Spain has plunged into what its foreign minister calls a "crisis of huge proportions," sparking speculation as to when, not if, its banks will need a bailout.
Its fiscal and economic situation continues to deteriorate, highlighted this week by a downgrade from Standard & Poor's and fresh data showing almost one in four people out of work.
Spain is in its second recession in three years following the 2008 bursting of its housing bubble, The economy has structural issues that make it uncompetitive, disposable income is shrinking and the private sector is de-leveraging. After blowing past its deficit targets last year – largely due to out-of-control spending by semi-autonomous regions – the new government of Prime Minister Mariano Rajoy is slashing spending, trying to chop the budget deficit to 5.3 per cent of gross domestic product this year, and 3 per cent in 2013.
Few believe Spain can achieve that, leading to declining bond prices in recent weeks. And while reduced spending will cut the deficit, it could also weigh on economic activity. As the economy shrinks, the government could face an unpalatable choice between worsening credit, or weaker output if it has to cut further.
"In our view, the strategy to manage the European sovereign debt crisis continues to lack effectiveness," said S&P, which cut Spain's rating by two notches to triple-B-plus, citing rising risks to the country's fiscal performance and debt burden as its economic performance fizzles.
"Credit conditions, and hence the economic outlook for Spain, could now deteriorate further than we anticipated … unless offsetting euro zone policy measures are implemented," said the agency, which projects GDP will shrink both this year and next.
The S&P downgrade was followed Friday by even bleaker news: Spain's unemployment rate, already the highest in the 17-country euro zone, worsened in March, hitting a record 24.4 per cent. More than half of Spain's youth is out of work – and 5.6 million people in total – after 374,000 jobs vanished in the first quarter. Unemployment "will likely worsen until a sustainable recovery sets in," S&P said.
"The figures are terrible for everyone and terrible for the government," Foreign Minister Jose Manuel Garcia-Margallo said in a Spanish radio interview. "Spain is in a crisis of huge proportions."
A weakening economy also presents challenges for Spain's listing banking sector. Continued weakness in the housing sector will lead the banks to take larger loan-loss provisions, which could trigger the need for another bailout.
Spanish banks already carry their biggest burden of bad loans in 18 years; this past week, Spanish bank Santander took $1.3-billion in losses on properties, while BBVA said it would take writedowns later this year.
"It's very likely the government will need to provide more support for the banking system," said Martin Schwerdtfeger, a senior economist at Toronto-Dominion Bank.
The government is unlikely to finance a bailout itself given its precarious finances, but would likely turn to one of the two European bailout mechanisms to establish a "precautionary lending line," a sort of line of credit, for its banks, said Gusavo Bagattini, European economist with RBC Dominion Securities. "You'd have to see a bigger deterioration in the bond market before the government would consider this," he said.
Economists say the bailout bodies – the European Financial Stability Facility and the European Stabilization Mechanism – could probably support a Spanish bank rescue, but wouldn't be able to afford to do the same in Italy if its fiscal situation worsens. "If both request a bailout, those structures will unravel," Mr. Schwerdtfeger said.
The Spanish government is expected to tell its banks to move all real-estate assets into a special holding company, after past efforts to get its banks to fix its own problems have had little effect.
Benjamin Reitzes, a senior economist with BMO Nesbitt Burns, said that if Spain "can get through the next 12 to 18 months and the economy turns modestly positive, that would be enough to get them going in the right direction. But 12 to 18 months is a long time. They need consistent, meaningful growth for a consistent period. That will be tough to come by. It's going to be a long road for Spain, and for Europe."
With files from Reuters