Italy’s debt is its biggest obstacle but Spain’s budget lacks credibility

Spain

The more Spanish officials talk about the budget the less credible it seems. The 10-year yield fell 11 bp on Friday when the budget first presented before the weekend. Now as more detail emerge as it goes to parliament, 10-year yields are rising.

The budget assumes that yields will remain around February levels. The 10-year yield averaged a little more than 5.10% in February. It averaged 5.20% in March. Yields rose in the second half of March and are now near 5.40%. This warns that Spain is likely under-estimating its debt servicing costs. Spain plans on selling as much as 3.5 bln euros of debt tomorrow with maturities in ranging between 3 and 8 years. Some concession ahead of the auction may also be a factor weighing on bond prices today.

On top of this the problems of Spanish banks are likely to spill over and hurt the sovereign. Spanish banks have been significant buyers of the sovereign bonds. As they address the rising non-performing loan problems stemming from the real estate bubble their appetite may wane. House and land prices are still falling.

Meanwhile Spain reported yet another increase in those registering for unemployment benefits today. The March increase was 0.8% but is now 9.6% above year ago levels and rising. It may seem a bit ironic, but Spain does not report unemployment rates. The 23.6% unemployment rate in February is a calculation from the EU’s stats agency. Spain has yet to cut its public sector work force, while the private sector continues to shed workers. This seems likely to change.

Despite what has been advertised as the most austere budget since Franco, the real commitment of Spanish officials remains questionable. Last year’s deficit was overshot by 2.5% of GDP. To appreciate this magnitude, note that the Stability and Growth Pact required deficits to be limited to 3% of GDP barring unusual circumstances. While these are unusual circumstances, the overshoot itself was large. Then Rajoy unilaterally loosened the target this year from 4.4% of GDP to 5.8%.

The EU fought a rearguard action and found what it appears to think is a face-saving compromise of 5.3%, which in effect accepts Spain’s fait accompli. And today, the Wall Street Journal quotes the finance minister saying that the government is concerned that too much austerity will exacerbate the economic downturn.

While one cannot help but to have sympathy for Spain’s plight, it depends on what the question is.If the question is: will Spain achieve its new 5.3% deficit target based on current plans, the answer is unlikely. If the question is: are Spanish officials committed to the kind of fiscal austerity that is entailed in the freshly signed fiscal compact, the answer is doubtful. If the question is: will the social strains and hardship increase, the answer is undoubtedly.

Italy

Italy reported that the Q1 state sector deficit declined by about 10% to 28.2 bln euros in Q1. This was completed due to the results in the month of March. Contrary to the conventional narrative about fiscal profligacy on the periphery, Italy’s fiscal policy has been among the tightest in the euro zone as it is one of the few countries that can point to a primary budget surplus.

Italy has to run hard to stay in the same place. The business association Confindustria warns that the Italian economy is likely to have contracted 1% in Q1. This takes roughly 16 bln euros away from GDP, the denominator of the deficit/GDP ratio. The state sector deficit, which is not even the most comprehensive measure of the deficit only fell 3 bln euros. This is to say, if these numbers are fair representations, Italy’s deficit to GDP actually rose in Q1.

Italian unemployment is also rising. In February it rose to 9.3% from 9.1% in January and is at its highest level in more than a decade.

Whereas Spain met about 45% of this year’s funding needs in Q1, Italy has secured less than a quarter. It is expected to be the euro zone’s largest sovereign issuer in Q2.

Unlike Spain’s Rajoy, Italy’s PM Monti had a honeymoon, but it is over. There has been increasing talk that Monti may not last until the term ends in May 2013. His support rating is falling and the municipal elections next month will be seen as a personal referendum.

There is an attempt to dilute some of his reforms, like the property tax. In addition, since Monti unveiled his proposal for labor market reform , his support has waned and bond yields have risen. The 10-year yield was 4.83% on the March 19th, the day before his proposal. It is now near 5.15%.

Although the labor reforms passed were approved by the cabinet, the fight in parliament will be ferocious. Even some who support the government will seek to dilute his reforms, which were already a compromise. The business lobby wants Monti to submit the labor reform bill as a vote of confidence to limit debate and the risk of dilution. However, Monti chose to go the draft law route rather than decree, which would have limited debate and been implemented immediately, suggesting a sensitivity to such a divisive issue.

The Spanish 10-year premium over Italy peaked near 41 bp the day Monti unveiled his labor reforms. The spread stands near 28 bp now. On balance, because Spain’s bubble has not completely deflated and the bottom of the house and land prices have not yet been seen, while Italy did not experience such a bubble, we suspect the downside risks to Spain are greater than Italy. However, the fall of Monti or his labor reforms could produce a dramatic swing in the pendulum of market sentiment.