Stranded Spain's rising unrest

Spanish bond yields continued to climb overnight, as nervous investors worried about rising popular resistance to the latest round of austerity measures unveiled by Spanish Prime Minister Mariano Rajoy and whether the €100 billion ($US122.7 billion) would be enough to cure the Spanish banks' problems.

Popular resistance to the Rajoy government – often organised using social media – is continuing to spread. Last Friday, the "indignants” assembled in Madrid to express their discontent, and on Sunday night thousands of public servants spontaneously assembled in the city to protest against the latest round of budget cuts. Overnight, Spanish municipal workers held their own "funeral march”, and the country's two major unions are organising major protests for Thursday.

The protests have gathered pace after Rajoy last week announced another round of tax hikes and spending cuts, aimed at slicing €65 billion off the Spanish budget deficit over two years. These included a hike in the value-added tax rate to 21 per cent, and cuts to jobless benefits, a controversial step in a country where the unemployment rate is close to 25 per cent. Public servants, who had already seen their wages cut by between 5 and 15 per cent in 2010, suffered a further 7 per cent salary reduction, and had their annual holidays reduced by three days.

Despite these cuts, many fear that the country's budget deficit will remain bloated, as the deep-ending recession is causing tax revenues to tumble. Spain, they worry, may need a full EU/IMF bailout, which could close an extra €300 billion on top of the €100 billion already earmarked for the Spanish banks.

They also fret that that the Spanish banks will remain a problem, despite the latest €100 billion rescue plan. They point out that Spanish banks are hugely dependent on wholesale, rather than retail funding, with the average loan to deposit ratio for the banks at close to 150 per cent.

But with bond markets closed, and with their deposit outflows accelerating, Spanish banks are becoming increasingly dependent on the European Central Bank for funding. Spanish banks borrowed a record €337.2 billion from the ECB in June, a big jump from the €287.8 billion they borrowed in May. Investors are worried that the ECB will itself become reluctant to continue lending such huge amounts to the Spanish banks.

Also unsettling investors were reports that that the ECB head, Mario Draghi, recently argued in favour of forcing senior bond holders of Spanish savings banks to suffer losses on their investments. In the end European finance ministers decided not to take this approach, for fear of unsettling financial markets. As a result, only the shareholders and subordinated bondholders of the banks receiving assistance under the €100 billion rescue package will suffer losses, and the senior bondholders will be spared.

Investors also soured on Spanish government debt after German Chancellor Angela Merkel emphasised in a German television interview that the Spanish government was "obviously liable” for the €100 billion that is being used to recapitalise the Spanish banks. She added that European leaders had yet to reach a decision on whether countries would continue to guarantee the aid received by their banks.

Her comments disappointed investors, who had hoped that European leaders might have finally cut through the vicious cycle that transforms banking crises into sovereign debt crises. They also appear to contradict the view of Klaus Regling, who heads up the eurozone bailout fund. In an interview with the German weekly Welt am Sonntag newspaper, he said that once a common banking supervisor for the eurozone was created, countries could be relieved of the liability for loans from the bailout fund to their banks.

But commentators were quick to point out that Merkel's comments came just days before Germany's parliament is set to vote on whether to approve the €100 billion package to recapitalise the weakened Spanish banks. The issue of whether governments should guarantee emergency loans to banks is extremely sensitive in Germany. Many argue that unless countries are forced to guarantee emergency loans to their banks, German taxpayers will be saddled with even greater risk.