Spain is in a deep economic and financial hole. Unemployment exceeds 23 percent and Madrid has missed targets to reduce its gaping budget deficit.
With yields on Spanish government bonds back around 6 percent, many pundits reckon a humiliating international bailout beckons to rescue a banking system weakened, like the economy, by a burst housing bubble.
Such an outcome is not inevitable. A charitable explanation puts the renewed loss of market faith down to political miscalculation and poor communication by a novice government.
Confidence could return if Prime Minister Mariano Rajoy's medium-term strategy to reduce public debt and deficit and shore up the banks is seen as credible. After all, external adjustment is well under way: Spain's current account is shrinking and falling labour costs are boosting exports.
Deutsche Bank economist Gilles Moec cited Monday's announcement of plans to cut 10 billion euros in health and education spending as evidence that Rajoy, who took office in December but did not unveil a budget until end March, was making up for lost time.
“We've seen more progress in a few days than in four months,” Moec said. Spain was neither facing an emergency nor incapable of reform. “It's a country that's intrinsically sustainable, but it's a country that needs to make decisions.”
POLITICAL SUPPORT
Rajoy has two things in his favour as he strives to placate demanding, volatile markets.
For all its early missteps, the government has made good use of the European Central Bank's generosity in providing euro zone banks with 1 trillion euros in cheap three-year loans. Spanish banks, like their counterparts in Italy, soaked up the money to cover their own short-term maturing debt and to buy their governments' bonds.
So Madrid has already met 45 percent of its borrowing needs for the year, winning time even as the burst of bond buying by domestic institutions ties the financial fate of Spain's banks ever more closely to that of the sovereign.
“Spain is moving very much in the right direction,” a senior euro zone policymaker said. “They might have done some things earlier, but there is still time because they have no immediate financing needs. They have a few months.”
Second, Rajoy enjoys the political support of his euro zone partners - despite some sniping from Italy, which blames its own rising bond yields on Spain's policy fumbles.
Germany, the euro zone's paymaster, went out of its way this week to express regret that markets were not recognising Spain's efforts to overhaul its economy and regain competitiveness.
Madrid says markets should give the reforms time to work. These include new labour market rules beyond many economists' expectations; a further round of bank restructuring with drastic writedowns of bad assets; and a law that will punish regions which do not meet deficit reduction targets.
A senior government source said Spain knew it was in the spotlight and would not be panicked by the spike in bond yields but rather would stand firm and wait for the reforms to bite.
“We have to tie ourselves to the mast and ignore the siren song,” the source said.
BANKING STRAINS
But what if the reforms do not bear fruit quickly and market confidence does not return?
Spain projects its economy will contract 1.7 percent this year as it compresses domestic demand to wrestle its budget deficit down to 5.3 percent of GDP from 8.5 percent in 2011.
Most economists say the risk is that output will shrink even faster, putting the 2013 deficit target of 3.0 percent of GDP well beyond reach and disenchanting investors.
Much will depend on the speed at which house prices, which have dropped 22 percent from their 2007 peak, continue to fall. The experiences of the United States and Ireland with housing booms and busts suggest they have a long way to go.
Loan default rates are already at an 18-year high and still-rising unemployment may trigger more mortgage defaults, making the outlook for Spanish banks bleak.
The government's strategy is to force lenders to set aside an extra 50 billion euros in provisions for real estate loan losses and encourage more rapid consolidation of the sector.
Prospects for a fresh infusion of private capital are poor. No suitor has stepped forward for Bankia , a large bank whose bloated real-estate loan book is under particular market scrutiny.
Yet central bank and government officials are adamant that no state aid will be required and that they have the funds to deal with any failures. Spain's Deposit Guarantee Fund, they argue, can be recharged if need be with up to 20 billion euros through government-backed bonds or loans from healthy banks.
Javier Diaz-Jimenez, an economics professor at IESE Business School in Madrid, said the government was deluding itself.
“Whatever solution they opt for is going to need a lot of capital - 50, 100 billion euros, who knows how much? - and it can only come from outside Spain,” Diaz-Jimenez said. “Right now, the sovereign is unable to put up even 20 billion euros.
“The Spanish banking sector is bankrupt, and if it's not bankrupt it appears bankrupt. And if it appears bankrupt it cannot get funding at a reasonable price on the international markets,” he said.
RANGE OF OPTIONS
This goes to the heart of market worries that an already over-indebted state will ultimately have to pay for the bank clean-up. Central bank governor Miguel Angel Fernandez Ordonez fanned those concerns on Thursday, saying banks could need more capital if the economy deteriorates.
The senior Brussels policymaker expressed surprise because he saw no large immediate needs for capital, while a high-level official in Madrid ruled out tapping the euro zone's bailout funds - the existing European Financial Stability Facility or the embryonic European Stability Mechanism
Nevertheless, speculation about some sort of external loan has intensified due to the surge in bond yields.
Economists at Citigroup expect Spain to need a bailout this year. They see a gamut of possibilities, ranging from a full-blown loan-for-reforms programme - similar to those for Greece, Ireland and Portugal, overseen by the European Commission and the International Monetary Fund - to a contingency credit line with more or less tough conditions attached.
“The trigger could be loss of market access on affordable terms, but is more likely to be that the ECB makes some form of a programme for the Spanish sovereign a condition for it to continue to fund the Spanish banks, which are currently the main buyers of newly issued Spanish sovereign debt,” Ebrahim Rahbari and Guillaume Menuet wrote in a report.
Talk of the role played by the European Central Bank in tackling the euro zone's woes touches a raw nerve.
By providing unlimited three-year loans, ECB President Mario Draghi proved his determination to prevent panic over sovereign debt levels from mutating into a full-scale credit crunch. The risk of a euro zone bank collapsing like Lehman Brothers in 2008, for lack of funds in the wholesale market, has faded.
But the ECB believes it has played its part and it is now up to Spain and other governments to help themselves with reforms. “Markets are asking these governments to deliver,” Draghi said last week.
ECB policymakers say privately they are concerned by Spain's deficit and frustrated by the government's policy response. But they believe the problems can be fixed by firm action and that Spain can pull through without applying for a full bailout.
ECB TENSIONS
ECB Executive Board member Benoit Coeure floated the idea on Wednesday of helping Spain by reviving the ECB's Securities Market Programme (SMP).
The central bank has bought 214 billion euros worth of euro zone bonds on the secondary market since May 2010 to hold down yields but none in seven of the past eight weeks.
Any move to reactivate bond-buying would meet resistance from Germany's Bundesbank, which regards the SMP as breaching European rules prohibiting the ECB from financing governments.
Another option weighed in Frankfurt and in Brussels would be an EFSF/ESM loan to recapitalise the banking system.
Despite the ECB's reluctance to be seen doing the job of governments, the bank might be forced to act in an emergency given the time needed to get EFSF/ESM interventions off the ground, said David Mackie, an economist at JP Morgan in London.
“We're not sure whether any of these external interventions will be needed. It depends whether sovereign yields keep rising and whether funding stress spreads to the banks. But we have no doubt that the support will be there if required,” he said.
The ECB has not been shy about using the stick as well as the carrot to prod governments into action.
When former Italian Prime Minister Silvio Berlusconi failed to keep his reform promises, the ECB scaled back SMP purchases of Italian bonds, allowing yields to rise to punishing heights and indirectly precipitating Berlusconi's resignation.
The lesson for Spain, from that episode and from the recent spike in yields, is that Rajoy's government cannot afford to squander its support and credibility.
It cannot take a policy breather, as it did by postponing its maiden budget until after regional elections in Andalusia in late March. It must also learn from mistakes - notably its unilateral decision to scrap the 2012 budget deficit reduction target the previous government had agreed with the Commission.
A lot will depend on performance in the months to come. The government will have to hold the line on spending as recession deepens, and face down powerful regional politicians who do not want to tighten their purse strings.
One EU official said domestic politics could be difficult for the next few weeks - a recipe for more nervousness in the markets. But he was also hopeful that the results of the reforms would start to show up as the year unfolds.
“I am quite confident about Spain. I wasn't so much a few weeks ago, but now I think things are on the right track,” he said. - Reuters