Spain's borrowing costs soar. Bailout needed?

As interest rates soar and investors distrust Spain's creditworthiness in the short term, the country faces a sovereign bailout.

Having failed to convince investors of its creditworthiness, Spain is facing the hard fact that many are betting it will eventually default on its debt unless it receives a sovereign bailout like those of Greece, Ireland, and Portugal.

Interest rates are breaking records almost daily. The government has acknowledged it won’t be able to meet its financial obligations unless rates drop soon – despite the promise of up to €100 billion from Europe to rescue the country’s financial system as well as tough reforms that have catalyzed mass discontent.

On Tuesday, Spain managed to sell €3 billion of short-term sovereign bonds, but only after offering rates three times higher than in March, before the decrepit state of its banks was disclosed. The sale signaled that the market trusts Spain’s economic sustainability in the long term, but not in the short term.

Highlighting the urgency, Italy’s borrowing costs are soaring, and experts are all but discounting the inevitable exit of Greece from the eurozone. Also on Monday, ratings agency Moody’s lowered its outlook for Germany, the Netherlands, and Luxembourg, citing increased risks over Greece, Spain, and Italy.

The broad uncertainty is rattling markets amid worries that a sovereign bailout could erode Europe’s firewall, which is designed to shield other countries' economies while reforms are allowed time to jump-start growth.

But analysts say that Europe could manage, even in the face of a bailout.

“Things have changed since the first three bailouts,” said Roberto Ruiz Scholtes, UBS strategy director in Spain. “There is an array of mechanisms at Europe’s disposal that would allow for a gradual rescue of Spain’s treasury.”

A plea for European funds

Madrid, backed by the governments of Italy and France, meanwhile, is pleading with the European Central Bank to use European rescue funds to buy public debt of distressed countries, a request that countries like Germany – which has deciding power in the ECB – have rejected.

European governments, including Germany, agree that Spain is doing its part. Last week, its parliament passed unprecedented reforms geared to raise €65 billion, more than half of which will come from tax hikes, especially on its eroding middle class. The rest will come from reduced government spending, mostly in the form of more working hours for public employees and wage cuts.

But there are daily protests, and desperation is growing among the population. Unemployment is expected to keep rising and the government has acknowledged the economy will contract in 2012 and 2013. On Tuesday, the regional government of Catalonia, one of Spain’s economic motors, joined Valencia and Murcia in requesting rescue funds from the government to meet their own debt obligations.

Some analysts say that all this means Spain will need a bailout – though it may not be as cataclysmic as some predict.

“The probability that Spain will require more funds is significant, but it’s not as much as many say nor imminent," says Mr. Ruiz Sholtes. "The cost of borrowing would fall and Europe would probably not demand more reforms than the existing ones.”

So why then doesn’t the government ask for a bailout already?

“Three reasons,” explains Ruiz Sholtes. “There is political resistance because it would mean admitting the government has failed; there is also a risk that markets will not be willing to lend it money at reasonable rates if it requests a sovereign bailout; and lastly because the rescue could be so big that Europe’s bailout fund could run out.”