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Smooth sailing now for Spain debt, horizon cloudy

Source: Reuters - Thu 15th Apr 2010

Spain is unlikely to be punished by markets this year despite soaring debt levels, but risks being stung in later years if deficit goals are missed as growth falters.

The country is sometimes seen as one of the peripheral euro zone members that could be hit by a funding crisis like the one the recently crafted EU/IMF loan deal has addressed in Greece.

However, Spain has managed to assure markets for now that it has a credible plan in place to cut its budget deficit from above 11 percent of GDP last year to 3 percent by 2013.

Its relatively low level of public debt as a share of GDP in comparison to European peers has helped the Socialist government gain some credibility for its deficit-cutting plans.

But that could fade fast if growth stalls as many economists expect or the government fails to enact much-needed economic reforms.

"The market is recognising the difference between Greece and Spain and the credibility the Spanish government has got. That's why we've seen a stabilisation but I don't think problems are over for Spain or the periphery" said Silvio Peruzzo economist at Royal Bank of Scotland.

The spread between Spanish and euro zone benchmark debt has fallen to around 66 basis points after hitting 110 back in February, less than one-fourth of the 462 bp peak set last week by Greece before the EU aid package was decided.

Although analysts expect Spain will have little problem meeting its 76.8 billion euros financing requirements this year, they will maintain a sharp look-out on actual economic growth and on economic reforms. 

Both will be vital for the government to stay on course for cutting the deficit over the next few years.

"The market will probably question again the medium-term feasibility of the fiscal consolidation programme because the outlook is not bright at all" Peruzzo said.

The European Commission said in a report in March that Spain's target of cutting its deficit to 3 percent by 2013 was based on "markedly" over-optimistic growth forecasts after 2010.

For 2011, Spain says the economy will grow by just under 3 percent. Economists, ratings agencies, the International Monetary Fund and even the Bank of Spain forecast the economy to face a much bleaker outlook. The latter sees GDP up 0.8 percent.

With no dynamic return seen for the construction sector, which powered a decade of growth, Spain must raise exports and look to new areas such as renewable energy to boost growth.

KEY LABOUR REFORM

But developments hinge on key reforms. While Spain has partly passed a package of anti-crisis measures, many say it has side-stepped making the labour reforms needed for the economy to grow and cut unemployment now close to 20 percent.

Javier Perez de Azpillaga at Goldman Sachs said the key for Spain could be to loosen a tough wage regime, even cutting wages by just 1-2 percent.

"The sooner it's accepted that that rigidity is at odds within a monetary union like EMU, the sooner the recovery will start in earnest, the smaller the output losses, and the more transient the damage to the economy's potential" he said. 

In ongoing talks with unions, Spain's government proposed on Monday cutting the cost of sacking workers in a move designed to make the labour market more flexible.

The plan, that aims to grant new hires 33 days' pay for every year worked if they are sacked versus the 45 days paid now, left workers representatives wary.

At the same time many analysts remain critical about the government's 50 billion euro austerity package, and on a 2 percentage point VAT rise, urging the country to take more painful measures to slash wages - something seen as non-negotiable by government and labour unions alike.

Ramon Tremosa, lecturer in economics at the University of Barcelona and an MEP, drew a more pessimistic conclusion than other analysts and said Spain will face funding problems this year.

"I would say there's a two-in-three chance Spain will have serious problems financing its public debt in the autumn."

He said the picture would be worsened by tough credit conditions for businesses, and high private sector debt, and forecast the economy to contract in coming quarters, hindered further by the rise in VAT to 18 percent from July.

So far Prime Minister Jose Luis Rodriguez Zapatero's hold on his Socialist Party is strong despite a testing recession.

But criticism has mounted over his leadership, including from former PM Felipe Gonzalez. Many remain unconvinced of Zapatero's ability to handle the crisis, though a general election is not due until 2012.

"The government is not preparing people for the blood, sweat and tears to come - a long period of price and wage deflation and a purge of real estate-related debt by the banks" said Tremosa. 

He said the fact that Zapatero had not made sharp spending cuts like Ireland's would end up costing Spain dear. But Zapatero reiterated in a recent interview that the government is committed to do whatever is needed.

"We have a plan, a credible and quantified plan, which we have already begun to implement" Zapatero told the Financial Times. "If we have to make more cuts or demand more austerity then we will do it".

But cuts risk weakening further an already fragile economy.

For 2010 Spain's refinancing requirements for 2010 are down 34 percent from the 116.7 billion euros issued last year and so far this year bond auctions have fared well, with the last auction of three-year debt 1.8 times oversubscribed.

Analysts said a low average maturity date of close to seven years made it comfortable for the Treasury to service its needs this year.

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