Argentina forces Spain closer to the precipice

Assets seizure deals new blow as Madrid struggles with bond sale

When it rains in Spain these days, it truly pours misery. Argentina announced on Monday that it is planning to nationalise an oil company, YPF, in which a Spanish firm, Repsol, has a majority stake. Coming at a time when the government in Madrid has just rammed through the most severe budget since the death of General Franco, this must feel like an economic insult for Spain on top of already intolerable injury.

The Spanish government has promised an "overwhelming" response to the threat to Repsol's financial interests in Argentina and the country's Prime Minister, Mariano Rajoy, is in South America to gather support from friendly governments such as Mexico and Colombia.

The Spanish company's shares fell by as much as 9 per cent yesterday. European Commission President José Manuel Barroso weighed in, saying he expected Argentina to abide by agreements. "I am seriously disappointed about the announcement," he said.

Madrid summoned Argentina's ambassador, Carlos Bettini, as the dispute threatened to evolve into an all-out trade war. "With this hostility, there will be consequences... in the diplomatic field, in the industrial field and on energy," Spain's Industry Minister, José Manuel Soria, said.

But the bitter truth is that Spain is in no real position to win battles abroad. Preventing the roof from falling in at home over the coming months will be difficult enough. Spanish unemployment levels, which were painfully high even in the boom years of the last decade, are now comparable to those seen in America in the depths of the Great Depression. Some 23 per cent of Spaniards are out of work, and youth unemployment in Spain has reached an agonising 50 per cent.

And, most alarming of all, Spain's borrowing costs have jumped in recent weeks, raising the prospect of national bankruptcy. The yield – or interest rate – on 10-year Spanish debt rose above 6 per cent in trading this week as investors' doubts intensified about the ability of the Madrid government to avoid having to seek a bailout from its European Union partners and the International Monetary Fund.

There will be an important new test of market sentiment tomorrow when Madrid attempts to raise €2.5bn in a medium-term debt auction. If investors refuse to lend to the Spanish government, or will only do so at punitively high interest rates, the panic will increase.

The government wisely took the opportunity of the period of calm in capital markets earlier this year to issue half of the debt it needs to finance its spending this year. But Madrid still needs a further €40bn to see it through to the end of 2012. If medium-term Spanish interest rates rise about 7 per cent, analysts predict that Madrid will be unable to avoid following Greece, Ireland and Portugal, and collapsing into the arms of the fraying EU safety net.

So how did Spain get here? European policymakers, particularly German ones, claim that "excessive state spending" was the root of the eurozone debt crisis. But while that was true of Greece, it was not the case in Spain, where the government ran a budget surplus going into the 2008 global banking crisis. What has dragged Spain to the brink of collapse is a massive housing and construction bubble which exploded four years ago.

The country's banking system is its weakest point. Last month Spanish banks were forced to borrow €316bn euros from the European Central Bank (ECB) because they could not raise credit from other European banks. Analysts estimate Spanish institutions to be sitting on unrecognised losses to property companies of up to €100bn.

Worse, the fates of Spain's weak banks are now entwined with the fate of the government in Madrid. The ECB flooded the European banking system with liquidity in December and February. Spanish banks used the cheap ECB loans to buy up Spanish government bonds, driving down Madrid's borrowing costs. But now, with sovereign interest rates up and fears rising about the health of Spanish banks, that virtuous circle has turned vicious. The more investors panic about Spanish banks, the more they panic about the Spanish state, and vice versa.

Can Spain make it without seeking help from abroad? That depends on whether Spain can regain the confidence of investors and generate the growth it requires to soften the impact of the austerity blows in store. The government plans to reduce its budget deficit from 8.5 per cent of GDP in 2011 to 5.3 per cent by the end of the year. To achieve this, it has outlined spending cuts and tax rises, over one year, adding up to €27bn.

But markets are waking up to the fact that all this austerity could prove self-defeating, sucking demand out of the economy as public-sector workers are laid off, taxes go up and government investment programmes are shelved. According to the IMF, the Spanish economy will contract by 1.8 per cent this year. That will push record unemployment and general misery still higher. Desperate though the Spanish population might already feel, the country's economic trials are only just beginning.

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