It’s easy to picture the grim surprise that Spanish officials must have had when they learned on Monday that interest rates on the country’s 10-year bonds were going up again. They had an even worse shock on Thursday, when that same yield crossed the critical 7% line beyond which it is virtually impossible for a country to service its debt. After all, market pressure had just forced Spain to accept a rescue package for its troubled banks and surely, those officials must have believed, 100 billion euros would buy at least a little respite. Instead, they got one of the worst weeks in Spain’s economic history, and one that bodes poorly for the country’s — and Europe’s — future.
In the six days since Spain requested a bailout that for months its government insisted it would not need or take, Moody’s has downgraded the country’s debt rating to one notch above junk. The Bank of Spain released figures today showing that public debt has doubled in the past four years, from an admirable 35.5% of GDP in 2008 to a worrisome 72.1% in the first quarter of this year — the highest rate since 1913. Worst of all was the risk premium on Spanish debt (the spread between Spanish bonds and the safer German ones), which on Thursday reached a historic high of 550 points.
At least one Spanish economist says he saw it coming. “I said on Sunday that this was going to happen,” says José Luis Peydro, a professor at the University of Pompeu Fabra. “It was logical that the risk premium would go up once it became clear that Spain didn’t get as good a deal as it could have.”
Although the exact terms of the deal are still being worked out, Spain did not get, for example, the direct injection of European funds into its banks that it wanted. That would have allowed it to avoid adding the loan to its debt tally. And several European authorities suggested that the money would come from a European fund that gives the E.U. seniority over private investors — essentially guaranteeing that if Spain could not meet all its debts, the E.U. rather than the private concerns would be paid back first. All of that has helped erode what little confidence the market still had in Spain.
The government’s handling of the rescue so far hasn’t helped matters. It has refused to call the package a bailout, referring to it instead as a “loan,” “a line of credit” and, in Prime Minister Mariano Rajoy’s euphemism of choice, “what happened on Saturday.”
The government has also made statements about what happened on Saturday that have since been contradicted by European officials. When he announced the package last week, Finance Minister Luis de Guindos said it would be issued “without conditions” on the government. It didn’t take two days for German Finance Minister Wolfgang Schaüble to correct him, noting that “there will be a troika [made up of the European Commission, the IMF and the European Central Bank] that will be in charge of precisely monitoring that the terms of the program are fulfilled.” Joaquin Almunia, who is the vice president of the European Commission and also a member of Rajoy’s Popular Party, was blunt: “Of course there will be conditions.” And indeed, on Friday afternoon, the IMF urged Spain to cut civil-servant salaries and raise its value-added tax now rather than waiting until 2013 as planned.
Although this strategy appears designed to allow Rajoy and his ministers to save face after insisting, as recently as May 25, that “there will be no bank bailout,” it has had the opposite effect, enraging many citizens who believe their government won’t tell them the truth. Outside Spain, it has annoyed European officials who now have to contend with other rescued countries, namely Ireland and Portugal, demanding similar treatment. “I don’t think these are calculated positions with [Rajoy] so much as him putting his foot in his mouth,” says José Ignacio Torreblanca, senior research fellow at the European Council on Foreign Relations. “Often it’s hard for politicians like Rajoy who have spent a lot of time in the opposition to rid themselves of the logic that what matters most is the party. But now that he’s Prime Minister, he has to realize that his audience is broader and more diverse. What works for his base isn’t necessarily going to work for a member of Parliament in Germany.”
And yet for all its mistakes or tactics, Spain has had few options. Its government has made many of the structural reforms Europe has demanded, only to find that these don’t convince the markets because they fail to stimulate growth. “The European Union has a strong incentive to blame Spain, because that way it can distract attention from the fact that the overall strategy has failed,” says Simon Tilford, chief economist at the London-based Centre for European Reform. “There’s no doubt that the Spanish government has made mistakes, but it’s increasingly being put in an impossibly difficult position.”
In other words, Spain is once again on the precipice, teetering between being forced to take a second bailout — this time for its rapidly accumulating sovereign debt, with all the conditions that will entail — or being forced to abandon the euro. And while the E.U. may be prepared — or so it says — for Greece to exit the euro zone after its elections on June 17, it’s not at all clear that it could withstand the exit of its fourth largest economy.
So what are Spain’s options? One would be to renegotiate the terms of Saturday’s bank bailout, which, after all, have yet to be set in stone. “Agree to more conditions, give the European Union the oversight and guarantees it wants, but get direct recapitalization of the banks and rethink seniority,” says Peydro. “Make the first rescue more appealing to the markets, or there’s going to be a second one.”
The other option, and the one that nearly everyone outside of certain Northern European countries is pressing for, is to achieve greater banking and fiscal union among the euro-zone member states. Rajoy has, in recent weeks, been advocating heavily for this option. “The European Central Bank is the only institution that can dispel investor fears, and Rajoy is right to argue that going forward, you need an activist bank that backstops debts at the euro-zone level,” says Tilford. “Compare the situation with the U.S.: the collapse of AIG did not bankrupt Delaware, whereas the collapse of the Irish Bank basically resulted in the insolvency of Ireland.”
Even if the euro zone were to agree to greater unification, significant problems would remain. Among other obstacles, each country would have to ratify — sometimes through referendum, sometimes through parliament — the changes, and it’s not at all clear that the Spanish, or for that matter, the Italian, economy can wait that long. But according to Torreblanca, there’s no other choice. “The good thing about the future is that it’s not predetermined,” he says. “It’s not too late to save the European project. Its leaders have the knowledge. The question is whether they have the will.”