The big euro-story once again this week is Spain. Government bond yields are hovering close to 7%. That's been the bail-out point of no return for other indebted Eurozone countries such as Portugal, Ireland and Greece.
Spanish PM, Mariano Rajoy, has tried to reassure the markets after Bankia, Spain's fourth biggest bank, needed government help. He insists that there will be no need for a European bail-out of Spain's banks. But then again, he would say that.
If he is wrong, will Brussels step in to support Spain? And if so, how? Bailing out an economy the size of, say, Greece is one thing. Spain is in a different league.
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Investors are right to be nervous. But wrong to think there are no opportunities out there.
Spain's banks are in trouble
As we've pointed out before, Spain's net debt was relatively low until very recently. However, the collapse of the Spanish property market has left banks with a lot of bad loans. This means that they need large amounts of capital to keep them afloat.
The government could force a private sector solution, either through the bankruptcy process or through a 'bail-in' (we've covered the alternatives in more detail here). Indeed, a few months ago there was vague talk about the private sector funding a "bad bank". However, Madrid quickly changed its mind, and injected £18.8bn into Bankia.
Rajoy has said that, "We are not going to let any region or financial entity fall, because otherwise the country would fall". This implies that the Spanish state, not bondholders, will be paying the costs of further support. The EU thinks that the tab for doing so will eventually rise to £100bn. This would cause Spanish public debt to spiral.
Could we see a pan-European bail-out?
So it should come as no surprise that, despite his tough talk, Rajoy is actually trying to get Brussels to help. One solution would be for the existing European Stability Fund to bail out all the troubled banks in Europe. The hope is that if banks in other countries were helped at the same time, Spain would avoid the shame and the loss of confidence - that would go with a limited bail-out.
However, as the Telegraph points out, "this amounts to EU debt-pooling a variant of Eurobonds". Since Germany has made it clear that it will not allow the Eurozone's weaker countries to get a free ride off its fiscal sobriety over the past decade, this plan looks to be a non-starter.
Are Spanish bond yields flashing red?
Italy shows that high bond yields are not a death sentence. Indeed, five-year yields are now 5.2%, down from just under 8% in November and December. However, Italy's banking system is in a much better shape than that of Spain. Also, much of the sudden spike was due to specific fears at the time that Berlusconi was unwilling to make public spending cuts.
Spain's economic woes, on the other hand, continue unabated. Unemployment in the first quarter of the year was 24.4%. Consumer spending is collapsing, with retail sales falling by nearly 10% a year last month. Even the Bank of Spain admits that growth will be negative through the second half of the year. This means that Spain is likely to miss its deficit target.
As Capital Economics points out, the Spanish deficit has been recently revised up to 8.9% of GDP from 8.5%, well above the target of 6%. Unless drastic action is taken in the very near future, it could be forced to default. In that context, Spanish bond yields anywhere near 7% matter a lot.
Two ways to protect yourself
Last month we suggested investors avoid Banco Santander (LSE: BNC), due to its large exposure to Portugal and Spain. Unsurprisingly we're sticking with that advice.
Savers meanwhile should note that the UK branches of Santander are legally ring-fenced from their Spanish parent. However, it is a good idea to limit the amount of money you keep there to the £85,000 per person set by the Financial Services Compensation Scheme.
And in the next issue of MoneyWeek, out Friday, deputy editor Tim Bennett explains how Europe's woes are proving no barrier to budget airline easyJet. If you would like to become a subscriber you can subscribe to MoneyWeek magazine.
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