Spain acts tough on debt, but investors say 'situation could still get ugly'

Spain has slashed government spending amid a stagnant economy and 20 percent unemployment. But investors aren't yet fully convinced that Europe's fifth largest economy is out of the woods.

Spain's effort to convince financial markets it will weather its worst economic crisis in decades without needing a bailout is falling on deaf ears.

Finance Minister Elena Salgado reiterated Friday that “there’s nothing in our economic situation indicating that we would need to ask for financial assistance from abroad.” Yet as she said this, yields on Spanish government debt rose to near record highs, increasing Spain's borrowing costs.

The consensus view among economists in Spain is that a government default is highly unlikely. But the chance of it – however slight – is a major concern for Europe. Has the Spanish bull of yore shed its horns or will it bounce back as the government insists? The country is Europe's fifth-largest economy and a pillar of the 16-member euro zone's stability. If Spain has to be rescued like Greece and Ireland, the euro currency could be at stake.

The Socialist government of Prime Minister José Luis Rodríguez Zapatero, like other European governments, has pushed through extremely unpopular austerity measures, despite stagnant growth and a whopping 20 percent unemployment rate (the highest rate in the European Union), to show markets it’s serious about getting its budget deficit under control.

Last week the government approved a tobacco tax increase and a partial privatization of its national lottery and airport authority. It also cut unemployment benefits and taxes for small- and medium-sized business, and promised to speed up pension reform. That comes on top of a $19 billion package approved last May that included severe public-spending cuts. The government’s resoluteness, at the expense of its popularity, has earned the praise of EU officials, especially with the deficit falling from 11 percent of the gross domestic product to around 9 percent, which is still far from the 3 percent goal set for 2012.

Not buying it?

Markets though remain unconvinced. The yield on Spanish 10-year bonds edged to almost 5.4 percent, compared to the nearly 3 percent demanded for German debt, the euro zone's benchmark. That 240 basis point spread between them reflects the risk premium investors are demanding to hold what they see as riskier Spanish debt. The spread has narrowed recently from a record of 270 basis points.

To be sure, Spain's borrowing costs remain much lower than those of Ireland, which has accepted a bailout, and Portugal, which is teetering on the brink. The yield on Irish debt is now about 8 percent and Portugal's is about 6.3 percent.

The Spanish goal is to keep rates low with a lot of short-term spending cuts that reassure investors. The idea is that if rates come down, its battered banks – many of which were swept up in a real estate bubble – will recover. That in turn, Spain hopes, will bring higher growth and start creating jobs.

If that doesn't work and they're forced to turn to the EU and the International Monetary Fund's $1 trillion bailout fund, rates will likely soar to Irish levels, and the bailout fund might not be enough to stave off a default anyway, with some economists estimating the country would need a further $650 billion, especially to avert the collapse of its banks.

'Situation could get ugly'

Still, most analysts in Spain rate the chances of default as low. "In the short term, financing of Spanish banks has improved,” says Madrid-based Javier Bernat, an analyst at Caja Madrid, a leading brokerage. "Spain is more solvent now, unlike Greece and Ireland. We expect things to be normalized."

“But if that is not the case, the situation could get ugly,” Mr. Bernat says. “Nobody has fallen off the [euro zone] deck of cards, but that could change. Not just Greece or Ireland, but one of the big countries could decide that is not the EU they signed up for.”

The next test will come in the spring, when at least $50 billion in public and private debt mature and Spain seeks fresh cash. If the market premium demanded then is prohibitively expensive, the country might have no choice but to accept a rescue package. Next week EU leaders are expected to consider raising the bailout fund to show markets they are ready even for a Spanish collapse, despite German opposition.

Roberto Ruiz-Scholtes, UBS strategy director and head of wealth management research for Spain, says there's enough cash within Spain to meet the country's needs. “Investment is not essential," he says. "Internal savings have skyrocketed and the available resources are enough to finance the deficit.”

“It’s about sentiment,” says Luigi Speranza, a BNP Paribas market specialist based in London. “Bottom line is that there is a high risk that Portugal will be forced to get funds. We believe Spain can get the funding on the market, albeit at higher rates.... But there is a legitimate concern, and not speculation to profit from instability, as many EU governments contend,” Speranza says. “The so-called speculators did their job with Greece and Ireland, and they were right. In fact, investors have been overly patient.”

Ultimately though, few analysts expect Spain will default on its debt. “There is very low probability of that or of the euro zone expelling a member,” Speranza said. “It would be too costly. The risk would be exceptionally high and everyone is aware of this.”