MADRID — Spain has become the latest country caught up in the government debt crisis crippling Europe, sparking fears that it'll join Greece, Portugal and Ireland and go asking for an international bailout.
Over the past week, investors have grown increasingly wary of buying Spain's debt on the international bond markets, sending the country's cost of borrowing to highs not seen in nearly four months and its stock markets plummeting.
In reality, worries about Spain have always been there. Bond market pressure on Spain began seriously to mount in 2011 as the country's deficit and unemployment rocketed. But late last year, two factors helped ease this pressure. First, Mariano Rajoy's right-wing and pro-austerity Popular Party took over the reins after winning general elections in November. But of much greater impact was the European Central Bank's decision to flood the region's financial system with more than €1 trillion ($1.3 trillion) in bargain loans to banks. The injection spurred lenders to snap up battered government debt, driving Spanish borrowing costs down. However, the effects of the cheap loans across Europe have since dissipated and Spain is taking the brunt of market distrust.
Rajoy's administration is faced with two big tasks: resurrect an economy with 23 percent unemployment through job creation while trying to reduce its deficit to satisfy EU overseers and international investors via austerity measures. To help them achieve these, the government has already imposed draconian spending cuts as well as introducing labor market and banking sector reforms.
Meanwhile, Spain's banks are saddled with huge amounts of toxic real estate loans and some of the country's regional governments have spent way beyond their means.
Rajoy has warned voters that Spain is in for a rough ride, acknowledging that things will get a lot worse before they get better. With one hand, the government is draining money from the economy as it tries to cut its deficit via austerity cuts. With the other, it is attempting to lay the foundation for a more efficient economy by, for instance, rewriting rigid labor laws to encourage companies to hire once Spain and Europe recovers.
The eurozone has recently increased the size of its financial firewall to help out its members should they fail to raise money from the markets. But Spain's €1.1 trillion ($1.45 trillion) economy is twice the size of the previous three bailout victims put together. Analysts are worried the eurozone's €800 billion firewall is not large enough to deal with the potential threats coming from Spain and other indebted countries such as Italy.
Here is a look at Spain's problems and what might be done to solve them.
__ RISING GOVERNMENT DEBT
Until recently Spain's national debt as a percentage of its economy did not look that bad when compared with other European countries. At the end of 2011, Spain's debt stood at 68.5 percent of gross domestic product, below the eurozone average of about 90 percent and in a different league from Greece at 160 percent.
But now that ratio is expected to shoot up. This is due largely to some of the country's 17 semiautonomous regions running up huge debts and thereby making the national figure look less manageable. It was overspending by some of these regions — Catalonia, Valencia and Madrid accounted for more than half of all regional debt last year — that made up more than a third of Spain's bloated deficit of 8.5 percent of GDPThat was well over the 6 percent which had been forecast.
The central government has guaranteed a €35 billion bank loan to help regions and town halls pay gardeners, medical suppliers and other businesses with long-outstanding bills. The economy minister says this loan is one reason why by the end of this year the national debt to GDP ratio will be around 80 percent.
After an austere budget unveiled in late March, Spain recently announced a new round of spending cuts designed to bring its deficit level down to 5.3 per cent of GDP. However, this has sparked concerns among analysts that if Madrid introduces more austerity measures, growth will be hit further and the country will even miss this target.
The bursting in 2008 of a real estate bubble that powered the economy for more than a decade has saddled banks, particularly Spain's savings banks or 'cajas', with enormous amounts of bad loans. The country's central bank, the Bank of Spain, says the sector is still burdened with about €175 billion in "problematic" real estate holdings.
As the second recession in three years bites further, bad loans are expected to surge while plunging house prices will lower the value of the vast sea of repossessed or unsold homes the banks already own.
The government has been pushing the lenders to strengthen their finances by merging. It has also introduced rules that require banks to set aside an estimated total of €50 billion more in provisions by the end of the 2012 to cover their toxic real estate assets.
Banks unable to raise extra capital on their own by the end of May must present plans for a merger. The government will help finance these tie-ups by offering loans from an existing bailout fund.
But one big fear is that if the plummeting real estate market takes too much of a toll on banks, the government would not have enough money to save the sector.
__NO EASY FIX
Spain's financial stability depends largely on whether it can borrow money from investors at affordable interest rates.
To help out Spain, the rest of the eurozone could promise to compensate investors against a first round of potential losses on Spanish bonds. That would make those bonds a safer investment and hopefully lower interest rates. Spain could also ask for more targeted loans from the eurozone emergency fund to, for example, fund bank rescues and then continue to foot the rest of its bills independently.
Given the limits of the eurozone's firewall, many analysts argue that the ECB is the only institution with the power to save large countries like Spain. The ECB could buy up hundreds of billions of euros worth of Spanish bonds from banks on secondary markets. This would lower the interest rates Madrid pays. But the ECB has so far insisted that such large-scale intervention would break the EU treaty. Alternatively, the ECB could launch another massive round of cheap loans to banks. But these loans do little to solve the underlying problems of the Spanish economy.
Above all this is the fear that investors would not want to lend money to Spain if it is seen to be teetering. Some analysts warn that admitting it needs help could quickly push the country all the way to a full bailout.
All eyes will be on Spain's next round of bond auctions — 12- and 18-month bills on Tuesday, and benchmark 10-year bonds on Thursday. The government has insisted that it will have no trouble financing itself this year and that auctions held so far have gone well. That was until last week, when an auction of medium-term debt hit the bottom end of what Spain was expected to raise and sent yields up and pushed the country firmly back into the eurozone debt crisis.
Gabriele Steinhauser contributed from Brussels.