 (rising dramatically to 11.4% of GDP in 2009), the government had run a surplus in the years immediately prior to the financial crisis. Moreover, public debt, at 55.2% of GDP in 2009, remains comfortably below the euro area average (such comparisons do conveniently ignore, however, the very high level of private-sector debt in Spain).
Huge uncertainties still remain. The economy has yet to show any convincing signs of recovery—most leading indicators point to continued underlying weakness. A preliminary estimate released on May 7th by the Bank of Spain (central bank) showed the economy finally crawling out of recession after close to two years, with output growing by a meagre 0.1% in the first quarter of 2010 (equivalent to a year-on-year fall of 1.3%). This was attributed in part to improved export demand (most likely from developing economies, rather than from the rest of the EU), which may also have contributed to the modest year-on-year rise in industrial production recorded in March—the first annual rise in two years. However, coming from such a low base, tentative evidence of a marginally higher level of activity doesn’t change our central forecast that the Spanish economy will continue to contract over 2010 as a whole.
In addition, although BBVA and Santander have continued to post decent results, there are worries about the extent to which Spanish banks in general are not acknowledging the full scale of losses on mortgage debt. A major restructuring and consolidation programme of its weak savings banks, which account for around half of all bank assets, may require more government intervention, at a higher cost. Moreover, wages have risen faster than in most other euro area countries in recent years and, despite the fact that inflation has recently been below the EU average, Spain will not be able to restore its international competitiveness without significant and sustained painful wage restraint. The country will experience, at best, a period of anaemic growth over the next few years, as it undergoes a correction of its domestic imbalances—a now-collapsed house price and construction bubble, over-indebted consumers and a large current-account deficit.
There is a real risk that contagion could spread further. This would have a serious impact upon Spain’s ability to recover economically and by extension, upon its ability to improve its fiscal situation. When financial market jitters emerged in late January 2010, the government unveiled an austerity plan for 2011-13, promising to cut the general government deficit from 11.4% of GDP in 2009 to 3% of GDP by 2013. So far the governing Spanish Socialist Workers’ Party (PSOE) prime minister, José Luis Rodríguez Zapatero has ruled out further austerity packages, warning that a more rapid tightening would risk stamping out an economic recovery. However, financial markets are now in a febrile state (a marked sell-off in the US on May 6th was followed by a further sharp slide in global markets in the afternoon of May 7th), which suggests that Mr Zapatero will soon have little choice but to be pushed into announcing further austerity measures.
On May 6th Spain successfully auctioned benchmark five-year bonds, selling €2.35bn of the 2015 issue, which was within its target range of between €2-3bn. On the one hand, it probably came as a relief to Spain that it was still able to tap the capital markets (which is no longer an option for Greece). However, the amount auctioned off was relatively small, and amid rumours that the government had to lean on domestic financial institutions to boost interest in the sale, Madrid was forced to offer investors the highest premium on new bonds since May 2008. The average yield rose to 3.58%, up 72 basis points from when Spain last issued five-year debt in March 2010. Yields at this level or higher will make the long path towards a sounder fiscal position extremely difficult to negotiate.
Indeed, serious doubts remain over the government’s ability to cut the deficit by as much as it is now forecasting, particularly as the government’s austerity plan is based upon a rapid return to trend economic growth, with real GDP forecast to grow by 1.8%, 2.9% and 3.1% in the three years from 2011. Such projections look hugely optimistic given existing economic imbalances, the anticipated hit to domestic demand from higher taxes and lower spending, and the weakness of many other developed economies. This implies that more painful cuts will have to be implemented. With unemployment averaging an already alarming 19% of the labour force (Eurostat’s harmonised measure) in the first quarter of 2010, social unrest cannot be ruled out, although so far there have not been any significant problems.
Earlier this week Mr Zapatero and the main opposition Popular Party (PP) leader, Mariano Rajoy, agreed to speed up the process of the restructuring of the country’s ailing savings banks. A new law on bank governance was also agreed upon, to be implemented within three months. This was the first head-to-head meeting between the two leaders for a year and a half. Such cross-party agreements are promising, but with the risk of further contagion likely to remain in the near term, the question remains as to whether the Spanish government (and the authorities in other weak euro area countries, as well as in the UK) can succeed in bolstering investor confidence and stemming a rise in debt-servicing costs. In common with policymakers across the world, Mr Zapatero and his colleagues will be keeping their fingers crossed. It is likely to require far more than that.