MARKETS POISED FOR A KILL AS SPAIN FIGHTS FOR FUTURE / THE FINANCIAL TIMES ( VERY HIGHLY RECOMMENDED READING )

Markets poised for kill as Spain fights for future

By Victor Mallet in Madrid

Published: May 24 2011 18:48


Watching Spain’s agony as it tries to escape the clutches of the eurozone’s expanding sovereign debt crisis is like being a spectator at a particularly cruel gladiatorial fight.


Whenever the weaker contestant skilfully sidesteps an assault by his opponent, he is promptly confronted with a still more ferocious attack or told to abide by a new set of arbitrary rules making defeat almost inevitable.


By the time José Luis Rodríguez Zapatero, Spain’s Socialist prime minister, proved last year that he was serious about cutting the country’s budget deficit after the bail-out of Greece, bond market investors had stopped worrying about public sector debt and started complaining about private sector indebtedness and the state of the banks.


Mindful of the banking collapse that had obliged Ireland to be rescued, like Greece, by the European Union and International Monetary Fund, Madrid and the Bank of Spain dutifully dealt with those two concerns as best they could – only to find that the markets took bank reform for granted and were now obsessed with the lack of economic growth.


A brief truce earlier this year was welcomed by both sides. Even the most heartless hedge fund investors reluctantly acknowledged that Spain’s successful efforts to limit public spending, restructure savings banks, boost exports and cut the current account deficit had “decoupled” it from the weaker economies on the eurozone’s periphery.


Indeed, the markets barely paid attention to Spanish assets when Portugal, Spain’s neighbour on the Iberian Peninsula, became the third eurozone member to seek a bail-out. That week in early April, the spread between Spanish 10-year treasury bonds and German Bunds – a measure of the perceived extra risk of holding Spanish paper – actually declined slightly to 170 basis points.


The ceasefire ended last week. Decoupling is no more than a fond memory. The Spanish bond spread has shot up – at one point on Monday, it reached 257bp, not far below the euro-era record of nearly 300bp – because of fresh fears of “contagion” from the crisis in Greece.


Investors also cited the defeat of Mr Zapatero’s Socialist party in Sunday’s regional and local elections as a reason for selling Spanish bonds. The triumphant Popular party, the rightwing opposition at the national level, has called in vain for the general election to be brought forward from March next year to allow it to run the economy better. For foreign investors, however, the fear that Greece would default on its debts was a more important factor, hitting the euro, global stock markets and the bonds of other countries, such as Italy, as well.


Spain is in a dangerous position in the gladiatorial arena. The danger extends to the rest of the eurozone and even to the broader world economy given that Spain is the fourth-largest economy in the single currency area after Germany, France and Italy.


The biggest problem is contagion: the eurozone crisis in general and Greece in particular, not some domestic Spanish policy failure that can be rectified by government action, have become the main reason for the lack of market confidence in Spain. “Part of the problem is that the eurozone crisis itself becomes a weight,” says one senior US economic official.


Interest rates are the mechanism through which the wounds are inflicted, with all three eurozone bail-outs so far triggered by a rise in bond yields to levels that made it impossible for governments to finance themselves at a price they could afford.


Miguel Angel Fernández Ordóñez, governor of the Bank of Spain, alluded on Monday to the dangers posed by this rising risk premium for Spain. The nation “should not accept” a spread of 200 basis points between Spanish and German bonds for long, he said, noting higher interest payments pushed up public spending and made it hard to finance companies.


Choosing his words with care, Mr Fernández Ordóñez emphasised that the best course for Spain was to deepen economic reforms and keep to the path of fiscal rectitude. He took pains to say it was a waste of time to blame “wickedness and greed” in the financial markets. But he must have seen out of the corner of his eye the movements of a merciless rival gladiator poised for the kill.


Copyright The Financial Times Limited 2011.