Spain--Deficit Problems Worse Next Week than Last Week?

European officials have been successful in establishing a firewall around Spain and insulating it from the crisis in the peripheral. That firewall may be tested shortly.

Spain holds local and regional elections on Sunday ahead of the national election next year. Socialist Prime Minister Zapatero has already indicated he will not seek re-election. The difference between being quitting and being fired is a fine line as Zapatero would most likely lose if he were to run.

His Socialist Party is headed for a drubbing in Sunday's contests. In particular, the polls show they are likely to lose 9 of the 13 regions and some key cities like Barcelona (for the first time in 30 years).

The change of power on the regional level is important in Spain because of their relative fiscal autonomy. Regions control spending on health care and education and account for half of government employees. They have an outstanding debt of 115 bln euros (~$165 bln). The risk is that what happened in Catalonia, the largest region, is repeated in other regions that the Socialists lose on Sunday.

The new government in Catalonia declared that its deficit was really 60% more than the previous government had forecast. Catalonia's long-term debt rating was cut yesterday by S&P from A+ to A, noting debt and deficit concerns. It retained a negative outlook.

It is thought that ahead of the regional elections, the existing governments have little incentive to implement the agreed upon austerity measures. The new regional governments will be under pressure to take most of this year's fiscal measures in the remaining months of the year.

One way in which we have managed to quantify the de-coupling of Spain from the periphery is to track the correlation between Spanish and Portuguese bonds. The correlation (both the 30 and 60 day) had fallen at the start of this week to the lowest level since last Sept/Oct, which itself was the lowest since the crisis began.

The risk is that the correlations will rise post-election. Spanish bonds have already begun under performing and the risk is that this continues and is aggravated in the days ahead. This week Spanish 10-year yields are the worst performing in the euro zone but Greece. 5-year CDS prices on Spanish sovereign debt is at 2-month highs today. Clearly, then some bad news has been discounted, but given the far reaching implications of the potential magnitudes involved, there is likely more scope for adjustment.