In recent weeks Spain’s banking crisis has gone from bad to worse. Spain’s credit rating has recently been downgraded from an A to BBB+ by Standard & Poor’s because of the debt it will most likely take on from its banks and regional government failures. Spain is the fifth largest economy in the Eurozone, leaving many worrying about the ramifications of these recent developments on the rest of Europe.

Currently Spain’s deficit is too high for the Eurozone. The European Commission says that Spain can be given more time to reduce their deficit from the 8.9% of the GDP – as it stands currently – by 2013. However, the high deficit in Spain is causing fewer individuals and countries to risk investing in the country.

Bond yields in Spain are up to 6.7% meaning that they are high risk. Yields on bonds are higher when they are riskier because investors want a higher return if they are putting money into something that is unstable. In contrast the German and US bond yield is at 1.28% and 1.64% respectively. Therefore, instead of investing in Spain’s government bonds more people are investing in the US and Germany. However, this high bond yield also means that Spain will accumulate more debt and have to pay a higher interest when borrowing money.

Despite all recent efforts the Spanish economy is expected to shrink 1.8% this year alone and another 0.3% next year. However, Prime Minister Mariano Rajoy insists that Spain will not require a bailout like Portugal, the Republic of Ireland, and Greece have needed; Spanish banks, on the other hand, have already asked for bailout money.

Bankia, a recently formed banking group of seven banks, asked for a 19 billion Euro bailout. Bankia originally reported a 309 million Euro profit for the year of 2011 when it actually had lost 2.98 billion euros. It is unknown as of yet how Spain will get the bailout money when it is already struggling under its own deficit.

The President of the European Commission, José Manuel Barroso, has suggested that they use the Eurozone’s new 500 billion euro stability mechanism to inject some capital into the banks, but Germany, Europe’s largest economy, has already rejected the plan. Another option is for Spain to give Bankia government bonds to then trade with the European Central Bank (ECB) for money.

Although it has been reported that the ECB has already rejected this plan a recent article by the BBC claims that these reports are false and that the solution is not yet off the table. The European Commission has also suggested creating a “banking union” to monitor all Eurozone banks in the future.

In addition to struggling with the mounting bank debts, Spain is also forced to rescue several regional governments who are no longer capable of borrowing money. Several regional governments have gone bankrupt and rating agencies, such as Standard & Poor’s, have put these regions at junk status. Most recently Catalonia, the wealthiest autonomous region in Spain, has asked for help from the central government; Catalonia accounts for one-fifth of the Spanish economy.

Spain is giving these regions government-backed bonds which they can then use to borrow money. However, as stated previously, these bonds are at a high yield which makes this solution temporary. A Spanish economy ministry spokesperson stated, “the goal is to reduce the pressure on the regions, which is often greater than the pressure on the state in general, with some regions not ale to borrow on the market.”

Regional banks have tried to strengthen each other through mergers. Ibercaja, Liberbank, and Caja3 merged in late May to become more resilient. This merger created the seventh biggest lender in Spain with 120 billion euros in assets. Liberbank and Caja3 were previously mergers of four and three regional banks respectively.

Spain’s unemployment as of April is at 24.3%, the worst in the Eurozone – even worse than Greece. It is expected to climb to 25.1% by 2013 even with the recent precautions taken by the newly elected center-right government. Prime Minister Rajoy has made several labor market cuts including cutting back on severance pay and restricting inflation-linked increases in salary; these decisions have been unpopular with unions and workers. Spain’s high unemployment also means that there are fewer people who are paying higher tax rates or even paying taxes.

Spain’s economy is heavily tied to the economy of Italy, the fourth largest economy in Europe. These close ties lead investors to worry that if there is a run on the Spanish banks there will also be a run on the Italian banks, throwing both countries into a deeper crisis. Italy is now borrowing at a rate over 5.66%; borrowing at a consistent 7% rate is considered unstable and has triggered the bailouts for Greece, Portugal, and the Republic of Ireland in the past.

The Spanish debt crisis was not caused by irresponsible government spending such as in Greece. Spain ran a balanced budget every year until the recession hit in 2008. The problems were planted when Spain joined the euro in 1999 and interest rates fell because Spain’s economy was good and other economies, such as the German economy, were not.

Investors wanted to invest in Spain which is what drove the interest rates lower. While the Spanish government resisted taking out more loans because of the cheaper interest rate the Spanish people did not. The country experienced a long housing boom that also affected the construction sector. When the recession hit, the housing and credit bubbles burst leaving many banks with toxic debt – debt that was unlikely to be repaid.

Image Courtesy of  Alberto Carrasco Casado

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The Spanish economy is currently trapped in the heavy shackles of debt, leading to harsh spending cuts and perhaps intolerable levels of financial hardship among the people. This became more evident when Standard and Poors (S&P) downgraded Spain’s rating by two notches.

Spain’s rating was downgraded from an A to a BBB+. This is the second time the rating was lowered within a year, leading to widespread fear and uncertainty over Spain’s fiscal conditions. Unfortunately, this is just part of an overload of bad news for Spain, along with unemployment reaching a record high of 24.4 percent and confirmation from the central bank that Spain is in recession for the second time in three years.

Debt and budgetary problems appear sovereign, but others should not be impacted even by its sheer scale. The problem is the movement of capital between nations, leading to the vicious cycle of debt. When fiscal imbalances erupted in Greece a few years back, they seemed to have transmitted unequivocally, like a deadly virus. After Greece’s announcement, another debt bomb exploded in Italy, again in Spain, and again in Portugal. Greece was the first of  multiple incidences of crisis.

Countries in debt struggle with a clash of recession and fiscal inefficiency in terms of debt management. One smooth way to get rid of debt is to increase tax rates so that the state can repay it and reduce interest burden. But a tax rate increase requires sound and consistent growth rate, which can rarely be found in the short-term.

Another major problem associated with public debt is a rise in the cost of borrowing in domestic as well as international markets, leading to complications in finding sources to repay it. In Spain, the economy contracted by o.3 percent in the last quarter of 2011. Bringing back a growth rate that can complement a rise in tax rates is a distant dream in the short term. On an annual basis, GDP slipped by 0.4 percent.

Debt problems have both micro and macroeconomic implications. At the microeconomic level, the households feel the heat of debt in terms of a rise in cost of living and a rise in interest rate in the initial stages of a problem.

At the macroeconomic level, public debt seems to grow if the ratio of debt to GDP is bigger. According to Global Finance magazine, Spanish Debt-GDP ratio was 56 percent in 2009. In 2012, the  ratio stood at 79.8 percent, a troublesome turnaround.

Out of the 100 percent of what a country produces, it is required to pay almost 80 percent to creditors, even at a time when the economy is struggling to get back to normalcy. If, somehow, a country reduces its debt load, then stiffer austerity measures are hardly necessary.

Smooth functioning of the economy acts as a cushion while fighting with debt. Because debt and growth in GDP are inversely related, when the GDP growth rate is higher debt can easily be warded off. But when the debt component is greater than GDP rate, the country faces crisis.

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The downgrade of the United States’ AAA status less than a week after the last minute debt agreement has left the world’s stock market fending for stability. In Europe, the already shaky eurozone began buying Italian and Spanish government bonds to slow down the panic over the European debt crisis. Asian markets, which opened earlier, saw a sharp drop. All eyes are currently on the U.S. stock which will open soon.

The historical downgrade was not expected to cause severe damage to the economy as Standard and Poor’s move could not have come as a surprise. “S&P doesn’t know anything that investors don’t already know, so the downgrade should not change expectations and interest rates,” said Martin Feldstein, a Harvard economist, to CNN. However, the downgrade caused turmoil over the weekend as Republicans and Democrats started throwing mud and the finance ministry in Washington lashed out at S&P, determining that there had been a calculation error of no less than 2.000 billion dollars. Judging by the error, the credibility of S&P should be reconsidered, according to an anonymous official.

In the unusually harsh comment that followed the downgrade, S&P argued that their decision was based on the unpredictability of the government and not the economy. They do not believe that the new debt deal guarantees the reduction of the government’s record-high deficit and would rather have seen a reduction of around $4.000 billion over the next 10 years instead of the agreed terms of roughly half that figure. S&P were neither hesitant to point out that the tax cuts that President George W. Bush introduced a few years ago should end by the end of 2012.

The $4.000 billion reduction was in fact a part of Obama’s plan during the debt negotiations and S&P made it clear that such initiative would have saved the country from the downgrade. Despite both parties taking a hit in the statement, S&P did not attempt to cover their sharper tone towards the Republican Party. The President’s supporters reacted by saying that Obama had been on the right track and had it not been for the irresponsible Tea Party fraction in the Republican camp, this would not have happened. Meanwhile, the Republicans deny the accusation and presidential candidate Mitt Romney framed the downgrade as another disturbing sign of how the country has gone down hill under Obama.

More than one news source has aired the question of Standard & Poor’s credibility. Critics call it the move they didn’t have the guts to make before the financial crisis and blame S&P for trying to make up for past mistake with a delayed and untimely decision. Others point to the fact that the two other firms Moody and Fitch Rating have yet to come up with their own analysis.

It might be days or weeks before the real damage will show, but for now we can rest assure that the 2012 election will take on this new debate with a vengeance.

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The center-right government launched a financial plan aimed at increasing tax revenues and lowering the spending by introducing a set of measures, some of which are not very clear yet. This plan has passed as decree but, as required by the legislative procedure, it has to be approved by the parliament within the next 60 days in order to become law.

In view of the parliament vote, Prime Minister Silvio Berlusconi sought the opposition support, aware of his coalition’s majority weakening and of the strong tensions which inflame the parliament over the austerity measures. “There is a need for unity in defense of our common currency,” said Berlusconi during a press conference. Nevertheless, the opposition leader Pier Luigi Bersani described the financial plan as a “time-bomb”.

As the Finance Minister Giulio Tremonti explained, the new austerity package consists of a set of cuts in various sectors in order to increase the revenues. The major aim is to reduce the public spending of government, both at central and local level, and to stabilize the country’s finance – as the European Union required. Only few details have been provided in regard to the actual extent of the cuts and the other measures which were confirmed in the latest version of the financial plan approved by the cabinet.

It seems that will be the public health service the most affected by the austerity measures. The estimated cuts in this sector will be heavy and the cost of public medical services will increase, in order to avoid the waste. In most of the public sectors the labour turnover will be stopped until 2014, as also the wage rise for public employees. The retirement age for women will be gradually increased from 2012. Furthermore, a special commission will be established to develop a plan to reduce the politician’s salaries and benefits, which will come into force from 2014 – with the next government – and will bring the Italian politicians’ compensation in line with the European Union’s average.

“Reducing the budget deficit is not just about numbers, it is a political and ethical objective of a country,” said Tremonti in a press conference. “It is reflected in choices of responsibilities between citizens and generations.”

Italy’s public debt is about 120% of its gross domestic product, which is one of the highest in the world and it’s second only to Greece in the eurozone. Because of this the country is under the particular observation of the rating’s agencies and the European Union. Recently Standard & Poor’s downgraded Italy from stable to negative, and doesn’t consider the new austerity package enough for the growth of the country – which was just 0.1% in the first quarter of the year.

Oppositions and some economist criticized the government’s financial plan particularly worried for the current situation of the country. In the meanwhile, the national institute of statistic (ISTAT) published the latest survey’s result about unemployment rate in Italy, which is currently at 8.6%. For young people between 15 and 24 the unemployment is at 29.6% – the highest level since 2004 -, and the rate of inactivity is at 37.8%. Italy and its people have to face a very difficult situation.

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