Spanish Bailout On The Horizon?

The major headline sprouting out from the Iberian peninsula last week was Portuguese Prime Minister José Socrates’ decision to resign because parliament didn’t pass his party’s proposed budget and austerity measures. This brought up concerns that Portugal may eventually need a bailout, just like Ireland and Greece.

Still, this didn’t seem to have too much of a lasting impact on the markets. The truth is, while a bailout to Portugal is likely coming, all the uber macroeconomic nerds out there (like myself) are actually shifting their focus to the next Big (Potential) Bailout: Spain.

A look at the data shows that aside from futbol and Rafael Nadal, Spain doesn’t have much going for it right now.

Unemployment is at a staggering 20%, which is the highest by far amongst euro zone members. Similarly to Portugal, Spain is plagued by an under-educated work force, as only 50% of its adult population has finished high school. Meanwhile, unemployment claims continue to rise, and is now up 4.1% from March last year. These are all indications of a weak labor market.

Looking at GDP data, we see that the Spanish economy grew just 0.2% last quarter, and 0.6% in 2010. Economic fortune tellers believe that things won’t get that much better in 2011 either, as they predict growth to be anywhere from 0.4% to 0.8%.

The major concern though, is the state of Spain’s banking system. Spanish cajas have been under fire because of recapitalization needs.

The problem? Bad loan exposure to the real estate and construction sectors. Spain’s housing prices have dropped nearly 40% from their peak in 2007, and based on price-to-rent estimates, could drop another 20% to 30%. Ouch!

The total amount of exposure you ask? A whopping 100 billion EUR.

The combination of a poor economic outlook and concerns about the banking sector led Moody’s to downgrade Spanish debt to Aa2. With the credit rating agency also having a “negative” outlook on Spain, chances are that we could see more downgrades in the future.

Let’s say that, in a worse case scenario, that Spain does indeed need a bailout. Is the ECB well-equipped enough to handle a bailout?

As I’ve said in the past, there are some real concerns as to whether there will be enough in the EFSF fund. Ireland got a bailout of about 85 billion EUR, and with market whiz kids pegging a Portuguese bailout at around 90 billion EUR, that leaves about 260 billion EUR left for Spain.

Would that be enough to save the Spanish economy? We’re talking about a 1.1 trillion EUR economy boys and girls – one that has a failing housing market and is heavily exposed to Portuguese debt!

I also wonder how this will affect the ECB’s stance towards monetary policy. There has been speculation that the ECB will be raising interest rates soon in an effort to counter high inflation.

The problem with raising rates though, is the underlying effects it has on growth and liquidity. If the ECB were to raise rates, it could cut into the already poor growth figures that are expected out of Spain. This would put a bigger burden on Germany to pick up the slack, which would then lead to political tensions… Yeah you get the picture.

For now, let’s hope that all the moves (such as self imposed austerity measures and recapitalization requirements on banks) that the Spanish government has taken will be effective. If it hasn’t learned its lesson from its PIIGS brothers, then the euro zone could be headed for a whole new round of trouble.