Spanish Bond Investors in Strike of Their Own

Much of Spain was brought to a halt by a general strike on Thursday, but the bond market vigilantes are also striking, by avoiding the country’s debt.

Yields on Spanish 10-year bonds rose sharply in March, overtaking the rate on sovereign debt in Italy — another troubled peripheral euro zone economy — for the first time since August.

Rates for Italy and Portugal — which have at different times taken the leading role in the euro zone debt drama — have fallen in the wake of the European Central Bank’s decision to flood the euro zone banking system with hundreds of billions of euros of cash on the final day of February; a move repeating its successful December initiative. Although this injection of liquidity has moderated fears that a credit crunch could hit other risky government bond markets, concerns about Spain have risen, as the bond vigilantes have protested against the country’s fiscal woes by selling their Spanish debt or even shorting the market. Why is this?

Spain’s economy is in a dismal state, even by the grim standards of much of the rest of the euro zone. A spectacular bust in the labor-intensive real estate sector has pushed unemployment up to 23.3 percent — the highest among the 34 developed nations in the Organization for Economic Cooperation and Development (OECD), and almost three times the OECD average of 8.2 percent. The ultra-high level of joblessness has depressed tax revenue — leaving Spain’s fiscal deficit at a massive 8.5 percent of gross domestic product (GDP) last year.

Unemployment is likely to rise even further, as Spain tries to calm its bond market by closing this fiscal gap. This means that instead of boosting government spending to bring unemployment down, it is reducing public sector budgets aggressively, which is likely to push joblessness up. “We expect the unemployment rate to increase to 25 percent as the impact of fiscal austerity measures is increasingly felt,” says Credit Suisse in a research note. Bank of America Merrill Lynch worries about the long-term consequences, saying, “The persistence of elevated joblessness risks becoming entrenched, as long-time jobseekers lose skills and face greater hurdles to return to employment.” Permanently high unemployment could place an unsustainably heavy burden on the public finances.

Many investors in Spanish bonds are fearful that the severe government cutbacks could damage Spain’s ability to finance its debt.

Mariano Rajoy, the Prime Minister, plans to push down the deficit to 5.3 percent of Spain’s total output this year. To achieve this, he announced cuts in ministerial expenditure of 16.9 percent in Friday’s austerity budget — an even larger reduction than had been expected. Slimming the deficit from 8.5 to 5.3 percent will take 3 percentage points out of GDP — almost certainly putting Spain into a severe recession. The central government predicts a contraction in output of 1.7 percent for 2012, and some private sector economists say the fall could be steeper. If their fears are proved right, Spain risks falling into a vicious spiral of heavy losses in tax revenue, triggering public sector layoffs — which would depress tax revenue even further.

But some investors are even more worried by the contrary danger: the possibility that Rajoy’s ruling Popular Party will prove either unwilling or unable to make these cutbacks. 

Spain’s former prime minister, José Luis Rodríguez Zapatero, agreed with the EU to slash the country’s deficit to 4.4 percent this year, but Rajoy sent Spanish bond yields higher in early March by unilaterally announcing a change to a less ambitious target of 5.8 percent. The Spanish premier eventually hammered out a compromise of 5.3 percent with EU economic and monetary affairs commissioner Olli Rehn. However, Thursday’s well-attended general strike, called to protest the government cuts and deregulation plans designed to ease layoffs, underlines the countervailing domestic pressure on Rajoy to let the fiscal target slip.

Moreover, Spain’s politically powerful regional governments have a long tradition of resisting attempts by the Madrid regime to curb their overspending — particularly if the party in power locally is different from the party in office at the center. On Sunday, March 25, concerns about the Popular Party’s ability to control the public sector’s purse strings grew after it failed to win an overall majority in an election in Andalusia, Spain’s largest autonomous region.

The collapse of confidence in Italy’s sovereign debt last year came not, at heart, from a sudden worsening in the mathematics of the crisis, such as disappointingly poor data for unemployment or GDP. The real cause was a progressive loss of trust in the Italian political class to take decisive measures to deal with Italy’s debt. Analysts fear that Spain could face the same crisis of credibility.

The yield on the benchmark Spanish 10-year closed on Friday at 5.39 percent — up 41 basis points since the end of February, though broadly unchanged on the day.