There have been signs of spring returning to debt-stricken Europe. Eurozone ministers in Brussels have this week signed off on the Greece bailout package. The International Monetary Fund will confirm its own contribution to the relief deal tomorrow. An agreement on bolstering the eurozone's bailout fund is expected later this month. The European Central Bank's €1trillion liquidity operation has averted the threat of a Continental banking crisis. Financial markets are calm. Some European officials are even daring to talk privately about a "turning point" in the long-running crisis. But in the corner of this encouraging scene, a dark, ominous cloud is growing. It is in the shape of Spain.
The Greek deal was the main topic of this week's Brussels meeting. But a close second was the problem of Spain's budget deficit. Last year Madrid's borrowing came in at 8.5 per cent of GDP, rather than the 6 per cent that had been expected. Spain had originally been tasked by Brussels with reducing its deficit to 4.4 per cent of GDP in 2012. But earlier this month the government of Mariano Rajoy announced that it would be unable to hit this target. Instead Rajoy announced a goal of 5.8 per cent of GDP, in what was seen as a direct challenge to his European partners.
At this week's Eurogroup meeting finance ministers hammered out a compromise. They said that Spain would not be expected to hit the original 4.4 per cent target this year. But Madrid would be expected to impose an extra 0.5 per cent of GDP in cuts – and the head of the Eurogroup, Jean-Claude Junker, stressed that Spain must not waver from reducing its deficit to 3 per cent of GDP by the end of 2013.
Spain is becoming the new front line in the battle over eurozone fiscal policy. Northern European governments are determined not to let the Continent's deficit reduction timetables slip. "We've got to be tough in the first round of monitoring so that everyone knows we're serious," said the Austrian Finance Minister, Maria Fekter, this week, referring to the new fiscal discipline pact agreed by eurozone ministers last December.
But struggling southern European governments are increasingly concerned that deep cuts to public spending at a time of recession will suck demand out of their economies and make their slumps deeper. "I don't think there is any doubt over Spain's commitment to budget adjustment efforts at a complex time" said the Spanish economy minister, Luis de Guindos, in Brussels.
"We are seeing a recession, not only in Spain, but also in Europe, and obviously the basic issue is to return to growth and get people back into jobs." In other words: do not push us too far.
Spain is certainly not coasting. It is already committed to €30bn euros of fiscal consolidation in 2012, despite the fact that the European Commission recently forecast that the economy will contract by 1 per cent this year, having previously projected growth of 0.7 per cent. This austerity includes a public sector wage freeze as well as higher taxes on income, savings and property. The pressure on the Spanish government from the street is increasing.
At the weekend, hundreds of thousands of workers protested against the Government's labour market reforms. A general strike has been called for 29 March. The unemployment rate has hit 23 per cent. Half of Spanish 16- to 24-year-olds are now out of work. The new labour rules, which most economists agree are necessary, will cut severance pay and make it easier to opt out of national pay agreements. But it is the cuts in spending that are causing alarm.
"Spain's disastrous unemployment rate and unresolved banking problems mean that even small cuts to public spending can trigger a downward spiral" said Sony Kapoor, of the Re-Define think tank. Some fear that spending cuts will deepen the Spanish recession, causing Spain to miss its deficit reduction targets again, and that the response of the Commission will be to come back to demand yet more austerity from Madrid. Nicholas Spiro of Spiro Sovereign Strategy warns that there is no chance Spain will be able to hit its deficit reduction targets this year.
"Spain is now faced with an almost insurmountable task on the fiscal front" he says. "It will not be able to meet the 5.3 per cent figure. It will be lucky to get anything under 6.5 per cent."
However, some take a more sanguine view of the road that Spain is being asked to travel. "Delivering the extra austerity and reining in the deficits will not be easy, but it should be doable" says Holger Schmieding, of Berenberg Bank.
He accepts that the additional cuts will "somewhat" deepen the recession, but forecasts that the country will nevertheless return to growth by the end of the year providing there is no external economic shock. Mr Schmieding argues that Spain does not have the extreme competitiveness problems of the likes of Greece and Portugal and that the country has plenty of scope to increase its exports.
"Spanish exports have risen slightly faster than those of the eurozone," he points out. "Spain had an import problem, not an export problem. [It] imported far too much while it enjoyed a party fuelled by a real estate boom".
Mr Schmieding also predicts that if the austerity medicine does serve to worsen the recession, Spain's European partners will not make the mistake of demanding yet more cuts. He points out that the wording of this week's European finance ministers' statement on Spain specifies the size of the required deficit reduction, rather than a new 2012 target for the Spanish deficit as a percentage of national output – something he says is a crucial distinction: "If an unexpectedly deep recession were to cause a fiscal overshoot, this implies that the Eurogroup may not ask Spain to offset such shortfall by extra austerity. If so, this would be huge progress. Reacting to fiscal shortfalls in a recession by asking for ever more new austerity had been the mistake that had derailed Greece."
Can it be true? Have hard line northern European ministers and disciplinarian Brussels officials truly seen the light and realised that excessive austerity in the eurozone periphery can be self-defeating? The answer to that question might determine whether the present calm in financial markets will last, or whether it is merely a pause before another fierce storm.
Debt: 162% of GDP
Growth forecast for 2012: –4.4%
Debt: 70% of GDP
Growth forecast for 2012: –1%
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