PJ Media

Europe’s Future Lies, Ominously, with Spain

A massive €750 billion ($1 trillion) bailout fund announced by European officials just six months ago has failed to contain the sovereign debt crisis that now threatens to bring down the euro single currency. After having spent €110 billion to rescue Greece from bankruptcy in May, Europe and the International Monetary Fund on November 28 announced a rescue package worth €85 billion to prevent a financial meltdown in Ireland. Europe’s debt contagion now threatens to take down Portugal and possibly even Spain.

A debt crisis in Spain would make the problems in Greece, Ireland, and Portugal look pale by comparison; at €1.3 trillion, the Spanish economy is bigger than those three countries combined. Spain is the fifth-largest economy in the 16-nation euro zone, the ninth-largest in the OECD, and the eleventh-largest in the world.

Analysts say the price tag for a Spanish bailout could exceed €500 billion, leading many observers to conclude that Spain is too big to be rescued, and that a Spanish default would almost certainly lead to the breakup of the euro zone.

Spanish politicians insist that Spain is not dancing on the edge of the abyss. Spanish Prime Minister José Luis Rodríguez Zapatero, for example, has dismissed speculation that the country would need a bailout as “complete madness.” Spanish Finance Minister Elena Salgado says Spain will “absolutely not” need help from the European Union, and that the country is in “the best conditions” to resist “speculative attacks.”

But investors — spooked by the size of the bailouts for Greece and Ireland — are not convinced, and the extra yield they are demanding to hold Spanish 10-year debt rather than rock-solid German bunds, Europe’s benchmark securities, has surged to its highest level since the single currency was introduced in 1999. That spread, or difference, represents the extra interest cushion investors are demanding to hold Spanish debt, which is now perceived to be more risky than ever.

With its borrowing costs rising, the Spanish government on November 24 was forced to freeze a plan to sell €13.5 billion worth of state-guaranteed power-revenue bonds until the volatility in sovereign debt markets abates. Spain was also forced to nearly double the interest paid on short-term bonds in an auction on November 23.

Spain’s problems largely stem from the collapse of the country’s housing and construction sectors, which accounted (directly and indirectly) for nearly one quarter of Spanish GDP before a speculative real estate bubble began to burst in 2007. The ensuing spike in unemployment, coupled with a sharp drop in domestic consumption and a steep decline in tax revenues, among myriad other woes, have all combined to leave Spain mired in its worst recession in 60 years.

The Bank of Spain projects that GDP growth will be zero in 2010, after falling nearly 4 percent in 2009. Spain’s jobless rate is stuck at 20 percent, almost twice the EU average. At the same time, Spain’s benchmark IBEX stock index is the euro zone’s worst performer this year after Greece.

Spain’s debt to GDP ratio is expected to climb from 53.2 percent last year to 64.9 percent this year and 72.5 percent next year. But investors are particularly concerned about Spain’s gaping budget deficit, which at 11.3 percent of GDP is the third-largest in the euro zone, and which may exceed that of Greece this year, according to the European Commission.

In late May, the Spanish Parliament narrowly approved a €15 billion austerity plan to rein in the public deficit and ease fears of a Greek-style debt crisis. The measure, which is intended to reduce the deficit to 6 percent by 2011, includes cutting the pay of public sector employees by 5 percent and freezing that pay next year. The plan also calls for suspending automatic inflation-adjusted pensions and scrapping a payout parents get for the birth of new children.

Although these measures won Zapatero some respite from the markets, they also left his political future hanging in the balance. In the face of public strikes organized by Spain’s largest labor unions, as well as a more than 10-point decline in support for his Socialist Party, Zapatero put off other reforms. Now, with the crises in Ireland and Portugal, nervous investors are once again focusing on Spain’s public finances.

Standard & Poor’s, the credit ratings agency, believes Spain is caught in a Catch-22 situation. If the government cuts public spending at the level needed to reduce the deficit, it will drag down economic growth and make it more difficult for Spain to emerge from recession. But if the government fails to reduce spending, the chances increase that Spain will default on its debts.

After considering Spain’s no-win situation, Standard & Poor’s on April 28 downgraded the country’s credit rating by one notch to AA from AA+, with a negative outlook. “Our conclusion is that challenging medium-term economic conditions will further pressure Spain’s public finances, and additional measures are likely to be needed to underpin the government’s fiscal consolidation strategy and planned program of structural reforms,” Standard & Poor’s said. “The negative outlook reflects the possibility of [another] downgrade if Spain’s fiscal position underperforms to a greater extent than we currently anticipate.”

Since then, other ratings agencies have also downgraded Spain’s credit rating. Fitch Ratings on May 28 removed Spain’s AAA credit rating, dropping it by a notch, on expectations that moves to cut the country’s debt will slow its economic growth. Fitch said that despite Spain’s promise to cut its budget deficit, government debt is likely to reach 78 percent of GDP by 2013, compared with less than 40 percent before the onset of the financial crisis in 2007 and the subsequent recession. Fitch also expects that the “inflexibility” of Spanish labor markets and the restructuring of Spain’s banking sector will hinder efforts to stabilize the economy.

Moody’s Investors Service on September 30 cut its rating for Spain to Aa1 from Aaa, citing a weak economic outlook. Moody’s said the downgrade reflected the “considerable deterioration” in Spain’s public finances, and added that the slow growth of the Spanish economy would make repairing the public finances far more difficult.

These concerns were subsequently confirmed by Bank of Spain Governor Miguel Ángel Fernández Ordóñez, who recently told the Spanish Senate that the outlook for Spain “is surrounded by uncertainties.”

In any case, the prospect of more cuts in government spending will not be well received by Spanish voters, most of whom view cradle-to-grave social welfare benefits as an inalienable right. With Zapatero — whose 2008 campaign promises alone added up to more than two percent of Spain’s GDP — trailing badly in the opinion polls, it seems unlikely that he will voluntarily implement politically costly fiscal reforms before the next general election, which is tentatively set for 2012. Plans to overhaul the pension system and push through additional changes to wage-bargaining and employment rules have already been postponed until at least next year.

According to Deputy Finance Minister José Manuel Campa, the best thing “to generate credibility in the Spanish economy is to execute the measures we have announced at the time and in the way they were announced, and that implies not taking additional measures.”

But that approach may not be enough to reassure jittery markets that Spain will be able to repay its debts. Economists say that given Spain’s large deficits and poor long-term growth prospects, any failure to achieve government targets for cutting the deficit, and/or any rise in Spanish bank risk, could cause a market panic and turn Spain into the next victim of market contagion.

A financial meltdown in Spain would have repercussions far beyond the Iberian Peninsula. For starters, many analysts believe a debt crisis in Spain would trigger a similar meltdown in Italy, which is the fourth-largest economy in the eurozone, and which suffers from many of the same financial woes that are plaguing Spain. What’s more, Italy has one of the world’s highest public debts, expected to reach a staggering 118 percent of GDP in 2010.

Given the relative size of the Spanish economy, financial turmoil in Spain would likely also doom the single European currency, and with that more than 60 years of European dreams of transforming the continent into a superpower-like United States of Europe capable of counter-balancing the United States of America on the global stage.

Germany, which arguably has more invested in (and also has benefited more from) the European Union than any other country in Europe, is alarmed by the potential unraveling of the euro. German Chancellor Angela Merkel says the prospect of serial European bailouts is “exceptionally serious,” and that while she does not want to “paint a dramatic picture,” it would have been hard a year ago to “imagine the debate” now taking place in Europe.

In an effort to save European monetary union — which like the European Union itself is essentially a political project — Merkel has taken the lead in trying to “reassert the primacy of politics over the financial markets.” She says governments cannot and should not be blackmailed by excessive financial sector risks, carrying all the costs of a crisis while the financial sector collects all the private gains. In quintessentially European fashion, she is demanding more regulation, tougher regulation, and quicker regulation of the financial markets.

In the meanwhile, Spain could solve its most urgent financial problems in one bold (albeit practically difficult) move. Withdrawing from the euro would permit a fiscal devaluation that would instantly increase Spain’s competitiveness and allow the economy to grow. A currency redenomination and devaluation would allow Spain to make its exports and tourism more competitive, and to free the country from the European Central Bank’s tight monetary policy designed for wealthier EU member states.

On the other hand, staying in the euro will mean years of slow growth, making the pain of fiscal adjustment prolonged and more painful. Moreover, as long as Spain remains a part of the euro, it will forfeit full control over many levers of economic policymaking; Madrid’s policy tools are now essentially limited to reducing spending and wages. In this context, some economists believe Spain cannot recover from the current crisis until it breaks free from the euro.

But Spanish pride stands in the way. For many decades Spain — geographically situated at the periphery of Europe — was the butt of an oft-repeated joke which held that “Europe ends at the Pyrenees Mountains.” The implication was that Spain formed part of Africa, not Europe. In this context, the vast majority of Spaniards view Spain’s joining the European Union in 1986 and the European single currency in 1999 as a national rite of passage.

Not surprisingly, most Spaniards if given the option would rather see Spain default on its debts than withdraw from Europe’s single currency. If the financial markets are any gauge, however, both options may become part of Spain’s future.