Facing up to the real Madrid

Investors breathed a sigh of relief overnight, as Spanish interest rates edged lower amid growing speculation that the European Central Bank would again start buying Spanish bonds.

The speculation was triggered by comments made by ECB board member Benot Coeur, who runs the bank's market operations division. Speaking at an event in Paris, Coeur said that markets were not reflecting "the fundamentals” of the Spanish economy, and he did not rule out the possibility that the ECB would again start buying Spanish bonds in order to reduce the country's borrowing costs.

The yield on Spanish 10-year bonds, which had climbed dangerously close to 6 per cent on Tuesday, eased back to 5.82 per cent after Coeur spoke, while European sharemarkets also headed higher.

According to the French newspaper Le Monde, Coeur emphasised that "the situation in financial markets has reached a turning point, but developments in recent days have shown how fragile it remains”. He added that while the ECB had done all that it could to avoid the crisis from spreading – including by providing European banks with cheap long-term loans – the bank could not solve the causes of the crisis.

But many critics argue that the ECB's move to douse the European banking system with €1 trillion in cheap three-year loans has made the situation even more worrying, because it has put the Spanish banks in an even more precarious position.

They point out that the ECB's move stabilised Spain's bond markets temporarily because Spanish banks were able to use this money to play the 'carry trade'. They borrowed from the ECB at a 1 per cent interest rate, and earned a handsome profit by investing the money in high-yielding Spanish government bonds. At the same time, foreign investors (including banks and insurance companies) took the opportunity to reduce their holdings of Spanish bonds.

But investors are now becoming increasingly concerned that Madrid will not be able to meet its ambitious deficit reduction targets, particularly since the Spanish economy is moving deeper into recession. As a result investors are now dumping Spanish bonds, thereby pushing bond prices lower and bond yields higher.

What's more, investors are anxious that Spanish banks are now sitting on massive losses from their investments in Spanish government bonds, in addition to the crippling real estate losses that they've suffered as a result of the collapse of the Spanish property bubble.

Some analysts estimate that the Spanish banks need a capital injection of at least €200 billion to cover their losses they've suffered on their real estate and bond portfolios. And a worsening Spanish economy could see these losses climb even higher.

Clearly Madrid, which is under intense pressure to slash its budget deficit, does not have enough resources for a recapitalisation of this size. Even though Spain continues to insist that it is capable of solving its problems on its own, investors fear that the size of the Spanish banks' losses will ultimately make a bailout inevitable.