April 16, 2012 at 12:57 PM ET
Just weeks after European officials defused a financial time bomb in Greece, the ticking is growing louder in Spain.
For officials in Madrid, the scenario is painfully familiar to what happened in Athens. Skittish investors, worried that Spain may not be able to pay back some 735 billion euros ($960 billion) in borrowing, have forced interest rates on Spanish debt above 6 percent. That’s a level that most market analysts say isn't sustainable.
But as Greek officials learned, the cure can be more painful than the disease. With its economy already in recession, Spain's central government is enacting spending cuts that likely will slow growth further.
Spending cuts may prove difficult to enforce because the Spanish constitution gives regional governments autonomy in setting budgets. That’s sparked concerns that the central government's deficit-cutting goals could be tough to achieve.
The central government had agreed to cut its budget deficit to 6.0 percent of GDP last year, but it overshot that target, posting a deficit of 8.51 percent of GDP. Madrid is now aiming for an annual deficit of 5.3 percent in 2012 and 3.0 percent in 2013.
Such sharp spending cuts would put even more pressure on the Spanish economy. The fear is that Spain faces the same downward economic spiral that has thrown the Greek economy into a sharp, ongoing contraction.
That would not bode well for the still-fragile global economic recovery.
“The euro crisis is not over,” said Robert Parker, a senior advisor at Credit Suisse. “And at least in the short term that can be drag on global growth. Let’s not forget that Europe, except Germany, is still in recession.”
In Spain, that recession has been driven by a steep collapse in house prices, which have dropped 22 percent from their 2007 peak and continue to fall. The government estimates that Spain’s economy will shrink by 1.7 percent this year as spending cuts take hold.
Private economists expect the economy to shrink more rapidly. Loan default rates are at an 18-year high and a rising unemployment rate could trigger more mortgage defaults.
Those defaults have hammered Spanish banks, which have turned to the European Central Bank for cheap funding after the cost of private capital has soared. Spain's banks borrowed a record 316.3 billion euros ($417 billion) from the ECB in March, almost double what they did in February.
The ECB has supplied European banks with roughly 1 trillion euros ($1.3 trillion) of cheap, three-year loans to ease a cash crunch that threatened to cripple the continent’s weaker financial institutions.
While the central bank’s lifeline helped buy some time for the battered European banking system, the longer-term outlook remains uncertain. A review of 100 European banks for possible downgrades by credit rating agency Moody’s was supposed to have been released this week. But amid heavily selling of Spanish bonds, the company said it would postpone the reports until next month.
Spanish officials are struggling to shore up the country’s banking system by asking healthy banks to pay for some of the cost of bailing out weaker competitors. The Bank of Spain, which has already sold four state-rescued banks, reportedly needs at least 20 billion euros ($26.35 billion) to cover losses at three more banks. To avoid tapping taxpayer funds, the government wants the rest of its hard-pressed banking sector to provide the cash.
The European Commission said last week that Spain would not need euro zone financial help to shore up its banking sector. But it’s unclear where the money will come from to bail out Spain’s failed banks.
"We're back in full crisis mode," said Rabobank rate strategist Lyn Graham-Taylor. "It is looking more and more likely that Spain is going to have some form of a bailout."