Spain Update

The Spanish news stream is poor as the media focuses on local bank reliance central bank funding and the 2012 budget that will be unveiled next week. Just like roughly 1 in 3 that are unemployed in the euro zone are in Spain, Spanish banks account for almost half of the borrowing from the ECB in February.

Recall that Prime Minister Rajoy unilaterally announced, within hours of signing the new fiscal compact, that it would not reach the 4.4% deficit/GDP ratio has negotiated with the EU, but instead deliver a 5.8% deficit. That follows the large (roughly 2.5 percentage point overshoot of the 2011 target, conveniently blamed on the outgoing Socialist government). The EU has come back and compromised with a 5.3% deficit target this year.

Rajoy's budget will be closely scrutinized for new savings measures. The local press suggests that focus may be on scrapping some tax deductions, but many observers are suspicious of the reliance on some cosmetic changes.

However, the private sector debt seems more intractable than the public sector. Private sector debt appears 3-4 times the public sector debt. De-leveraging by both the public and private sector simultaneously is a recipe for an economic recession. It is also a recipe for social instability with unemployment finishing last year just below 23%.

Andalusia, the most populous of the autonomous regions in Spain, goes to the polls on March 25. Rajoy's Popular Party is set to win according to most of the latest polls, but if it does not win an outright majority, which appears close, the Socialists will likely maintain power through a coalition with the Izquierda Unida Party. Andalusia is among Spain's poorest regions.

The regional governments are important in Spain as they account for more than a third of government spending. The regions overshot their deficit targets which compounds the central government efforts. If the PP wins, it is thought to enhance Rajoy's ability to rein in fiscal policy.

Spain's 10-year bond yield has risen steadily this month. On March 1, it retested the low yield point since Nov 2010 near 4.85%, encouraged by the two LTROs. The yield today hit the high for the month near 5.25%. This seems to be the middle of a 5.0%-5.25% range that will likely prevail ahead of the unveiling of the 2012 budget details.

The price of the 5-year credit default swap has risen from about 356 bp on March 1 to 415 bp in the middle of last week. It is currently near the 100-day moving average of about 400 bp. It is essentially unchanged year-to-date, suggesting that the LTROs may have helped ease this year's roll-over risk (Spain has met almost 50% of this year's refinancing needs), it has not substantially altered the market's views of the risks of an eventual restructuring.