Bailout or not, Spain faces years of sacrifice

In the wake of Ireland’s bailout agreement with the European Union (EU), speculation has mounted that the nations of the Iberian Peninsula, including Spain, will be next in line for financial assistance packages.

Despite the recent frenetic declarations by Prime Minister José Luis Rodríguez Zapatero that Spain does not need a bailout, the bond markets strongly disagree with him as traders continue to unload Spanish (as well as Portuguese and Italian) bonds, driving up the financing costs for the nation’s lenders to all-time highs.

Moreover, the cost of insuring Spanish debt against default recently soared to its highest level ever -- underscoring investors’ tremendous anxiety that the Spanish government will not be able to either meet its financial obligations nor reduce its debt and deficits by any meaningful degree (all this coming four months after Spain’s central banks declared the “soundness” of the banking system following the application of stress-tests).

But bailing out Spain – should it come to that --- won’t be easy.

While Spain suffers many of the same issues as other peripheral Euro Zone countries (namely huge budget deficit, high amounts of debt, soaring unemployment, government struggling to cope, etc,), a potential bailout here might be tremendously problematic – not least of which has to do with the country’s sheer size.

Spain is not only the fourth-largest economy in Europe, but it accounts for 12 percent of the euro zone’s total GDP. Or, to put it another way, Spain is twice as big as the economies of Portugal, Greece and Ireland combined. Given that these latter two smaller countries have recently received bailouts of 110-billion and 85-billion euros, respectively, the cost to save Spain might be so high that it could severely strain (or possibly bankrupt) whatever funds the EU has in reserve for such emergencies.

Nourel Roubini, the renowned economist at New York University, put the complex issue in crystal clear (bit contradictory) terms: Spain is too big to fail and too big to be saved.

“There is not enough official money to bail out Spain if trouble occurs,” he said.

In a research note, Willem Buiter, chief economist at Citigroup, suggested that The European Central Bank might have to increase its purchases of Spanish government bonds and backstop its banking system if the country encounters more financing difficulties.

Capital Economics of London has estimated that Spain would need about 420-billion euros to cover its financing needs for 2 ½ years.

If problems spill over to Spain the fund that is in place would not be enough to cover its financing requirements and would put into question the existence of the euro zone, said Marco Valli, chief euro zone economist at Unicredit.

Of course, it’s possible that if European leaders feel that a bailout of Spain is an absolute necessity, the more powerful member nations like Germany and France would likely have to raise money in their sovereign debt markets (in addition to EU and IMF capital reserves) to cover payments to Spain.

Spain’s basic problem stems from the fact that bubbles in both its real estate sector and stock market burst simultaneously, thereby perpetrating a series of financial shocks that will likely take years, if not decades, to sort out.

Spain, now recovering from a two-year recession, is burdened by the euro zone’s third-highest public deficit (11.1 percent of GDP as of 2009), and the highest unemployment rate (at 20 percent).

For now, Spain’s largest banks (which still have untold toxic assets on its balance sheets related to the housing market crash) needs to refinance about 85-billion euros in debt next year – a Herculean task indeed. In addition, the Spanish government will confront about 65 billion euros of debt payments next year, including interest.

Meanwhile, Prime Minister Zapatero crows that he is committed to his government’s austerity program as the means of alleviating Spain’s crushing debt problems. These measures include higher taxes, cuts in spending, a restructuring of the regional saving banks, and significant changes in the country’s labor markets, pensions, health care benefits, retirement age and public sector salaries, among many others.

Laura Gonzalez-Alana, assistant professor of finance and business economics at Fordham University in New York, said that Zapatero is currently in a much weakened position.

“Clearly, he is lost as a leader,” he said. “He recently replaced his team of advisors, he has lost leadership of his party; and with national elections coming up in 2012, and it is unclear if he can retain a majority. Obviously, he is hoping for the current cycle to reverse before that.”

The current government has claimed it will try to cut its deficit from 11.1 percent of GDP last year down to the EU-mandated 3 percent by 2013 – a highly ambitious, and probably unrealistic, target, especially given Spain’s decentralized government and the relative autonomy of its provinces. Moreover, economic growth has been weak, with GDP essentially remaining flat in the third quarter of this year.

“Spain is in a very difficult position,” Gonazalez-Alana said.

Indeed, the adoption of the euro and membership in the EU has served as both a blessing as a curse for Spain.

“One of the main advantages of adopting the euro was that it limited and stalled the speculation that occurred with the old currency, the peseta,” Gonzalez-Alana said. “So, the euro gave the country a stable currency and EU membership led to huge funds for the construction of infrastructure projects in Spain.”

However, on the other hand. Gonzalez-Alana notes that when Spain converted from the peseta to the euro, salaries were not “rounded up” whereas the costs of goods like food and clothing were rounded up, leading to a sudden spike in inflation.

“Another problem was that [peseta] money from the black market needed to be converted and banks could not do it,” she added. “So, a lot of that ‘black money’ poured into real estate, which, in turn, helped create the real estate bubble that ultimately shattered the economy.”

Thus, while belonging to a 16-member currency bloc, Spain has enjoyed a relatively stable currency. But, conversely, it cannot revalue its currency to reduce the deficit. So, it is stuck.

However, Gonzalez-Alana believes that Spaniards (by and large) will eventually come to accept the terms of the government’s austerity measures, since they will realize there are no other options, and most of the population sees the value and advantages of belonging to the EU.

Supporting her assertion, Gonzalez-Alana pointed out what when Spanish unions called for strikes this past summer to protest the government’s spending cuts, not everybody participated and there was an absence of social disorder.

“Spaniards have grown up with the miracle of the last 30 years, and have worked very hard for it,” she said. “In contrast, the young people of France believe they deserve [a high living standard and government benefits] no matter what, since the status quo [in France] has been higher for much longer.”

However, for Spanish people who have lived for decades under an old European Socialistic-style economic model, swallowing changes and reductions in benefits will still be painful.

Moreover, the country will likely be swept up in severe socio-economic problems and drastic changes in behavior and the social model itself.

“For one thing, I expect that many highly educated young Spaniards will likely move to other EU nations to look for work,” Gonzalez-Alana said.

“Spain’s university system will also change, fewer students will attend them, and more will go to professional schools which will provide them with more practical training for jobs once they graduate.”

Nonetheless, Gonzalez-Alana does not think Spain will quit the euro; however, it will eventually need some kind of a bailout, or perhaps a “partial bailout” with significant assistance from Germany.

Overall, Gonzalez-Alana envisions at least ten years of struggle for Spain and its people as its sorts out its huge financial problems (bailout or not).