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Spanish worries

15 October 2012 By Hugo Dixon

The art of politics is about squaring circles. In the euro crisis, this means pushing ahead with painful but necessary reforms while hanging onto power.

In Spain, where I spent part of last week, these circles are getting harder to square. Mariano Rajoy isn’t at any immediate risk of losing power. His 10-month old government has also taken important steps to reform the economy – cleaning up banks, liberalising the labour market and reining in government spending.

But the recession is deepening, the prime minister is a poor communicator and his political capital has plummeted. Madrid will also find it harder than thought to access help from its euro zone partners.

GDP will shrink by 1.5 percent this year and another 1.8 percent next year, according to Funcas, the Spanish savings bank association. That is a result of both a severe fiscal squeeze and private-sector deleveraging. An austerity spiral is in operation. As the International Monetary Fund argued last week, so-called fiscal multipliers across the world are bigger than forecasters had previously estimated.

The severity of the downturn means the government seems destined to miss its deficit reduction targets again. This year, Madrid economists think it will end up with a deficit of around 7 percent of gross domestic product, against a revised target of 6.3 percent. Next year, the deficit could be in the 5-6 percent range rather than the new, 4.5 percent target.

It might seem that these slippages matter less now that the IMF and even some euro zone policymakers are softening their demands for austerity. Foreign governments are less likely to demand Madrid tighten its belt further if a failure to hit targets is not its fault.

However, Spain will have to sell 207 billion euros of bonds, equivalent to 20 percent of GDP, next year – to fund the deficit and rollover maturing debt. That’s even more than the 186 billion scheduled for this year – an amount Madrid has only been able to shift because the European Central Bank lent 230 billion euros of cheap long-term money to Spanish banks, much of it recycled into buying government bonds.

Spain should be able to sell the remainder of this year’s bonds because investors have been lulled by the ECB’s promise to purchase unlimited amounts of sovereign paper. For example, they brushed aside last week’s two-notch downgrade of the country’s credit rating by Standard and Poor’s. But as next year approaches, the mood could turn ugly – especially if Madrid hasn’t by that time taken advantage of the central bank’s security blanket and its credit-rating is junked.

Investors could start worrying about the fact that the state’s debt could well reach 100 percent of GDP in 2015 after including the cost of injecting capital into the banking system. They may also focus on the fact that the ECB’s bond-buying plan is partly a confidence trick because it is limited to the secondary market and short-term bonds – and would end if Madrid couldn’t sell bonds in the primary market. A loss of confidence could be self-fulfilling.

Why doesn’t the government just get on with it and ask for ECB help? That would lower the risk of a renewed “Spanic” attack and cut both the government’s and the private-sector’s borrowing costs – taking the edge off the recession.

Before I went to Madrid, I thought Rajoy’s misplaced pride was the main reason he was not asking for help. This, and the desire to wait until after regional elections in Galicia later this month, may be minor factors. But the two more important reasons for delay are lack of clarity over what the ECB will do and concern that Germany will block the bailout.

Does the ECB just want to cap Spanish 10-year bond yields at around the current level of 5.7 percent? Or does it want to drive them down to, say, 4.5 percent – the level that might be justified if there weren’t residual fears about a break-up of the euro? Rajoy hasn’t asked Mario Draghi, the ECB’s president. Even if he did, he wouldn’t get a straight answer. But it should still be possible to get some rough sense of what the ECB wants.

The bigger issue is Berlin. The ECB’s bond-buying scheme is contingent on a parallel programme being agreed between Madrid and the other euro zone governments. Unfortunately, Germany has been saying that it doesn’t think Spain needs help. That, in turn, seems to be mainly because Angela Merkel, the chancellor, doesn’t want to have to push another bailout programme through the Bundestag only three months after it got parliamentarians to agree to a mega-loan for Spain’s banks. Sentiment in Germany towards bailouts in general and the ECB’s bond-buying plan in particular is negative.

Madrid has seen how Berlin is seeming to renege on an earlier plan that would have allowed it to transfer the cost of bailing out its banks to the euro zone rather than just receive a loan. It now doesn’t want to ask for help only to be turned down.

If there is another panic, Merkel will presumably decide to get parliamentary approval for Spanish aid. It is also possible that she will push a package deal through the Bundestag next month covering not just Spain but also Greece and Cyprus. But it would be far preferable to act before then. Sadly, that isn’t the way Europe, despite its new Nobel Peace Prize, normally works.

 

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