Spain’s 'lose-lose' struggle reignites euro crisis

The eurozone crisis has returned with a vengeance after Spain’s mounting woes pushed 10-year bonds yields back to the danger line of 6pc and the Madrid bourse crashed to its lowest level since the 2009

http://www.telegraph.co.uk/finance/comment/ambroseevans_pritchard/9196551/Spains-lose-lose-struggle-reignites-euro-crisis.html

8:39PM BST 10 Apr 2012

By Ambrose Evans-Pritchard

Markets took no notice of fresh austerity pledges from premier Mariano Rajoy, including new cuts worth €10bn in health and education - seen as a belated move to salvage Spain’s credibility after a spat with Brussels over fiscal slippage.

Mr Rajoy said the bond attack should dispel the illusions of those who think Spain can muddle through without serious austerity. "Markets can decide to lend or not to lend, and they can do so at a rate that is affordable or not," he said.

The country’s borrowing costs have jumped 100 basis points since February, when the European Central Bank last flooded banks with liquidity under its three-year lending scheme (LTRO). "The LTRO was supposed to be the game changer but the stimulus has worn off. It looks like it is falling apart at the seams," said the Suki Mann from Societe Generale.

A disastrous debt auction last week was taken as a sign that Spanish banks have exhausted their LTRO money and can no longer prop up the Spanish state through this back-door funding, leaving the country nakedly exposed. Other buyers are scarce after the EU imposed a 75pc haircut on investors in Greece.

Finance minister Luis de Guindos confirmed that Spain has tipped back into recession, with a 0.3pc contraction in the first quarter. He expects the economy to shrink by 1.7pc this year, though Citgroup said it could be much worse. Unemployment is already 23.6pc.

Mr de Guindos said Madrid faces a "lose-lose situation" since markets will punish excessive austerity as harshly as too little austerity. Tightening too fast risks pushing the economy into the sort of self-defeating spiral already seen in Greece, where the tax base shrivels.

Central bank governor Miguel Ángel Fernández Ordóñez denied that Spain would become the fourth EMU state to need a rescue, but warned that Spanish banks are not yet in the clear. "If the Spanish economy deteriorates more than expected, they’ll have to keep boosting capital," he said.

The Madrid bourse fell 2pc, led by banks. Short positions on Banco Santander jumped to 11.12pc of the total share base. Funds have built an extra 237m short positions in the past week alone.

Professor Jesus Fernandez-Villaverde from Pennsylvania University said the fiscal austerity imposed by the EU is deeply misguided. "Trying to cut the deficit from 8.5pc to 3pc in two years during a recession is a recipe for disaster. The Germans are crazy," he said.

He said wage cuts and internal devaluations may have restored competitiveness in the Baltic states, but it is doomed to failure in a complex country like Spain where there no national consensus on what needs to be done. "We have two trade unions in Spain that still live in the 19th century," he said.

The Rajoy government has made matters worse by cutting public investment without tackling deeper structural problems. "Markets are not stupid. They can see that he is pushing problems down the road," he said.

Critics say Mr Rajoy has created a small disaster for himself. His fight with the EU ensures that the ECB will exact a high price before stepping in to back-stop the Spanish bond markets. Investors will stay well clear of Spanish debt while this battle over moral hazard unfolds.

Prof Fernandez-Villarde said Mr Rajoy would have done better to avoid an EU fight by issuing a promise that he had no real intention of keeping - the "Italian way" - or going for broke by defying the EU altogether.

"I think he should have done what David Cameron did and told them where to go," he said.