As the European debt crisis approaches its third anniversary,
there is no sign of abatement. Even as Eurozone finance
ministers approved an interim loan of €30 billion to recapitalize
Spain's banking sector, the eastern region of Valencia
announced Friday that it would seek a bailout from the central
government without which it would be unable to service its
obligations. Valencia's request for aid may be followed by other
regions having similar problems. The various regions' debt-related difficulties increase the likelihood that Spain will be
forced to seek a full-blown bailout for the public sector, much as
Greece, Ireland and Portugal have done. Unsustainably high
borrowing rates in private markets could force such a bailout on
the national government in a matter of weeks.
Investors were also spooked by statements from senior
German officials that the €30 billion aid to Spain would not be
infused directly in the banking system, but through a
government entity. The shift contradicts Prime Minister
Mariano Rajoy's statement last month that the bailout would
not add to public debt. If the full amount of the promised
assistance of €100 billion is added to Spain's public debt, it
would raise the debt-GDP ratio from 66% in September 2011
to 76% at the end of 2012. Even if some do not consider 76%
to be too high a level -- after all, the U.S. debt-GDP ratio is
around 100% -- the speed of the increase in Spain's debt-GDP
ratio is worrisome because it suggests a sharp deterioration in
country risk.
Renewed problems in the Eurozone's fourth largest economy
resulted in intense selling pressure in debt markets. Ten-year
Spanish paper increased in yield to 7.30% on Friday, and
surged to a new record of 7.57% this morning. The stock
market index dropped 5.8% on Friday, and an additional 2.5%
this morning before newly imposed restrictions on short-sales
limited the decline to 1.1%. And as investors took Spain's
travails as an indication that European leaders are flailing in
their efforts to resolve the crisis, debt yields rose in Italy, the
Eurozone's largest debtor nation. Ten-year Italian debt yield
has risen from a low of 4.78% reached on March 8 following
the European Central Bank’s €1 trillion LTRO programs, to
6.36% this morning, the highest since January. A full-fledged
bailout of Spain will further shift market focus to Italy.
As I
have stressed in past reports, Italy with total public debt of
€1.95 trillion, equivalent to 120% of GDP, would be too big to
bail out should it need one.
European leaders' dilemma
While European leaders may be able to scrape together the
funds needed to temporarily rescue Spain -- €300 billion in
additional funds from the troika would be necessary, by my
estimate -- that would not solve the country's problems.
Following the experience of past bailouts that have
worsened the domestic economy in "rescued" countries
rather than resolve the crisis, Spain's recession will deepen
following cutbacks in public spending and increases in taxes.
The rise in unemployment from current levels -- already
almost 25% of the work force, and over 50% for those less
than 25-years old -- would only increase public opposition to
further austerity, which would further raise debt yields in
secondary markets.
European leaders are not yet willing to recognize that a
significant portion of the sovereign credits in the crisis-ridden
countries are non-performing. Nor are they ready to
reduce debt levels through haircuts imposed on lenders to
enable renewed economic growth in the affected countries. It
is the inability to fully service the debt that would be the
immediate cause of a further deterioration in the domestic
economic situation in Spain and Italy.
Komal S. Sri-Kumar, a senior fellow at the Milken Institute, is chief global strategist at TCW.
