The Return of the Spanish Flu: Uncertainty about Spain Worries Euro Zone

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The markets appeared to have forgotten about the euro crisis for a few weeks, but now uncertainty is returning, with yields rising again on Spanish and Italian government bonds. The effects of the ECB's massive cash injection are wearing off, and Spain's banks have already reportedly run out of the cheap cash they got from the central bank.

A police officer blocks the main door of the Barcelona stock exchange during last Thursday's general strike in Spain. Zoom
AP

A police officer blocks the main door of the Barcelona stock exchange during last Thursday's general strike in Spain.

In Rasquera, they reckon marijuana is the solution.

On Wednesday, the authorities in the eastern Spanish village, population 900, announced that the residents had agreed to an unsual plan that the municipality has come up with to fight the crisis. In the future, Rasquera will lease several fields to a Barcelona association that plans to grow hemp there. The revenue is intended to help the municipality reduce its debts of €1.3 million ($1.7 million).

Around 500 kilometers (300 miles) away, in Madrid, the federal government is also worried about money. This week, Spain found itself in the financial markets' crosshairs again. On Tuesday, the government had to pay significantly higher interest rates, of almost 6 percent, on its 10-year bonds.

Italy's borrowing costs have also risen. The rate that the country pays for one-year bonds more than doubled, to 2.84 percent, from last month's rate of 1.40 percent at an auction on Wednesday, while yields on three-year bonds hit 3.89 percent at an auction on Thursday, up from 2.76 percent last month.

It looks like the euro zone is getting sick again -- this time with a case of Spanish flu.

New Uncertainty

For a while, it looked like the patient was recovering. The situation in the euro zone had stabilized at the beginning of the year. The head of the European Central Bank (ECB), Mario Draghi, even said that the worst of the crisis had passed. So why is the situation heating up again?

There doesn't appear to be a single, unambiguous reason for the concerns about Spain. But a speech by newly elected Spanish Prime Minister Mariano Rajoy on March 2 played a key role in fuelling renewed uncertainty about Spain's ability to service its debts.

The conservative prime minister announced that his country would not comply with the planned deficit target of 4.4 percent of gross domestic product for 2012, but would only cut its budget deficit to 5.8 percent. In itself, that was hardly surprising: The original target was somewhat ambitious, particularly given Spain's 2011 deficit of 8.5 percent. But, by revising the target, Spain broke a promise to its EU partners without consulting them first. It was only later that Madrid and its fellow euro-zone states retroactively agreed on a target of 5.3 percent.

"That dealt a severe blow to Rajoy's credibility," says economist Jürgen Matthes of the Cologne Institute for Economic Research (IW), which is closely aligned with employer associations. At the same time, however, he says it is incomprehensible why the EU is insisting on severe austerity targets despite the deep recession. "One should not force Spain to fall into the same trap as Greece," Matthes warns.

Deeper and Deeper

It could be this fear of suffering the same fate as Athens that is currently unsettling investors. In his short time in office, Rajoy has already had to revise the country's austerity plans. In addition to previously passed cuts of €27 billion for this year, over the Easter weekend, he pushed for an additional €10 billion in cuts in health and education spending. The situation is reminiscent of moves made by the government in Athens, whichcontinually announced new cuts but only managed to achieve one thing: pushing Greece deeper into recession.

In contrast, Spain has actually chosen "the right path," says Nicolaus Heinen, an analyst at Deutsche Bank. "The country needs to strike a careful balance between growth and austerity efforts." The issue of revising the deficit target was mainly a communication problem, he argues. "It should have been announced earlier, ideally right after the boost provided by the ECB's loans."

In December and February, the ECB injected a total of roughly €1 trillion into the euro-zone banking system, providing banks with cheap three-year loans at 1 percent interest as part of the central bank's so-called long-term refinancing operation (LTRO). The money initially acted as a sedative on the nervous markets because Italian and Spanish banks invested part of the borrowed cash in domestic sovereign bonds, just as the central bankers had been hoping.

Now, however, the effects of the mega-loans are wearing off in Spain. According to a Deutsche Bank estimate, Italian banks still have reserves of around €60 billion from the cash injection, but Spanish banks have already run out of their share of the funds. That's another reason why interest rates on Spanish bonds could now rise again.

Plan for Joint Spanish Bonds

Another factor is concerns that Madrid's austerity drive will not be sufficient in by itself. A large part of the Spanish deficit is down to the 17 autonomous communities, which are similar to Germany's federal states. The regions are supposed to cut their budget deficits to 1.5 percent this year, but most of them are a long way from that target. The central region of Castilla-La Mancha, for example, managed to rack up a deficit of over 7 percent in 2011.

"What is happening in Spain is a miniature version of what is happening on a large scale in Europe," says Deutsche Bank analyst Nicolaus Heinen. "Some regions are running up debt, and the government finds it hard to control."

But that could soon change. Firstly, most of the regions now have conservative governments, which are likely to be more willing to cooperate with the central government. Secondly, Spain has adopted a German-style "debt brake" balanced budget legislation, which will limit the country's structural deficit to 0.4 percent of GDP as of 2020 and also obliges the regions to cut spending.

Madrid could wield even greater influence using a different instrument. Economics Minister Luis de Guindos wants to draw up a plan for so-called "hispabonos" by the summer. This would allow the autonomous communities to jointly issue bonds with the Spanish government and thereby reduce the interest rates that they have to pay to borrow money. A similar idea has recently been proposed in Germany by some northern German states, and the model also resembles the proposed euro bonds on the European level, which never got anywhere owing to German resistance. "This discussion is far more advanced in Spain than in Germany," says Heinen. "On the national level, it is an effective tool."

Fostering Growth

For Spain, however, generating new growth is at least as important as reducing the budget deficit. The situation on the labor market remains dire, with unemployment at almost 23 percent. As a result, the country is pinning its hopes on exports. "Over the years, Spain has achieved relatively good export growth," says IW economist Jürgen Matthes, who recently published a new study on the subject. According to that report, Spain reduced its trade deficit -- the imbalance between imports and exports -- over the past four years from 5.8 percent of GDP to just 0.5 percent. Greece, by comparison, only managed to get its trade deficit down from 11.1 to 5.5 percent in the same period.

Spain's export success comes despite the fact that Spanish unit labor costs have, unlike in Germany, been rising strongly for many years. Economists such as Hans-Werner Sinn, head of Germany's influential Institute for Economic Research (Ifo), have demanded that wages and prices in the euro zone's crisis-stricken countries be reduced by up to 30 percent as a result.

But Matthes disagrees. "We doubt that such harsh cuts are necessary," he says. After all, he points out, Spanish companies are already managing to notch up significant growth. "They are having greater success than the textbooks say they should."

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