Mario Draghi’s plan to save the euro is about to get a test run. Spanish Prime Minister Mariano Rajoy appears ready to accept—perhaps not immediately, but soon—the European Central Bank president’s offer of a deal, in which the bank would buy up Spanish government debt in exchange for promised austerity and economic reforms. Investors seem persuaded that a bailout is at hand: The returns they’re demanding on Spanish bonds have fallen noticeably in recent days.
Even as the foundations of a rescue fall into place, though, it’s becoming clear that Europe’s fourth-largest economy is in worse shape than previously understood—and that ECB bond-buying won’t fix it. On Oct. 2, Madrid reported that unemployment rose for a second month in September to 24.6 percent, contradicting earlier government assurances that joblessness had peaked. The same day, Moody’s Investors Service (MCO) estimated that Spanish banks faced a capital shortfall of up to 105 billion euros ($135 billion), almost twice the figure reported to the government a few days earlier.
Spain has acknowledged that its budget deficit this year will reach a higher-than-predicted 7.4 percent, as it extends billions in aid to stricken banks, power companies, and regional governments. Capital flight is accelerating. And most economists regard the government’s growth forecasts as wildly optimistic. “All Spanish macro indicators are flashing red,” says Thomas Costerg, an economist at Standard Chartered Bank in London. “You need to bring back growth, and this is something the ECB cannot do.”
Rajoy said at an Oct. 2 press conference that a bailout was not imminent. But over the past week his government has moved itself squarely into position for a bailout, approving a budget on Sept. 27 that closely tracks the austerity and structural reform measures its European neighbors have demanded. By appearing to set the terms himself, Rajoy could spare Spain the humiliation suffered by Greece and other countries where bailout requirements were dictated by outsiders.
European Union Economic and Monetary Affairs Commissioner Olli Rehn flew to Madrid to huddle with Economy Minister Luis de Guindos on Oct. 1, heightening speculation that a deal could happen son.
Draghi’s willingness to buy unlimited amounts of Spanish debt reflects the urgency of pulling one of the euro zone’s biggest members back from the brink. Spain’s economy is almost twice the total of all three previous bailout recipients, Greece, Ireland, and Portugal.
No question, a big dose of ECB bond-buying would make things easier in Madrid. The government’s debt burden has spiraled as yields on its benchmark bonds spiked above 6 percent during the summer. While borrowing costs have now eased to about 5.7 percent, the government “may only have enough cash to cover its deficit and its bond redemptions through the end of October,” says Ricardo Santos, an economist at BNP Paribas in London. He thinks a bailout will be in place by November, at the latest.
A bigger question is whether an austerity-based rescue plan is what Spain really needs. Greece ran up unmanageable debts because of a bloated public sector and poor tax collection. The problem in Spain, by contrast, “is not fiscal profligacy,” says Martin van Vliet, an economist at ING Bank (ING) in the Netherlands. Spain’s woes originated in the private sector, where the collapse of a housing boom devastated the tax base and left the government having to prop up banks saddled with billions in bad loans. Before the housing crisis, Madrid had relatively little debt and ran modest deficits. ECB bond-buying would prevent the situation from worsening, van Vliet says. “But it won’t kick-start the economy.”
Euro zone governments in July offered Spanish banks a bailout of up to 100 billion euros. But now even that may be in doubt. An independent stress test by consulting group Oliver Wyman, required as a condition of the aid, put the banks’ capital shortfall at less than 60 billion euros. But within days, Moody’s estimated the shortfall at nearly twice that amount. At the same time, the finance ministers of Germany, the Netherlands, and Finland now say that the aid can only be used for future financing needs, and can’t help clean up the balance sheets of “legacy” Spanish banks.
Fudged promises, dubious math—and a recession that’s deepening by the day. That’s the toxic mess facing Draghi in Spain. When he announced the bond-buying plan in July, the ECB chief promised to do “whatever it takes” to save the euro, and added, “Believe me, it will be enough.” Spain may show whether he was right.
