Fears of sovereign bailout for Spain

SPAIN’S BORROWING costs spiked to a euro-era high yesterday after the nation was downgraded by Moody’s and concerns grew that it would require external assistance to fund its sovereign financing requirements.

Meanwhile Italy was forced to pay 5.3 per cent on three-year bonds at an auction yesterday morning, which represented an increase of 1.4 per cent on last month.

At one point yesterday the yield on Spain’s 10-year bonds hovered just below 7 per cent, the mark widely viewed as a crucial trigger point, with Ireland, Portugal and Greece driven to seek international bailouts after their borrowing costs breached this level.

This escalation in pressure on the Spanish sovereign debt markets came despite last weekend’s euro zone agreement to lend Madrid up to €100 billion to recapitalise it ailing banks.

It followed the announcement on Wednesday night that rating agency Moody’s had slashed the country’s sovereign credit rating by three notches to Baa3, one level above junk, which added to the sense of emergency in financial markets ahead of an election in debt-plagued Greece on Sunday.

The spike in Spain’s bond yields “seems to suggest that the market is increasingly expecting that the sovereign will also have to be bailed out ”, said John Fahey, economist at Ulster Bank.

Such fears can become a self-fulfilling prophecy, he said. If the 10-year yield remains around 7 per cent or higher, it will become unsustainable for the country to fund itself long-term.

Italy succeeded in reaching its maximum target at yesterday’s bond auction, but it was required to pay yields of 5.3 per cent on three-year notes, up from 3.9 per cent in May.

“It was a decent result, given the circumstances,” Mr Fahey said.

However he warned the increased pressure on Italy and Spain is a worrying development in the debt crisis “given the systemic importance of both countries and the pressure that potential financial assistance for the two countries could put on the firewall in place to deal with the crisis”.

The pressure on the two countries may have intensified this week, but it has been mounting since the Greek elections in early May. The yield on Spanish 10-year paper has jumped more than 100 basis points over the intervening weeks, while Italy has seen yields rise over 70 basis points.

While the political instability in Greece has been a driving factor, Mr Fahey said the “double whammy” of a banking crisis and now a sovereign funding problem are the key factors weighing on Spain.

Italy, on the other hand, is grappling with a legacy debt issue, having built up a debt-to-GDP ratio of about 123 per cent over a long period of time.

“In once sense, in Spain it is the private debt that is putting pressure on the budget deficit. In Italy, the government debt could put pressure on the private sector because the banking sector holds a high level of sovereign debt,” Mr Fahey said.

Speculation is growing that European leaders are considering another LTRO (long-term refinancing operation), a Dublin broker said.

He said Spanish borrowing levels have been driven up to an unsustainable level and that German chancellor Angela Merkel is “using the market” to lever the Spanish government into facing up to its problems. – (Additional reporting by Reuters and Bloomberg)