The Tragedy that is Spain

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The Greek PSI will be resolved one way or the other this week. Early reports suggest a weak start and the triggering of collective action clauses and credit default swaps remain a distinct possibility. Portugal is next and, although the credit dynamics and implementation of reforms are superior to Greece, the risk remains high that it will need a second aid package and/or debt restructuring, as it is unlikely to be able to return to the capital markets in H2 2013. With 2 LTROs and collateral liberalization, the 10-year benchmark in Portugal is yielding more than 13%, compared with a bit more than 12% at the end of last year.

However, the devolution in Spain is particularly troubling. The new fiscal compact had just been signed last week, which includes somewhat more rigorous fiscal rule and enforcement, when Spain's PM Rajoy revealed that this year's deficit would come in around 5.8% of GDP rather the 4.4% target. This of course follows last year's 8.5% overshoot of the 6% target.

The problem for Spain is that the 4.4% target was based on forecasts for more than 2% growth this year. However, in late February, the EU cut its forecast to a 1% contraction. This still seems optimistic. The IMF forecasts a 1.7% contraction, which the Spanish government now accepts.

This will be the third year in 5 that the Spanish economy contracts. Unemployment stands at an EU-high of 23.5% in February. The strong export growth seen in recent years, the best growth in the euro area, is stalling. Domestic demand has been hit by rising unemployment and government austerity. At the end of last year, the Rajoy government adopted a 15 bln euro package of spending cuts and tax increases.

Moody's says that another 25 bln euros in savings is needed for Spain to reach its budget target. Fitch says this is unrealistic and that the overshoot will not necessarily impact their credit worthiness.

Spain is already under the excessive deficit procedure (since April 2009), as are 23 of the EU 27 members. Rajoy's revelations butt against the EU agreement that urged members to adhere to their fiscal commitments. Moreover, Rajoy struck a strident chord by saying he did not communicate this to the other heads of state because he did not have to and that Spain was sovereign.

In mid-February, a Reuters report noted that the EU believes that the Spanish government overstated the 2011 deficit to make this year's data looks better. A recent Der Spiegel report quoted a senior source in Berlin saying: "Everybody knows that the Spanish are lying about the [deficit] figures."

Spain puts the EU in a difficult position. Belgium and Hungary have already been formally requested to address their budget shortfalls. The Netherlands is also coming under pressure after admitting recently that it is not on track to reach the 3% deficit/GDP target next year. The EU has to enforce the new agreement or lose credibility. On the other hand, enforcing it runs risks of deepening the economic downturn and fueling social and political instability, through which the EU also would lose credibility.

Some of the machinations of Spain's government could be related the upcoming regional election in the autonomous regions of Andalusia on March 25. Rajoy's Popular Party could win for the first time in more than 30 years. If so, the PP would govern 12 of the 17 regions. This is important because the deficit overshoot on the regional level accounted for an estimated 2/3 of the overall miss.

While Greece and the LTRO dominate the headlines, investors are already marking down Spain. Since advent of EMU, Spanish 10-year (generic) yields have been below Italy's with the notable exception being May 2010-August 2011. However this is changing and Spain is beginning to pay a premium over Italy. In part this reflects the incredible recovery in Italy after Monti became the technocrat prime minister. The Italian 10-year benchmark yield has fallen more than 200 bp this year already, while Spain's 10-year benchmark has seen a 6 bp decline.

Perhaps an even more compelling evidence of the changed attitude toward Spain is the 5-year credit default swap is now above Italy's for the first time in six months. At the end of last week, Italy's 5-year CDS price fell to its lowest level since last August. The Spanish 5-year CDS price had fallen to 340 bp on Feb 8 and now stands at almost 387, about a one month high.

A confrontation between Spain and the EU is likely in the coming weeks. There is no good outcome and that what makes it a tragedy. In Greece's case, implementation was/is a problem. Portugal is implementing reforms but still may not be able to return to the capital markets as envisioned. Spain is (understandably) reluctant to implement additional austerity and wants to miss this year's deficit target after blowing through last year's. Can the EU fine Spain? Really ?