On Thursday, Spain’s government bonds reached a malign milestone: the yield on 10-years rose above 7 percent for the first time in the euro zone’s history.
Traders were reacting to renewed fears about the Spanish government’s debt burden, five days after it revealed that it had increased this load by tens of billions of euros by asking euro zone institutions for help in rescuing its crisis-ridden banks. On Wednesday Moody’s Investors Service downgraded Spain to one notch above junk status -- adding a warning that its rating might fall further.
The total level of Spanish debt does not in itself look unsustainable. Euro zone ministers have agreed to lend up to €100 billion to the Spanish government, to be passed on to the banks. This will be done through either the European Financial Stability Facility or the European Stability Mechanism – its imminent successor as the euro zone’s rescue fund. At the end of last year Spanish government debt was only 68.5 percent of gross domestic product (GDP) -- lower than Britain’s, France’s or even Germany’s. If the government borrows €100 billion for its banks, and continues to run a large fiscal deficit, Stefan Isaacs, fund manager at M&G in London, calculates that its debt-to-GDP will be about 85 percent to 90 percent by the end of the year. Judging by the International Monetary Fund’s most recent forecasts for other nations, this will make its debt plight broadly similar to France’s or Britain’s. Nobody is worrying -- yet, at least -- about the debt sustainability of either of those countries. Britain’s 10-year gilts closed at only 1.70 percent on Thursday. Even France, which, like Spain, does not have the backstop of being able to print more of its own currency to stop a collapse in its bond market, had a yield of 2.69 percent.
Moreover, the Spanish government is trying hard to limit its debt. Through savage cuts in departmental spending, it plans a fiscal tightening of 2.5 percent of GDP this year. Only a year ago such radical surgery by a country on its public debt would have been rewarded by the markets with a fall in bond yields. However, investors increasingly believe that such extreme austerity is bearish for government bond markets, because it depresses tax revenue.
This conviction is particularly strong in the case of Spain, because of the banks’ parlous situation. “The weakness of the banking sector means that there is no scope for monetary policy to offset the fiscal tightening and the impact of structural reforms”, explains James Nixon, European economist at Societe Generale in London. “This means that the fiscal multiplier in Spain is probably close to unity if not higher, which in turn means the government’s austerity measures are pushing the economy into a protracted recession.”
The higher the fiscal multiplier, the more an increase in tax, or a reduction in government spending, hits GDP. A fiscal multiplier of ‘unity’, or 1, means that fiscal tightening of 1 percent will reduce overall GDP by 1 percent -- depressing tax revenue. In other words, fiscal tightening in Spain achieves very little for the government, because it creates a perfect spiral.
Because of Spain’s fiscal hawkishness, Nixon expects Spain’s economy to shrink for the next three years. It is this common expectation of long-term economic decline that makes institutional investors reluctant to buy Spanish debt, even while they lap up French and particularly British government paper.
A progressive decline in GDP of this protracted length of time would raise questions about the mathematics of Spanish debt.
But it would raise even more questions about the politics of Spanish debt. Cuts in spending together with government attempts to boost structural economic growth by jettisoning time-honored cultural practices ranging from strong employment rights to Sunday store trading triggered a well-attended general strike in March. At 24.3 percent, unemployment is already the highest in the developed world. Further austerity in the coming years will push it even higher. Faced with these threats to the basic structure of their society, Spanish citizens may simply decide, as Greece’s citizens are threatening to do in Sunday’s general election, to instruct the government to walk away from its debts.
The glimmer of hope for Spain is that in recent months euro zone politicians, and even more importantly markets, have become disillusioned with a diet that consists entirely of gruel.
Jonathan Loynes of Capital Economics, the independent macroeconomic consultancy, notes that unlike the bail-outs of Greece, Portugal and Ireland, Saturday’s agreement “does not impose additional austerity on Spain” -- it therefore “adheres to the growing view that piling ever bigger fiscal squeezes on bail-out recipients has been a decidedly ineffective strategy.” Spain’s target deficit for this year, agreed between its premier Mariano Rajoy and the EU, remains 5.3 percent of GDP.
This outlook -- that the burdens shouldered by peripheral euro zone economies are heavy enough already -- is widely shared in financial markets.
The yield on Spanish 10-years ended the day 17 basis points higher at 6.92 percent.
