Europe's Leaders Face a New Crisis in Spain

Just as the euro had begun recovering from the Irish crisis, another financial crisis has emerged in Spain.
Just as the euro had begun recovering from the Irish crisis, another financial crisis has emerged in Spain.

As European leaders begin a two-day summit Thursday, a new crisis is brewing in Spain that could threaten the stability of the euro.

U.S. ratings agency Moody's Investor Service on Wednesday placed Spain's government bonds on review for possible downgrade. In late September, the agency already had downgraded Spain's bonds from the top rating of Aaa to Aa1, a notch lower.

Moody's analyst Kathrin Muehlbronnr said that while she didn't think the country was having a solvency crisis, the fact that it has to raise $226 billion next year, plus an additional $40 billion for regional governments, "make the country susceptible to further episodes of funding stress."

The news sent the euro plummeting against the U.S. dollar to $1.321, down from $1.42 as recently as November, just as the currency had begun to recover from the crisis over Ireland's banks. That debacle forced the Dublin government to take a $113 billion bailout from the European Union and the International Monetary Fund (IMF). The Irish parliament approved the deal Wednesday.

Talking Points

Ministers meeting in Brussels on Thursday will be discussing whether to increase the European Commission's $1 trillion bailout fund to help Portugal and Spain through their financial crises, an idea that Spanish Economy Minister Elena Salgado supports.

Arturo Bris, a finance professor at the International Institute for Management Development in Lausanne, Switzerland, says Spain's immediate problem isn't that it can't repay its government debt -- which was the problem that Greece faced in April -- but is instead a problem of refinancing.

Bris noted that Spain's debt-to-GDP ratio is only 65%, way below that of the U.S., which has a debt-to-GDP ratio of 120%. But Spain borrows 50% of its funding abroad, and it must raise that money at bond auctions where international markets control the interest rates.

For example, Bris says, at an auction Tuesday, Spain had to pay 4% interest on one-year government bonds, an extraordinarily high level for sovereign debt from a European country. In contrast, one-year U.S. Treasury rates are around 0.29%.

"There is not a danger Spain will not be able to honor its obligations," Bris says. "The danger is that now, when Spain goes to the Treasury auction, financial markets won't be willing to provide financing because they don't believe in the process of the economy."

New Deal for Spain?

Bris believes Spain will be forced, much as Ireland was, to take either a bailout or announce a drastic reorganization of the economy. Northern-tier European countries, such as Germany, like to keep pressure on the peripheral countries because that tends to drive down the euro's value, helping European exporters sell abroad, he says.

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For example, when the euro started rising last month after the resolution of the Irish crisis, German Chancellor Angela Merkel announced that in the future, bondholders would have to share in the losses of any European government bonds that need to be refinanced. That news sent markets tumbling again, Bris points out.

In Athens, an outbreak of civil unrest showed the dangers that Europe faces if the debt crisis isn't resolved soon. Protests broke out against the new cuts in government services mandated by a reform package with the EU and the IMF. Protesters fought running battles with police, and the nation endured its seventh general strike of the year, grounding flights and halting most public transportation.