Is the Bailout for Spain Good Enough?

Practical Economics

Is the Bailout for Spain Good Enough?

Though Spain will get what it needs to keep its banks and its finances afloat, investor concerns about euro recession and the prospect of contagion linger.

The tentative deal between Spain and European financial officials for $125 billion in funds provides more than enough to shore up Spain's banking system. The scale of the proposed financing "gives assurance that the financing needs of Spain's banking system will be fully met," says Christine Lagarde, managing director of the International Monetary Fund, which is not contributing to this bailout.

SEE ALSO: Greece's Exit from the Euro Is Imminent

The IMF estimates that Spanish banks have a shortfall of just $50 billion, while others estimate needs of between $80 billion and $100 billion. The official request for funds is expected before June 21, when euro zone finance ministers meet in Luxembourg and after private stress tests of the banks are concluded.

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But euro area problems don't stop at Spain's borders, and investors are already looking for the next spot of weakness within the monetary union, causing a spike in the yield of Italy's government bonds. Moreover, fundamental issues -- such as how to encourage economic growth while implementing spending cuts and how to rectify diverging competitiveness among countries -- haven't been sufficiently addressed by euro zone leaders. And there's still uncertainty as to whether Greece will abandon the euro and whether Germany will continue to put up funds for additional bailouts.


And even though aid for Spain is more than enough to keep Spanish banks afloat, other factors continue to make investors antsy.

The lenient terms of the agreed-upon bailout for Spain are giving credence to Greek politicians' call for better conditions for that country's financial aid. There's a huge difference in the two countries' circumstances, however. Spain's problems stem from a weak financial system and not from the government overspending and mismanagement that are at the root of Greece's woes. Spanish banks are suffering losses specifically tied to a real estate bust in which home prices fell by more than 25% from 2007 levels. What's more, Madrid has already implemented austerity measures and put the country on a path to reach fiscal targets, while Greece has vacillated. Elections this weekend will test Greeks' willingness to make the cuts necessary to win euro zone support.

Another worry is that the Spanish bailout will be funneled to banks through official government accounts, which will inevitably lead to a jump in public debt levels. A $125-billion bailout loan will push Spain's debt-to-GDP ratio to about 90% by the end of the year -- up from 70% in 2011 -- and make it harder for Spain to borrow from other investors. In addition, the funds are likely to come from the European Stability Mechanism, a new, permanent euro zone rescue facility that officially goes into effect next month. ESM loans are senior debts that get priority over private debtors in the case of a default -- not a happy prospect for bond investors.

Finally, consolidation of Spain's banking industry is far from over. It needs to continue even as the injection of new funds removes some of the urgency. Spain's banks face declining loan demand and revenues as widespread recession makes it harder for even the healthy banks to take on more debt. Spain's GDP is expected to contract 1.7% this year. With unemployment hovering around 25%, a new wave of loan defaults could hit the industry while it's down.