Zapatero Loses Credit at Home and Abroad as Fitch Dumps Spain's AAA Rating

Spanish Prime Minister Jose Luis Rodriguez Zapatero, isolated in parliament and his popularity slumping amid the biggest budget cuts in 30 years, is finding his efforts aren’t paying off internationally either.

Fitch Ratings late last week stripped Spain of its top AAA credit grade and questioned the nation’s ability to grow its economy as the government reduces spending. U.S. stocks and the euro declined after the downgrade to AA+, on concern the European debt crisis will deepen.

“It’s bad news for the government,” said Fernando Fernandez, a former International Monetary Fund economist at IE business school in Madrid. “It shows a lack of confidence in the government internationally. It looks like the budget cuts haven’t helped.”

Zapatero, a Socialist running a minority government, faces strike threats from his traditional allies in the unions and risks being unable to pass next year’s budget because of opposition to his plans. His attempt to rein in the euro area’s third-largest budget deficit has also failed to reverse a surge in Spain’s risk premium amid concern that the European Union’s 750 billion-euro ($920 billion) bailout plan won’t solve the problems of its indebted nations.

Wage Cuts

In return for the European financial backstop, and urged on by U.S. President Barack Obama, Zapatero announced on May 12 the first cut to public wages in Spain’s 30-year democracy and a freeze on pensions.

The measures are aimed at reducing the budget gap from 11.2 percent of gross domestic product last year to 6 percent in 2011. While they were initially welcomed by markets, pushing up bond prices and Spanish stocks, concerns have resurfaced.

Spain’s Ibex-35 share index fell 0.6 percent at 9:40 a.m. in Madrid to 9,360 points. The Ibex has declined 22 percent this year amid concerns over the economic outlook. Even as bad loans are stabilizing after a two-year surge, shares in Banco Bilbao Vizcaya Argentaria SA have fallen by almost a third.

The yield on Spain’s benchmark 10-year bond rose 4 basis points to 4.27 percent, while the 2-year bond yielded a three- week high of 2.60 percent, up 18 basis point.

The extra yield that investors demand to hold Spanish debt rather than German equivalents rose 5 basis points to 158 basis points, 15 basis points less than the post-euro high of 173 basis points reached on May 7. The average spread over the last decade is 23 basis points.

Close Vote

“The outlook for the government is complicated precisely because of the lack of support for these measures but also the lack of effectiveness in terms of calming the markets,” said David Rueda, a professor of comparative politics at Oxford University. The prospect of Zapatero staying in office until the next general election in 2012 “doesn’t seem as certain as it was a few months ago,” he said.

The austerity program scraped through parliament with a margin of one vote as smaller parties that lent Zapatero support in the past turned against him. The premier’s next challenge will be gathering enough support to get the budget through parliament by the end of this year, at a time when two parties are calling for early elections.

Zapatero’s spending cuts aren’t helping the economy either as households pay down one of the largest private debt burdens in the euro region. Fitch cited the impact of Spain’s belt- tightening on the growth outlook for its credit-rating downgrade.

Debt, Growth

“The process of adjustment to a lower level of private sector and external indebtedness will materially reduce the rate of growth of the Spanish economy over the medium-term,” Brian Coulton, Fitch’s head of Europe, Middle East and Africa sovereign ratings in London, said in a statement on May 28.

That may cast further doubt on the government’s growth assumptions, which show the economy expanding 1.3 percent next year and 2.7 percent in 2013. The IMF forecasts more modest growth of 0.9 percent in 2011 and 1.6 percent in 2013. IMF Managing Director Dominique Strauss-Kahn said Spain is taking the “necessary steps” to fix the economy, according to an interview published in ABC newspaper today.

Retailers are bracing for a value-added tax increase in July, with Inditex SA, the owner of clothing retailer Zara, planning to absorb the hike rather than pass it on.

Debt Burden

Government debt, at 53 percent of GDP last year, is lower than that of Germany, France and the euro-region average. Still, weak growth may increase the burden as a proportion of the economy. Standard & Poor’s, which has downgraded Spain twice since the start of 2009, sees average annual growth of 0.7 percent from 2010 to 2016.

“The debt’s not very big; the problem is that the economy isn’t going to grow,” said Juan Jose Dolado, an economics professor at Carlos III University in Madrid and former deputy chief economist at the Bank of Spain.

The government “runs the risk of being far too optimistic,” further undermining its credibility, said Fernandez, previously chief economist at Banco Santander SA. “We’re not going to grow 1.3 percent in 2011 no matter what they do.”

Zapatero’s reputation was damaged at the start of the financial crisis. His government predicted in October 2008, when the economy was already shrinking, that Spain would avoid a recession. It now forecasts a second year of contraction in 2010. A prediction of 19 percent unemployment this year was surpassed in the first quarter, as the jobless rate hit 20 percent, the highest among the 16 nations sharing the euro.

Popularity Slumps

Now, the austerity steps announced by Zapatero have undermined his support to the point where the opposition People’s Party could win an outright majority if elections were held today, according to a poll in El Periodico on May 29. It showed 60 percent of those surveyed thought the government’s performance was “bad” or “very bad,” even as the equivalent figure for the PP was 57 percent.

Unions, which Zapatero has courted and tended to consult on policies that affect them, have threatened the first general strike since the Socialists came to power in 2004. They are set to clash again as Zapatero has said he will overhaul labor- market rules.

Under pressure from all sides, it will be a challenge for the government to see out its term, said Pere Puig Bastard, a professor at ESADE business school in Barcelona. “We’ll have to see if they hang on many more months.”

To contact the reporter on this story: Emma Ross-Thomas in Madrid at erossthomas@bloomberg.net

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