Spain's burning bonds at stake

Pressure on Spain has become so intense that Madrid is now prepared to accept far greater fiscal integration in return for ECB aid. But for Paris and Rome, it's a different story.

Which way will European leaders jump?

That’s the question overhanging markets this week, as investors worry that Spain is lurching closer to a bailout as a result of rescuing big-spending regional governments, and bailing out banks which have suffered crippling losses following the country’s property crash.

Last week, the country’s stock market plunged to its lowest level since April 2003, while the spread between Spanish 10-year bonds and German bunds soared to 540 basis points. Spanish 10-year bond yields closed above 6.5 per cent on Friday, perilously close to the 7 per cent level which triggered bailouts for Greece, Portugal and Ireland.

On the weekend, Spanish leader Mariano Rajoy emphasised that it was not only Spain’s economic future that was now at stake, but the entire future of the common currency.

Madrid is pressing European leaders to act quickly to help Spain. It wants the European Central Bank to provide short-term relief by buying up huge quantities of Spanish bonds, which would reduce the country’s borrowing costs.

What’s more, Madrid wants to change the rules so that the eurozone bailout fund can pump money directly into Spanish banks, which would spare the Spanish government the humiliation of asking for a bailout. Berlin, which is pushing Spain to seek a bailout, is deeply annoyed at what it sees as Madrid’s attempts to play brinkmanship over the terms of its rescue.

Meanwhile, new French president Franois Hollande has joined Italy and Spain in putting pressure on Berlin to relent and allow debt-laden eurozone countries to lower their borrowing costs by issuing eurobonds – which would be guaranteed by all eurozone countries.

Italian prime minister Mario Monti predicted that the eurozone would end up adopting eurobonds, despite Berlin’s fierce opposition. "I think that we will have eurobonds in one form or another, because our union is becoming increasingly close”, he said in an interview published in the Greek weekly To Vima on the weekend. But he warned it had to be made clear to big-spending governments that eurobonds "do not constitute a licence to spend”.

In the very same newspaper, however, Germany's foreign minister, Guido Westerwelle, repeated Berlin’s hostility to the idea, warning that eurobonds would lead to "more debt, and even weaker competitiveness”.

Berlin is worried that eurobonds will reduce the pressure on debt-laden eurozone countries to slash their budget deficits. What’s more, Berlin’s own borrowing costs could start rising if investors start to focus on the potential debts that Germany is incurring as a result of guaranteeing the debts of other eurozone countries.

At a conference of Christian Democrats in Berlin, German Chancellor Angela Merkel argued that national budgets would have to be subject to tighter controls before Germany would agree to eurobonds. "You can’t ask for eurobonds, but then not be prepared to take the next step towards closer integration,” she argued.

So far, eurozone countries have resisted Berlin’s calls for closer fiscal controls. But the pressure on Spain has reached such a level of intensity that Rajoy is now prepared to offer Merkel a sweetener.

On the weekend, he called on the eurozone to set up a central budget authority which would harmonise national budgets, and manage the debts of eurozone countries. It was, he declared, time for the eurozone to reinforce its architecture, adding "this entails moving towards more integration, transferring more sovereignty, especially in the fiscal field.”

But although Madrid may now be prepared to hand over much more budgetary control to Brussels, Paris and Rome are far more reluctant to agree to a similar sacrifice of national sovereignty. As a result, markets face a tense few weeks as they await the outcome of this latest European stand-off.

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