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Spain’s Finances Deteriorate

Posted by Steve Markowitz on July 23, 2012

The Wall Street Journal today reported on deteriorating financial condition of Spain.  While just a couple of weeks ago Spain was the approved for a bailout, this only offered the country a short reprieve from the bond vigilantes.  Today Spanish bond yields spiked to 7 .5%, significantly above the 6% figure that is problematic for Spain.  As bond yields rise, the cost of governmental borrowing increases.  Given Spain’s huge debt, this is a significant problem.

Worldwide markets reacted negatively to today’s news out of Spain.  Greece’s equity markets were off 7% with Germany’s down 3%.  Other European markets had losses of between 2 and 3%.  It remarkable how the markets are gyrating on a daily basis over the news emanating from Spain and Europe.  The macro-economic problems of Europe are not solvable without significant pain for.  Several countries, including Spain, are insolvent and need to write off their government’s debt before they can hope for growth.  However, instead of moving forward with this reality, European governments continue to kick the can down the road with Band-Aid fixes that have offered ever shortening cycles of benefit.

Economists John Mauldin on July 21 published an article, The Lion in the Grass, that put perspective on Europe’s debt crisis.  In it Mauldin reviews the shell game Europe is using to kick the can down the road.  Previously, Spain was given access to significant funds at interest rates near 0%.  It was then cajoled into loan these funds back the Spanish government by purchasing Spanish bonds at 2 or 3% with the spread making easy profits for the banks.  Supposedly this alchemy included no risk to the Spanish banks.  However, this trickery was foiled by the invisible hand of the bond markets that have since jacked up these rates to over 7%.  Now the government bonds these banks previously purchased have lost principal value with the rising yields placing the banks in even worst financial condition.  This downward spiral is forcing Spain to implement more severe austerity measures, something that is not politically palatable in democracies.  As a result, there is significant capital flight from Spain with investors being concerned for their own capital preservation, as outlined in the chart.

Mauldin then points out a potentially more serious issue in Europe; France’s finances.  The next chart was produced by the IMF (International Monetary Fund) and studies the debt prospects for six European countries.  Five of the countries have three dotted lines indicating the potential directions for their country’s debt.  The chart that jumps out of this group is the one for France.  Even under the best scenario projected by the IMF, France’s debt goes in a direction that is unsustainable.  Should France make the same significant austerity cuts that Greece has been forced into, its debt–two–GDP ratio would still rise to 200% in the next 25 years.

Considering the perilous situation France finds itself rational thought would dictate that the country would take steps for corrective action.  However, just the opposite has occurred.  A little over a month ago France elected Socialist François Hollande and threw out the more economically conservative Nicholas Sarkozy.  Since that election Hollande lowered France’s retirement age from 62 to 60.  In addition, he significantly increased taxes on the wealthy.  It is not hard to imagine that these and similar steps will lead to a capital flight from France similar to what is occurring in Spain.  That has the potential for making an even uglier scenario in Europe.

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