Rejection of further austerity leaves Spanish bailout in limbo

Spanish PM Rajoy has made no secret of his aversion to EU-dictated austerity measures in return for a bailout. The financial markets and Germany in particular are demanding further Spanish cuts but Rajoy’s response last week was; “"I will look at the conditions but I would not like, and I could not accept, being told which were the concrete policies where we had to cut." His country's economy is already in shreds after a July austerity-drive. 

Thousands of angry Spaniards marched in protest in Madrid over the weekend, demanding a referendum to decide on the government’s measures. Tensions and unrest in the country are at such levels now that Spanish finance minister Luis de Guindos has responded by ruling out further spending cuts. He said “Spain's existing measures are significant and ambitious enough” to meet the EU’s target of a budget deficit that 3.0% of GDP by 2014. It is common knowledge that Mr de Guindos is quite incorrect in saying this, and he well knows it, but it is in his country’s interest to keep up the charade.  

But where does this leave Spain with respect to the European Central Bank? Whilst the market went wild for the ECB bond-buying plan just over a week ago, the fact remains that Spain must officially request a bailout if it is to benefit from the plan. It will not do so if Germany’s demands are too onerous.

The announcement of the ECB’s bond-buying plan has bought Spain a little bit of time by bringing borrowing costs down, coming way down from the 7.0% level (10-year debt). Nonetheless, yields are back on the rise and the clock is very much ticking. Deposits are being withdrawn from Spanish banks at an alarming rate amid the current crisis of confidence, which will necessarily constrict the banks’ ability to support much-needed economic growth with lending.  

In an indication that Spain is edging towards a bailout request, it has pledged to unveil a reform programme on September 28, which will include clear deadlines and intended structural changes. We are still in the dark over bailout terms though and this is likely to be a huge source of uncertainty in the coming weeks. 

And how has the euro started the week? Well its rally has stalled, as it consolidates on last week's hefty gains. However, the market euphoria with respect to the ECB pledge to flash the cash and the Fed's decision to pull the trigger on QE3 may well give the euro further support in the coming sessions. 

Richard Driver

Currency Analyst

Caxton FX