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At the end of 2011, the Long-Term Refinancing Operation (LTRO) brought a modicum of stability to financial markets in Europe. When coupled with the “orderly” default of Greece, the situation in Europe is seemingly on a road to more pleasant ground. Just as soon as investors place Europe in their periphery, however, problems once again begin bubbling to the surface. In recent weeks, the spotlight has turned to Spain, where unemployment is near 24% and the government is expected to run a 5.9% budget deficit for 2012. Greece created a roadmap for sovereign defaults, but the sheer size and magnitude of a potential Spanish default is weighing on investors’ recent bullishness.
Spain, as one of the largest economies in the European Union, received a reprieve from investors last year as most attention was focused on Greece. The introduction of the LTRO effectively squashed investors’ concerns about the solvency of Spain, but those fears reemerged in early March.
The Spanish government announced that it expected a budget deficit equal to 5.8% of gross domestic product in 2012, lower than its 8.5% deficit in 2011, but well above the 4.4% it agreed to with the European Commission.
Spain subsequently announced plans to reduce its deficit through a combination of spending cuts and revenue increases, bringing the estimated deficit to 5.3% of GDP, but investors were already on high alert.
Yields on Spanish 10-year debt, which jumped as high as 6.5% last year but fell to 4.9% following the LTRO, have been on the rise in the last 30 days. After falling below 5% in early March, yields on 10-year Spanish debt are back to 5.3%.
While the government is aggressively seeking ways to reduce the deficit, the stark reality remains that Spain is a country with an unfavorable outlook. GDP is expected to shrink by nearly 2% this year, and its unemployment rate is the worst in the EU at 24%. Among those under 24 years old, the unemployment rate is a staggering 50%.
Spain’s problems are massive in the context of Greece, which was a relative drop in the bucket. Resolutions for Spain are limited, but the EU is scrambling to come up with a contingency plan. Many expect that the same Troika that oversaw Greece’s austerity measures will become involved in Spain. That means officials from the European Commission, International Monetary Fund and European Central Bank are all expected to become involved in Spain’s fiscal management this year.
Until we cross that precipice, expect markets to renew their focus on European sovereign debt issues, with a particular eye towards Spain. Spain will prove to be a bigger headache than Greece ever was, merely due to its size and economic importance, so this is an issue that could drag on for an extended period of time.