Respite for Spain, Fiscal Challenges Remain

Spain is offered an extra year to reduce its budget deficit, a target its autonomous regions are unlikely to meet.

The European Commission offered Spain an extra year to reduce its budget deficit on Wednesday and recommended direct aid for its ailing banks from Europe’s permanent financial rescue mechanism.

Olli Rehn, the commissioner for economic and monetary affairs, said that Brussels was prepared to give Spain until 2014 to bring its deficit down to the treaty limit of 3 percent of gross domestic product if Madrid reins in overspending by its autonomous regions.

Rehn appeared cool though to permitting the European Stability Mechanism, which is expected to take over from the temporary bailout fund this summer, to lend directly to banks. He pointed out that this this is “not foreseen as such in the treaty and therefore this is not an available option.” Frugal stages like Germany are wary of the proposal but Spanish prime minister Mariano Rajoy immediately backed the European Commission.

Spanish banks were weakened by the bursting of a property bubble in 2008. The subsequent European debt crisis, combined with growing uncertainty about Greece’s survival in the eurozone, have put further pressure on the country’s financial institutions. The government’s borrowing costs are also mounting.

A bank rescue plan offered by Madrid would issue bonds to inject funds into the nationalized lender Bankia but with interest on Spanish sovereign bonds over 6 percent, close to levels at which Greece and Ireland were forced to seek international bailouts, that efforts seems incredible unless other European countries support it.

The banking sector is Spain’s immediate worry but a far greater challenge looms in its largely autonomous provinces. Catalonia, Spain’s wealthiest region, asked the central government for financial assistance this week to repay its €13 billion debt.

In Spain’s highly decentralized system of government, the provinces account for more than half of total public spending. Even in regions where Rajoy’s conservative party is in government and has been for years, the financial difficulties are pressing.

Spanish regions have committed to find over €18 billion of savings by the end of this year, almost half of Spain’s planned deficit reduction, but given their past record, “the regions are unlikely to deliver,” writes Vincenzo Scarpetta in City A.M., “meaning that the central government would have to pick up the slack.”

This would put further strains on Spain’s public finances which will need much of the ammunition at their disposal to deal with potential future bank bailouts.

Rajoy commands large enough of a parliamentary majority to pass political reforms that would enable the central government to take control of the regions’ finances but areas like Catalonia and the Basque Country in the north are highly nationalistic and would likely resist any changes that dilute their autonomy.

Spain’s economy is barely expanding. One out of five workers is unemployed. Among the young, the jobless rate stands at over 50 percent. If if slumps further, other European countries could be convinced to provide financial support although Rajoy has ruled out a bailout.

With an economy twice the size of Greece, Ireland and Portugal combined, countries that have previously received bailouts, a debt crisis in Spain would severely test Europe’s ability to maintain economic stability and could threaten the future of the eurozone.