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News Analysis: How bond markets' herd mentality is hurting Spain

By J Diaz and E Martin (Xinhua)

08:29, August 12, 2011

MADRID, Aug. 11 (Xinhua) -- Since the start of the public debt crisis in Europe, a new paradigm has emerged: public debt of developed countries with a stable currency is an asset that is no longer risk free. How long can Spain resist high spreads?

Some factors including public debt volume, future maturities, budget deficit and unemployment are objective. Other factors are harder to predict, as they depend on the speculator behavior, political decisions or intangibles such as investor confidence.

The fundamentals of Spain's financial situation are not as bad as markets make it seem. The Spanish treasury did its homework when the economy was growing, managing to reduce public debt from 62.3 percent of GDP in 1999 to 36.1 percent in 2007. In 2010, Spanish debt was 60 percent of GDP and is expected to close this year at around 67 percent.

Prestigious international firms such as the Center for Economics and Business Research said last Thursday that even in the worst-case scenario, Spanish public debt would not exceed 75 percent of GDP. Less pessimistic forecasts as the Brookings Institution Financial Times foresee a 65 percent debt-GDP ratio in 2016.

Another positive is that Spain has managed its financial issues with a clear objective: changing the structure of its debt to longer maturity bonds which allows it to issue less public debt in the coming years.

According to the treasury, Spain will have to issue bonds worth 88,900 million euros in 2012, 60,360 million in 2013 and 49,700 million in 2014.

Moreover, the adjustment process agreed between the Spanish government and the EU implies that its current 14 percent of GDP budget deficit has been reduced to 9 percent this year. This will be further reduced to 6 percent and 3 percent next year and the year after. This means that Spanish public debt will be stable, at the latest, from 2014.

These facts lead most experts to assert that the problem of Spain is not a solvency problem, but rather a liquidity constraint. Spanish public debt is not excessive. The question is whether Spain can continue refinancing it by issuing bonds to the markets in late 2011 and early 2012 -- which is the critical period.

Another advantage of starting with a pre-crisis level of debt much smaller than other countries is that Spain can better resist increases in interest rates. For example, let us imagine a scenario where there are average interest rates of 5 percent for public debts of Italy and Spain. For Italy, it will imply that the interest bill as a percentage of the GDP will be as high as 6 percent. This will mean that a substantial part of tax revenues will be used to service public debt.

However, with the same 5 percent average interest rates, the Spanish interest bill will only represent 3.5 percent of GDP.

Moreover, the likelihood of Spanish bonds actually having average interest rates of 5 percent is very low. The current burden of interest is low for Spain at 2.2 percent of GDP, even lower than the one paid by Germany or Britain. As future bond emissions will not represent all the debt but only a part of it, Spain can still resist increases in the spread of future emissions, much better than Greece, Ireland or Portugal did.

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