The spike in Spanish bond yields in the last couple of weeks reminded the global community that Greece is not the only euro zone member we should worry about. The Greek debt restructure and the ECB's Long-Term Refinancing Operations (LTRO) have now been overshadowed by the upward drift of Spanish bond yields. This rise has moved Spanish 10-year bond yields above Italian bonds - this has not occurred since August 2011.
Spain's condition is of a different nature to Greece since Spain is the fourth largest economy in the euro zone, accounting for 10.1% of euro zone GDP (five times larger than Greece). This country is in a fight to avoid becoming the fourth euro zone member to require a bailout. However, due to the worsening conditions of this nation, the future of this country has become increasingly unclear.
The current situation in Spain is dire as evidenced by the Spanish bond slump last week. The biggest gains since January were recorded for 10-year bonds and barely enough were sold to cover Spain's minimum target at a debt auction. As a result, only €2.6bn in bonds were sold with interest rates on the notes higher than the last time Spain sold bonds in September. This event placed an obstacle on the euro zone's road to recovery as it showed that the ECB-funded stimulus was wearing off.
Monday, yields jumped precariously close to 6% inching its way closer to the dangerous 7% mark. As seen below, yields for 10-year bonds are now hovering above 5.8% - their highest level since December.
Spain's future looks grim due to the poor state of its economy, which includes private sector imbalances, weak economic outlook and political conflict in initiating austerity measures. The benchmark IBEX-35 stock market index, shown below, highlights the negative outlook of Spain as the index is falling closer to GFC lows.
Spain experienced easy financial conditions during the past decade that has allowed Spanish households and corporations to accumulate excessive debt. This combined debt equates to more than 200% of GDP and has been focused in the property sector.
Also, Spain's fiscal responsibility has deteriorated from the budget surpluses that were recorded between 2005 and 2007. Between 2009 and 2011, budget deficits exceeded 8% of GDP as shown below.
As expected, Spain's stock of government debt has also gone north although this largely occurred after the GFC. Spain's government debt-to-GDP is not as high as some of the other troubled euro zone countries but the absolute amount is still significantly high.
One of the main issues in regards to the Spanish economy is a weak domestic economic outlook. The graph below shows the abysmal GDP growth of Spain since the GFC.
The Bank of Spain confirmed bearish sentiment when it stated that a 'contractionary dynamic' continued into Q1 2012. Therefore, Spain appears to have entered its second recession since 2009. The government of Spain is also expecting GDP to contract by 1.7% in 2012 which would equate to a 5.6% GDP reduction since Q1 2008. The most distressing of all the figures released by Spain is its gigantic unemployment rate of 23.3% - the highest in the euro zone.
In addition to a weak labour market, household debt is extremely high so private consumption will continue going down. One positive figure to be released is an increase in net exports as a result of declining imports. However, Spain's exports are heavily dependent on the euro zone nations since they account for 53% of export trade.
Another highly publicised and concerning issue in regards to Spain is its poor fiscal position. Euro zone finance ministers assigned Spain with a target budget deficit of 6% of GDP in 2011 - the actual GDP for the year was significantly higher at 8.5% of GDP. Bond rates rose on 2 March after Prime Minister Rajoy announced that the government would not comply with a 4.4% deficit target for this year. The euro zone finance ministers responded to Spain's pleas and agreed to reduce the 2012 budget deficit target to 5.3% of GDP. This targeted deficits translates to €30bn (2.8% of GDP) worth of austerity measures in addition to the €15bn announced in late 2011.
Political tension and civil unrest are another set of factors worsening Spain's national condition. The Spanish population have accepted the fiscal austerity measures to date however the additional measures may not be met with such friendly terms. The unpopularity of Rajoy's People's Party was exhibited in the recent Andalusia regional election in which Rajoy was not able to hold a majority win.
Spain's central government is seeking to tighten control on spending by cutting 1.5% of GDP. However, it should be noted that Madrid has only limited control over the provinces of Spain. Over one third of Spain's spending is controlled by its regions which are known for spending overruns. It was this difficulty of dealing with regional governments that contributed greatly towards Spain's 2011 budget target miss. Coalition regional governments will continue to make it difficult to implement austerity measures that are deemed unpopular.
Spain's housing market is another area of concern since it still appears to be overheated. Construction played a vital role in Spain's economic growth before 2008 since it reached 17% of Spanish GDP in early 2007. Now it accounts for just over 10% of GDP and housing prices have dropped 19% since peaking in Q1 2008. Housing prices seem overheated since other troubled nations dropped considerably more such as Ireland, which had house prices fall 48% from their late 2007 peak.
A natural consequence of plummeting housing prices is a heavily risky banking sector. Spanish banks remain deeply exposed to their domestic property sector. It is estimated that Spanish banks have €388bn worth of exposure. Citigroup concluded that banks could face losses of €203bn under a stressed scenario. The Spanish government has made an attempt to shield banks from property asset devaluations by asking banks to set aside €147bn (14% of GDP) since the beginning of the crisis. However, this amount would not be able to help banks that are facing loan delinquencies of close to 8% (as a proportion of total loans) which equates to approximately 13% of Spanish GDP.
Spanish banks are highly leveraged to domestic real estate and sovereign debt so remedying their problems may not be achieved by a Greek-sized bailout. Write-downs could be reduced by increasing the use of the Spanish Governments Fund for Orderly Bank Restructuring or external assistance could be received by the European Financial Stability Facility (EFSF).
But unlike Greece, Spain's bailout requirements may be significantly higher and could easily consume the already expanded EFSF. The ECB has its hands tied in regards to Spain since Spanish lenders have been the main beneficiaries of the LTRO having increased holdings of Spanish government debt by €52bn in two months.
Private sector imbalances, weak economic outlook and political conflict in initiating further austerity measures remain Spain's most concerning problems. The world is now bracing itself until Spain can officially implement its 5.3% budget target, a dramatic reduction from their 8.5% budget deficit last year.
There is one positive point to mention, Spain has raised about 47% of its funding needs for the year. This means that the impact of higher bond yields has lessened. However, Spanish 10-year bond yields must stay under 6% before investor fears create a rapid acceleration to the dreaded 7% region.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.