While Italy looks less close to disaster than it did six months ago (an improvement which could easily be reversed) market perceptions of Spain have deteriorated.
Despite a much lower public debt than Italy’s, and after a 2012 budget which was just been presented on March 30th and is described as the harshest since Spain became a democracy, with swinging cuts averaging 17%, and up to 54%, on all ministries, rates on Spanish ten-year bonds on March 30th remained distinctly higher than those on Italian bonds, with both over 5% and more than 300 points above German equivalent bonds.
Although the amount available in rescue funds is likely to be increased gradually to around €700bn (€500bn from the proposed European Stability Mechanism (ESM) plus funds earmarked for Greece, Portugal and Ireland) European policy makers will be earnestly hoping that this does not have to be used to rescue Spain, given the likely contagion effect on Italy and other countries.
There are three main reasons for increased concern over Spain. The first is the considerably worse than expected outturn of the general government budget in 2011 when the deficit amounted to 8.5% of GDP, after already two years of severe austerity under the previous Socialist government. The worse than expected outcome cannot be blamed primarily on the Socialists since the principle cause was higher regional deficits. The harsh 2012 budget aims to reduce the deficit to 5.3% of GDP. The second reason is concern over Spain’s banks, particularly its savings banks, which are being called on to realize their capital losses from the collapse in Spain’s property market since 2008, and raise €50bn in new capital. They will be forced to sell property into a weakening property market, with prices continuing to decline after already falling about 30%. The third reason is the continuing weakness of the Spanish economy with unemployment at 23% the highest in the EU and only weak signs of a pick-up in exports. The austerity measures though necessary are likely to further weaken the economy.
The political situation in Spain should be favourable. In December 2011 a newly elected centre-right Popular Party government, led by Mariano Rajoy, took office committed to a combination of the necessary fiscal austerity and economic reforms to boost employment and growth. However, although the government has consistently pursued its policies, it has made presentational mistakes. These include delaying the 2012 budget even more than it had already been delayed by the general election and change of government, in order to allow regional elections to take place in the misplaced hope that delaying the bad news would help the PP in these elections. This gave the impression that at a time when the government should having its four year term ahead have been free from party political considerations, it was giving priority to political maneuvering over tackling Spain’s economic problems.
A second presentational mistake was in the course of discussion over the reasonable request to revise the 2012 budget target in view of the 2011 overshoot, Mr Rajoy talked about Spain’s “sovereign” right to decide its own budget. In reality he should recognize that a vulnerable country like Spain has sovereignty limited by the need to convince investors to buy Spanish debt and that as a member of the euro zone it also has to consider the impact of its own policies on the rest of the euro zone. However, despite such criticisms the budget itself is as good an effort as is possible in unfavourable circumstances to tackle the budget deficit. Policy actions are more important than presentation and at present these seem to be in the right direction. But the mountain to climb remains formidable.