How to profit as markets panic over Spain

Of all the European countries, Portugal and Greece have received the most negative attention. Things are certainly grim, particularly in Greece, where suicides and petrol bombings are regularly hitting the headlines.

However, the duo may not be the first to leave the euro. That honour could go to Spain.

As the market has recently remembered, Spain also has huge problems. High levels of debt as well as a vicious recession - have pushed it to crisis point.

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In the past few days, bond yieldshave started to rise as fears grow that Spain might need extra help. The head of Spain's central bank, Miguel Angel Fernandez Ordonez, has also stated that the country's banks might need more capital.

Can Spain stay in the euro? If not, how can you act to protect your wealth?

Spain's public debt picture isn't so bad but it's deteriorating very rapidly

The key thing about Spain is that it has deceptively low levels of public debt: net government debt is less than half of GDP.

However, a chronic deficit (in other words, the government is currently spending much more each year than it gets in tax) combined with a high likelihood that the Spanish banking sector will need to be bailed out, is expected to change this quickly.

The fact that a large amount of debt is coming due in the next few years also means that Madrid will need to refinance (roll over' its borrowings) at a time when demand is very limited and interest rates are high.

The fact that Spain found it hard to find buyers for its sovereign debt in last Thursday's bond auction, barely meeting its minimum target, is a sign of things to come. Lombard Street Research thinks that even with a large amount of external support and low interest rates, state debt will reach 112% of GDP by 2015.

The high levels of private debt also mean that households will be cutting spending at the same time as the government is trying to keep the budget under control. This will hit demand and make the recession even worse.

That's bad news given that Spain's economy is already in a grim state. Industrial output in February was down 3% on a year ago. Seasonally adjusted retail sales were down 6.4% in real (ie adjusted for inflation) terms.

Meanwhile, the construction industry, a major part of the economy, is in free fall. The number of housing permits issued in January was down by a quarter year-on-year. The number of mortgages taken out was also down by more than 40% in the same period.

The European Central Bank may act too late

There have been hopes that the European Central Bank (ECB) will intervene again to push down bond yields, either through buying more bonds, or lending money to banks to do so.

However, Mario Draghi, head of the ECB, said last week that "national policy-makers need to fully meet their responsibilities to ensure fiscal sustainability". He also suggested that "prudent fiscal policies are of crucial importance for the functioning of the euro area economy".

As Capital Economics points out, this means that "any lingering hopes" of action, at least in the short term, "were surely put to bed".

Of course, as my colleague John Stepek points out, the ECB will eventually have to change its mind, since another round of QE is quickly becoming the only plausible option. But German pressure means that it may well come too late to keep Spain from leaving the euro.

How to avoid any Spanish fallout

So what is the best way to play the current situation? One share that you should avoid is Santander (LSE: BNC), the largest bank in Spain. In our look at Portugal last month, we pointed out that it has a large exposure to the sovereign debt of both countries. This means that it will surely be hit badly by a Spanish default.

Also, watch out for Spanish-issued euros. That might sound a little paranoid, but one of the serious proposals for a recent high-profile competition to find a relatively painless exit route from the eurozone, noted that serial numbers could be used effectively to split the currency back into its constituent parts as an interim measure. To find out how a few minutes checking the serial numbers of the notes in your wallet may save you a lot of money can be, see: How a euro break-up could affect your holiday money.

Buy Italy on the dips

However, the fact that fears about Spain have spooked other markets creates an opportunity. As I've said before, I think Italy is worth a look. Yes, it may be only a matter of time before it leaves the euro. However, the economic reforms that the interim Prime Minister Mario Monti is pushing should leave it in a much stronger position. Recent Spain-related falls have made the iShares FTSE MIB (UK: IMIB) look even more attractive.