Dilemma over Spain’s debt woes

Spaniards may well feel that it is unfair for the markets to put their country back in the spotlight.

Even after some big deficits, their total government debt will be shy of 80 per cent of GDP this year, below the European average and a long way below Italy’s 120 per cent. The country has also elected a right-wing government that is pushing through some painful austerity measures.

But none of that is helping at the moment. Spanish bond yields fell in the wake of the European Central Bank’s (ECB) three-year lending programme unveiled last December. Spanish banks borrowed money from the ECB and invested the proceeds in government bonds. Between them, Spanish and Italian banks bought some €122 billion (£100 billion) of government debt.

Alas, the effect of the ECB programme faded rather quickly. Having briefly fallen below 5 per cent, Spanish 10-year bond yields last week drifted above the 6 per cent barriers. Luckily, thanks to past borrowing, the average cost of Spain’s debt is around 3 per cent, according to Dhaval Joshi of BCA Research. But clearly that average cost is going to rise if current conditions persist. Spain could fall into a debt trap, where its cost of financing is higher than its GDP growth. Escaping from such a trap requires a country to run a budget surplus (before interest costs) in order to get the debt-to-GDP ratio down again.

Hence, Spain’s EU partners have urged the government to pursue fiscal austerity. But the result has been a mess. Having agreed to a budget deficit of 4.4 per cent of GDP, Spain’s government announced a 5.8 per cent target. The compromise was 5.3 per cent.

Three problems arise. The first is that the 2011 deficit was 8.5 per cent of GDP. So meeting the target requires a fiscal squeeze of 3.2 per cent of GDP, a huge headwind for the economy. This is a recurring problem for most developed nations. They want their budgets to balance over time, but they are starting from such big deficits that, if they move too quickly, they can plunge their economies into recession. Spain has a 23.6 per cent unemployment rate and its economy is expected to shrink again this year.

The other two problems are more Spain-specific. Years of devolution mean that much spending occurs at the regional level, and thus out of the control of the central government. Then there are the banks. Spain went through a huge housing bubble, financed by the banks, which have borrowed heavily from abroad. Since governments stand behind the banking system, the true level of government debt may be much higher than 80 per cent of GDP.