April 11, 2011 6:59 pm

Spain on debt tightrope

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The evidence of previous eurozone sovereign debt crises suggests investors should now be nervously shunning Spanish government bonds after Portugal’s request for a bail-out. Yet exactly the opposite has happened.

When Greece and Ireland needed rescuing last year, yields on Spanish debt rose sharply in the primary and secondary markets.

As Ireland struggled through the first stage of its financial nightmare in November, the interest rate spread between Spanish and benchmark German 10-year bonds rose to a euro-era record of just less than 300 basis points, reflecting the higher perceived risk of Spanish paper and the effects of “contagion” across the eurozone.

But as the crisis has spread this year to Portugal, a neighbouring economy with close financial and commercial ties to Spain, investors have been so relaxed about the possible impact that the spread between German and Spanish bonds has even narrowed, to about 175bp on Monday. The share prices of the country’s banks have bounced from early-January lows.

Spain’s future, and the integrity of the euro, will depend on whether this recovery can be sustained or whether pessimists such as Lorenzo Bernaldo de Quirós, economist and partner at Freemarket Corporate Intelligence in Madrid – who calls it “a dead-cat bounce” and a “passing phase of optimism” – are ultimately proved right.

The steady restoration of Spain’s reputation among investors began more than two months ago, “decoupling” its sovereign debt yields from those of the smaller and riskier economies on the fringes of the eurozone.

spain

spain

“We find that such market differentiation is warranted,” says Deutsche Bank in its latest review of Spain, arguing that economic resilience should allow the country to grow slowly and manage its relatively modest public debt burden.

Gary Jenkins, head of fixed income at Evolution Securities, compares the instant market reactions to the Greek and Irish bail-outs, when investors feared “a knock-on effect, carnage and panic”, with the current situation: European structures in place to cope with such crises and a realisation that Spain is neither Ireland nor Portugal, even if “it’s not out of the woods either”.

Two perceptions in particular have worked in Spain’s favour. First, the government of José Luis Rodríguez Zapatero, the Socialist prime minister, implemented austerity measures that, unlike in Portugal, produced visible results in cutting the budget deficit. It fell from 11.1 per cent of gross domestic product in 2009 to 9.2 per cent last year and is due to reach 6 per cent this year.

Second, even the grimmest forecasts for the cost to the exchequer of recapitalising the banking system are regarded as manageable for an economy the size of Spain’s.

In a report last week, Evolution Securities noted that the cost of Ireland’s bank bail-out had reached 45 per cent of GDP. Even the most pessimistic calculation of Spanish bank capital needs – the €120bn posited by Moody’s, the credit rating agency, for its “worst case” scenario, a sum eight times as large as the one published by the Bank
of Spain – would come to only a quarter of the Irish damage as a proportion of output.

“Spanish cajas [savings banks] may be in a weak position, but relative to the size of the overall economy their losses and potential losses remain manageable,” Evolution says.

Spanish government officials and bankers are eager to ensure that Spain’s image in international markets continues to improve. But, even among Spaniards, there are pessimists who say the country still faces unquantified financial challenges.

In banking, for example, the Bank of Spain has disclosed detailed figures for exposure to bad loans to construction companies and property developers. But ­little is known about how many individual home mortgages have been refinanced by savings banks to keep the default rate low, a tendency that could store up trouble for the future.

As for the public finances, economists are concerned about the growing debt of some of the 17 autonomous regions, which, unlike the central government, have generally overshot their budget limits. Catalonia – the most indebted region, with an economy the size of Portugal’s – has flatly announced that it will not meet the official deficit target this year.

And, even if Spain prospers in the bond markets in the coming months, the long-term future is clouded by the widespread assumption that its economy remains uncompetitive and will struggle to expand.

“It’s true that Spain isn’t Ireland and isn’t Portugal, but it does have some of the bad elements of both,” says one sceptical Spanish economist who wishes to remain anonymous, referring to the parallels between Spanish and Irish banks and between Spanish and Portuguese competitiveness levels.

Mr Bernaldo de Quirós says investors are so anxious about the idea of having to rescue Spain, the eurozone’s fourth-biggest economy, that they are simply deluding themselves about the risks.

“These are self-sustaining expectations. Nobody wants Spain to fall,” he says. “Investors want to believe that Spain won’t be affected by the Portuguese crisis.” The result, he says, is clear: “The markets are giving Spain a breathing space. But I think it’s just for a matter of weeks.”

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