Portugal failing, what about Spain?

Portugal’s admission that it will probably need a financial bailout raises a question that will shape the outcome of the euro zone’s debt crisis: Is Spain next?

The cost of saving Spain, a €1.1 trillion ($1.56 trillion) economy, would dwarf previous bailouts and could test the financial strength of Europe as a whole.

But if Spain can continue to repair investors’ trust, as in recent weeks, then Europe stands a chance of containing the debt crisis to three countries, Greece, Ireland and Portugal, whose combined economies are half the size of Spain’s.

Spain’s banking sector remains a big worry. Moody’s Investors Service cut 30 Spanish lenders’ credit ratings on Thursday, citing the sector’s fragility. Spain’s other challenges include a large budget deficit, burst housing bubble and feeble growth.

But despite continued strains, financial markets have grown more confident that Spain won’t need a bailout.

Even pessimistic projections of bank losses don’t appear to threaten the country’s solvency, while the government has stepped up overhauls of the budget, banks and labor market, and the economy has shown more resilience than expected.

Spanish bonds and stocks, including those of banks, rose Thursday despite the downgrades and concerns that Spanish lenders could be hit by the deepening crisis in neighboring Portugal.

Spain’s borrowing costs have stabilized and come down slightly in recent months, whereas investors have continued to dump bonds of the three smaller crisis-hit countries.

“Investors increasingly have come to differentiate between these countries and…Spain,” said Antonio Garcia Pascual, economist at Barclays Capital in London.

Policy makers in Europe and the U.S. have long believed that Spain would be the crucial battlefield in the euro zone’s struggle to prevent a collapse of creditors’ trust in its weaker nations.

Last year, U.S. officials even worried that the crisis could spin out of control and undermine the global economic recovery.

“That fear has subsided,” Dallas Federal Reserve President Richard Fisher told reporters in Berlin on Wednesday, praising Spain’s “corrective surgery” on its banks and finances.

Spain is forcing its banks to raise capital from either markets or the state. The government remains under pressure to reduce its budget deficit and Spain’s unemployment rate of just over 20%.

Prime Minister José Luis Rodríguez Zapatero was due to outline further steps to improve budget controls, labor rules and productivity at a European Union summit in Brussels Thursday.Investors could still turn against Spain if it fails to deliver, or if events elsewhere trigger a market panic.

“Spain isn’t out of the woods. But the market is less afraid of the worst-case scenario occurring than a few months ago,” said Ben May, European economist at London consultancy Capital Economics.

The worst-case scenario is that Spain’s property market falls so hard that the country’s struggling regional savings banks, known as cajas, need more money to cover their losses than the Spanish state can raise.

Similar problems sank Ireland last year. Concerns about Ireland’s solvency are mounting despite international rescue loans granted in November.

But a report by credit-rating agency Fitch this month pointed out that Spain’s banks and their property risks are significantly smaller than Ireland’s in proportion to the overall national economy. As a result, “it will likely be easier for Spain to cope with the country’s real-estate collapse” even if Spanish home-price falls and banking losses become as severe as Ireland’s—”an extreme scenario which is not likely to materialize,” according to Fitch.

In an Irish-style meltdown, Spanish banks would need to raise nearly €100 billion in extra capital, Fitch calculates, an estimate similar to that of the most pessimistic economists. If the state had to provide all of those funds, Spain’s public debt would jump by about 10 percentage points of gross domestic product.

That amount would be challenging for Spain to borrow quickly from bond markets.

But economists say it wouldn’t undermine the state’s solvency, since public debt stood at just over 60% of GDP at the end of 2010, well below the ratios of Germany, the U.S. and many other Western countries.

Economists expect Spanish property prices to fall further this year, but not as drastically as in Ireland.

Some major urban markets appear to be bottoming out, analysts said. Spaniards’ attachment to homeownership as their main form of saving, and Spain’s unforgiving laws for mortgage debtors, slow down price declines and banks’ loan losses, said observers.

“In Spain, you are liable for all your mortgage debt even if your house is repossessed, so you do everything you can to avoid losing your house,” said Unai Ansejo, an investment manager at the public-pension fund of the Basque region.

Spain’s budget deficit, at 9.2% of GDP last year, remains too high for comfort, but was down from more than 11% in 2009. Spain improved its credibility with investors by meeting its deficit-reduction target, despite overspending by some regional authorities. This year’s deficit target of 6% is achievable, said economists, but might require extra fiscal measures if economic growth disappoints.

The economy grew at an annualized rate of 0.9% in last year’s fourth quarter, marking another contrast with Greece, Ireland and Portugal, which stayed mired in recession. Spanish consumer spending is falling thanks to mass unemployment and households’ efforts to reduce their debts, but Spanish exports are doing better than expected, growing at an annualized 16.6% last quarter.

Source: Wall Street Journal

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