Markets fear that Spain's financial sector bailout is too small and contains questionable fine print. Starting at 10:00am yesterday, the risk premium shot up again to 520 basis points. The stock market, which had risen 6% on news of the bailout, shaved 0.54% by the end of the day.
Experts agree that there was a "slight rebound" and doubt that the stock market can sustain its gains. While it seems paradoxical that the stock market would falter after the Spanish government convinced the EU to bail out its financial sector, risk premiums in other countries have risen after bailouts.
Why are the markets reacting this way? Because investors want to know, as do citizens, the terms that the EU is going to impose on Spain in exchange for the bailout. People fear that after the bailout, Spain will be cut off from credit markets, nobody will want to but its debt besides its own banks and that the government will be forced to ask for its own bailout. Because the EU would not agree to rescue the Spanish government, a euro zone debacle would ensue.
In order to build confidence in Spain, it's necessary to know the terms and conditions of the bailout as soon as possible. For example, who will issue debt for the EU? This question is a great cause of concern and explains the risk premium's erratic behavior. The debt could be financed through either the European Financial Stability Facility (EFSF) or the European Stability Mechanism (ESM), which will replace the EFSF as of July 1. The funds differ greatly. Why? Because debt holders know that of the ESM would have collection priority over all other creditors in the case of a default. This is not the case with the EFSF. This mechanism is structured so that all creditors have equal collection priority. Further, the bailout does not break ties with the Spanish state, which will issue debt to banks so that they can service the financial sector bailout debt, leading to an increase to Spain's budget deficit.
So the EU will watch carefully to ensure that the financial sector meets their loan conditions. It will be subject to a quarterly inspection by the European Commission, European Central Bank (ECB) and the International Monetary Fund (IMF) plus a representative from the European Banking Authority (EBA), which is considered the germ of Europe's future financial supervisor.
Spain has a big banking problem, but it also has an over-sized public sector, is running the risk of recession and is suffering from rampant unemployment. These factors further increase the doubts of investors who have been steering clear of Spanish debt for a long time.
They also give the European Commission more reasons to monitor the situation closely and cut off Spain's bailout funding if the country doesn't make debt payments quickly enough. We mustn't forget the wording of the road map that the European Commission published at the end of May. Spain has one more year to cut its budget deficit to 3%. To do so, the EU recommends raising the VAT, extending the retirement age, subsidizing home ownership in the personal income tax and deepening labor reforms. The work left to do is substantial.
The Spanish government found some relief this week with the bailout, but all indicators suggest that the relief is not going to last long enough. We have to persuade the markets and other countries on the euro that we are capable of handling the situation. The work ahead will be tough, but we have to persevere in order for past and current measures to successfully instill confidence in Spain.
