History repeating as Spain slips away

The stand-off between European political leaders and financial markets grew more critical overnight, pushing Spain closer to becoming the latest victim of the eurozone's raging debt crisis.

Austria's finance minister, Maria Fekter, who was attending a meeting of eurozone finance ministers in Brussels, made a vain attempt to reassure investors that the situation was under control. Spain, she argued could still finance itself on capital markets even though its borrowing costs were high.

"We are watching it very closely, in terms of the financial capacity,” she said. "Spain can still get money on the capital markets, even if it's expensive.”

But investors took little heed. Spain's sharemarket dropped 2.6 per cent overnight, hitting its lowest level since March 2009, and bringing its total decline so far this year to 20 per cent. At the same time, Spain's 10-year bond yields – a barometer of eurozone anxiety – climbed 8 basis points to 5.85 per cent, perilously close to the critical 6 per cent level that markets believe is the trigger-point for a bailout.

Spanish banks bore the brunt of the selling, with banking giant, Banco Santander, and Spain's second largest bank, BBVA, both suffering share price declines of 3.3 per cent, as Moody's Investors Service said it was finalising its review of the eurozone banks.

Last week, Standard & Poor's cut Spain's credit rating to BBB-plus, only three notches above junk level. On Monday, the ratings agency lowered its rating for 11 Spanish banks, including Banco Santander and BBVA, citing "potentially negative implications” from the cut in Spain's credit rating.

Investors now believe that the combination of Spain's rapidly deteriorating economy and higher borrowing costs means that it will be near impossible for the Spanish government to meet its ambitious deficit reduction targets, and the country will be forced to seek a bailout.

At the same time, they're concerned that European leaders have shown little resolve in tackling Spain's obvious financial difficulties, and instead have left it to the European Central Bank to bring down Spanish interest rates by flooding European banks with more than €1 trillion ($US1.3 trillion) in cheap money through its longer term refinancing operations. Spanish banks, which were enthusiastic participants in the LTRO program, used the money to buy Spanish bonds, which reduced Spain's borrowing costs.

But Spanish banks are now close to running out of cash and as a result their "firepower” to buy Spanish bonds has diminished, according to a report by Royal Bank of Scotland strategists.

According to the report, Spanish banks have already spent 42.3 per cent of the cheap three-year loans they got from the European Central Bank. If the banks intend to use half of their LTRO funds to buy Spanish bonds, that means the Spanish banks only have about €16 billion left to spend. If they intend to use 65 per cent of their LTRO funds to buy bonds, the banks would have €46 billion left to spend – which translates into another 1.6 months of bond purchases for Spain.

Meanwhile, investors are also querying whether the political will of European leaders to provide a financial rescue for Spain has been frayed because LTRO has allowed foreign investors – such as French and German banks and pension funds – to dump a large portion of their Spanish bonds portfolios onto the Spanish banks.

Spanish banks now hold €263.3 billion of Spanish government bonds, a huge increase from the €177.9 billion in bonds they held last November before the LTRO program began.

This buying by the Spanish banks allowed foreign investors to reduce their exposures to Spain. According to figures from Spain's economy ministry, foreign investors cut their holdings of Spanish bonds by €20 billion , or 9.3 per cent of their total holdings, in the month of March alone.

Investors are now deeply concerned that Europe's leaders have learnt nothing from the horrific experiences of Greece, Ireland and Portugal, and will once again wait until the crisis overwhelms Spain before they are finally prodded into action.