Spain begins to turn the wheel

Spain's fifth austerity package has cleared the way for a further bailout from the troika, and even its beleaguered banks may be stronger than expected.

Spain’s austerity budget has probably done enough to enable it to qualify for urgently needed bailout funds for its banks and government. Financial markets reacted positively with global stocks and the euro rising. Most importantly, the 10-year Spanish bond yield fell 12 basis points to 5.95 per cent.

This was the fifth austerity package that saw Prime Minister Mariano Rajoy prepare the groundwork for what is seen as an inevitable requirement for Spain to go cap in hand to the troika – the European Central Bank, International Monetary Fund and European Commission – for financial aid. For what are largely domestic political reasons, Rajoy is still coy about whether he will actually seek financial assistance, but the reality of the budget numbers and state of the banks make it certain that Spain will forced to capitulate and apply for bailout funds in the months ahead.

This latest austerity package was actually not that austere, certainly not in the genre of the recent cuts in Greece. The spending cuts were limited to 0.8 per cent of GDP with pensions and education quarantined from the cuts. Tax receipts are forecast to rise by almost 4 per cent despite the economy being in recession as new taxes and tighter tax compliance is implemented. The spending measures follow the script which has some electoral appeal as they include cuts in ministerial spending, a tax on lottery winnings and a third straight year of a public sector wage freeze.

There has also been a positive response to the decision to establish a budget authority, which will operate independently of the government and will have oversight of the progress of the government towards its fiscal targets as well as dealing with regional financial issues. The budget authority will liaise with the troika on fiscal trends.

After these changes, the budget deficit is forecast to be 6.3 per cent of GDP in 2012 before narrowing to 4.5 per cent of GDP in 2013. GDP is forecast to fall 0.5 per cent in 2013 and the unemployment rate remain around 25 per cent.

The positive market reaction to the budget plan was boosted by comments from Olli Rehn, the European Union Economic and Monetary Affairs Commissioner who said the government’s latest move "responds to country-specific recommendations and goes even beyond them in some areas”.

For Spain, there remain a number of keynote events on the calendar as it works to fix its budget and strive for a return to economic growth. Tomorrow sees the release of a comprehensive review of Spain’s banks. This review has the potential to reshape views not only on the fragility and exposures of the local banks, but also their links to banks outside Spain. The banks have been in severe financial stress, not only linked to the sovereign debt problems throughout Europe, but they have been exposed to the property collapse, which has seen house prices in some areas fall by more than 50 per cent.

The banking report will form the basis of Spain’s request for bailout funds. The EU has set aside €100 billion to recapitalise the Spanish banks, although there are expectations that the banks may need only €60 billion. There is a speculation about the "excess” €40 billion and whether it can be reallocated as a loan to the government.

The current fiscal estimates and schedule of bond maturities suggest that the government will need to raise €180 billion over the next 12 months, a massive task even if it is allocated the spare €40 billion previously earmarked for the banks.

On October 8, the Economic and Financial Affairs Council (Ecofin) meets to pass judgment on the budget measures and banking report and their findings will be important in Spain’s quest for funding.

The other near-term event will be the regional elections on 21 October. Given the public hostility to towards the austerity measures and the general economic malaise, the election outcomes are another potential source of instability. The regional governments are largely autonomous and have acted to constrain reform at the national level.

Until then, the policy makers and financial markets seem content that the Spanish government is making progress to repair the budget and economy amid the constraints of 25 per cent unemployment, another year of recession and long-run structural inefficiencies.

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