Just two weeks after the last European summit apparently delivered more than was expected, concern has returned to financial markets. In trading yesterday morning, Spain's 10Y borrowing cost were back up above 7%, the level that is assumed to be 'psychologically important' for financial markets. In reality, there is nothing particularly special about 7% vs 6.5% or 7.5%, other than being a nice round number that traders can understand. The bottom line is that this kind of funding cost is unsustainable, certainly when put in context against the implicit 3.5% rate that the IMF forecasts Spain will pay on its (total) debt this year.
Back in the late 1980s and early 1990s, Spain was used to paying implicit funding rates of 8%, 9% and even 10%. One of the great benefits of the fiscal conservatism that followed (yes, the euro mattered too, but less than you might think) was to bring this borrowing cost down. Between 1997 and 2007 Spain ran primary budget surpluses (ie before interest payments) averaging 2% of GDP each year. Total gross government debt in 2007 was just 36% of GDP. Spain, like Ireland, did not go on a borrowing binge before the crisis took hold.
What it did have though, like Ireland, was something of a property bubble. And, again like Ireland, the banks were looking like they would prove to be the government's downfall. In light of that, the recent agreement to let European funding mechanisms recapitalise banks directly – albeit once a single banking supervision framework was in place – was positive, as in principle it could break the destructive and downward cycle linking the banks and the Spanish government.
However, the market clearly still has doubts. And for good reason.
While the French, Italians and Spanish were all congratulating themselves after the last summit, careful reading of the text left grounds for concern. In particular, participants did nothing to increase the size of the European Financial Stability Facility (EFSF) or European Stability Mechanism (ESM). And with about â‚¬100bn about to walk out the door to fund Spanish banks and Cyprus, that leaves less for Spain or Italy should either government come calling. Although there have been discussions about 'leveraging' the remaining bailout funds, the EFSF's own literature notes that overall lending from the new ESM and new EFSF programmes 'will not exceed €500bn'. That is unlikely to provide enough support to Spain or – God forbid – Italy if they get into trouble.
This has drummed home one important message – all the smoke and mirrors in the world should not detract from fundamentals. When politicians from core euro countries went home and pointed out that their (contingent) liabilities had not increased, we should all have realised that the same risks were still out there, and had not gone away. Fundamentally, without more money and support, then if Spain and Italy get into trouble it could be game over.
Such a conclusion may be some way off, however. If Spain can get through the next few weeks, it should be OK at least until the Autumn. In fact, after July there is only one more month this year when Spain faces sizeable outflows, when €34bn falls due in October. Spain could continue to rely on short-term market funding in the meantime, which should ensure market access but expose it to significant and repeated refinancing risk. Put another way, if Spain can rollover short-term borrowing for a while, it might well reach 2013 without needing support.
All of this means that we are once again stuck in limbo. The announcements from European policymakers have been exposed as insufficient to properly resolve the crisis. But at the same time Spain could limp on for a while, provided short-term markets continue to operate. And without the pressure of an immediate event, will politicians deliver on their promises? All told, the crisis looks set to run and run for some time yet, even before we properly enter the gradual and lengthy process of resolution. And the uncertainty that entails will continue to weigh on jobs and growth.