Spain, Italy Face Continuing Risks

The following commentary comes from an independent investor or market observer as part of TheStreet's guest contributor program, which is separate from the company's news coverage.

By Marc Chandler

NEW YORK ( BBH FX Strategy) -- The more Spanish officials talk about the budget, the less credible it seems. The 10-year yield fell 11 basis points on Friday when the budget was first presented before the weekend. Now as more detail emerges as it goes to parliament, 10-year yields are rising.

The budget assumes that yields will remain around February levels. The 10-year yield averaged a little more than 5.10% in February. It averaged 5.20% in March. Yields rose in the second half of March and are now near 5.40%.

This raises alarms that Spain is underestimating its debt-servicing costs. Spain plans on selling as much as 3.5 billion euros of debt tomorrow with maturities ranging between three and eight years. Some concession ahead of the auction may also be a factor weighing on bond prices today.

On top of this, the problems of Spanish banks are likely to spill over and hurt the sovereign. As the banks address the rising nonperforming loan problems stemming from the real estate bubble, their appetite for Spain's sovereign debt may wane. Note that house and land prices are still falling.

Meanwhile, Spain reported Tuesday yet another increase in those registering for unemployment benefits. The March increase was 0.8% but is now 9.6% above year-ago levels and rising.

It may seem a bit ironic, but Spain does not report unemployment rates. The 23.6% unemployment rate in February is a calculation from the EU's stats agency. Spain has yet to cut its public sector work force, while the private sector continues shed workers. This seems likely to change.

Despite what has been advertised as the most austere budget since Franco, the real commitment of Spanish officials remains questionable. Last year's deficit was overshot by 2.5% of GDP.

To appreciate this magnitude, note that the Stability and Growth Pact required deficits to be limited to 3% of GDP barring unusual circumstances. Although these are unusual circumstances, the overshoot itself was large. Then Prime Minister Mariano Rajoy unilaterally loosened the target this year from 4.4% of GDP to 5.8%.

The EU fought a rearguard action and found what it appears to think is a face-saving compromise of 5.3%, which in effect accepts Spain's fait accompli. And today, The Wall Street Journal quotes the finance minister saying that the government is concerned that too much austerity will exacerbate the economic downturn.

One cannot help but to have sympathy for Spain's plight.

There are multiple questions -- and answers -- about the country's future.

If the question is whether Spain will achieve its new 5.3% deficit target based on current plans, the answer is that it's unlikely.

If the question is whether Spanish officials are committed to the kind of fiscal austerity that is entailed in the freshly signed fiscal compact, the answer is that it's doubtful.

If the question is whether the social strains and hardship will increase, the answer is most definitely yes.


Italy reported that the state sector deficit declined by about 10% to 28.2 billion euros in the first quarter. This was completed due to the results in the month of March.

Contrary to the conventional narrative about fiscal profligacy on the periphery, Italy's fiscal policy has been among the tightest in the eurozone as it is one of the few countries that can point to a primary budget surplus.

Italy has to run hard to stay in the same place, however.

The business association Confindustria warns that the Italian economy is likely to have contracted 1% in the first quarter. This takes away roughly 16 billion euros from GDP, the denominator of the deficit/GDP ratio.

The state-sector deficit, which is not even the most comprehensive measure of the deficit, only fell 3 billion euros. This is to say, if these numbers are fair representations, Italy's deficit-to-GDP actually rose in the first quarter.

Italian unemployment is also rising. In February, it rose to 9.3% from 9.1% in January and is at its highest level in more than a decade.

Whereas Spain has met about 45% of this year's funding needs in the first quarter, Italy has secured less than one-quarter. It is expected to be the eurozone's largest sovereign issuer.

Unlike Spain's Rajoy, Italian Prime Minister Mario Monti had a honeymoon, but it is over.

There has been increasing talk that Monti may not last until the term ends in May 2013.

His support rating is falling, and the municipal elections next month will be seen as a personal referendum

There is an attempt to dilute some of his reforms, such as the property tax.

In addition, since Monti unveiled his proposal for labor market reform, his support has waned and bond yields have risen.

The 10-year yield was 4.83% on March 19, the day before his proposal. It is now near 5.15%.

Although the labor reforms passed were approved by the cabinet, the fight in parliament will be ferocious. Even some who support the government will seek to dilute his reforms, which were already a compromise.

The business lobby wants Monti to submit the labor reform bill as a vote of confidence to limit debate and the risk of dilution. However, Monti chose to go the draft law route, rather than decree, which would have limited debate and been implemented immediately, suggesting a sensitivity to such a divisive issue.

The Spanish 10-year premium over Italy peaked near 41 basis points on the day Monti unveiled his labor reforms. The spread stands near 28 basis points now.

On balance, we suspect the downside risks for Spain are greater than those for Italy. That's because Spain's bubble has not completely deflated, and housing and land prices have yet to see a bottom.

That said, the fall of Monti or his labor reforms could produce a dramatic swing in market sentiment.

This commentary comes from an independent investor or market observer as part of TheStreet guest contributor program. The views expressed are those of the author and do not necessarily represent the views of TheStreet or its management.

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