Spanish Crisis Faces Second Front on Regional Debt

Jose Luis Rodriguez Zapatero, Spain's prime minister
Jose Luis Rodriguez Zapatero, Spain's prime minister. Photographer: Denis Doyle/Bloomberg

Prime Minister Jose Luis Rodriguez Zapatero may face a second front in his battle to contain Spain’s fiscal crisis as borrowing costs for the country’s regional governments climb.

Catalonia, which accounts for a fifth of Spanish gross domestic product, has been shut out of public bond markets since March and the extra yield it pays over national government debt has almost tripled this year. Galicia, in the northwest, has asked to freeze payments of debt it owes the central government and the Madrid region postponed a bond sale last month.

Spain’s regions, which borrowed at similar rates to the central government before the global credit crisis started in 2007, are key players in Zapatero’s drive to get his budget in order and push down the country’s borrowing costs. They control around twice as much spending as the state, employ more than half of all public workers and piled on debt during the recession.

“If investors focused more on the problems in the regions, they would be less optimistic on Spain’s central government debt, and see that the rally in July was a bit overdone,” said Olaf Penninga, who helps manage 140 billion euros ($182 billion) at Rotterdam-based Robeco Group, and sold Spanish bonds last year. “If the central government has to help the regions it would aggravate an already bad situation.”

Risk Premium

The yield on 10-year Spanish government bonds has dropped 79 basis points to 4.09 percent since June 16, according to Bloomberg generic prices. The extra return investors demand to hold the debt rather than German equivalents was at 165 basis points today, down from a euro-era high of 221 points two months ago.

Banks are nevertheless charging Catalonia more for loans than the building companies stung by Spain’s construction slump.

The region, which attracts more tourists than any other in Spain, paid 300 basis points more than three-month Euribor for 1 billion euros of four-year bank loans last month, a spokesman said. Fomento de Construcciones & Contratas SA, Spain’s fourth-largest builder, said on Aug. 2 it agreed to pay a 260-basis point spread to extend 1.1 billion euros of loans until 2014.

While government records on Aug. 9 show that Catalonia sold 1 billion euros of five-year debt via savings bank La Caixa in June, it hasn’t issued a benchmark-sized bond in public markets since March even after taking a road show to Asia in April. “Debt markets closed” as Greece’s fiscal crisis spread through the euro region in the second quarter, said spokesman Adam Sedo last month.

At 5.5 percent, the yield on Catalan 10-year bonds is on a par with Peru.

Greek Fate

The regions’ budget problems come as Zapatero tries to convince investors that Spain can avoid the fate of Greece, which was forced to seek a European Union-led bailout this year after its deficit ran out of control. Zapatero, his popularity slumping in opinion polls, is pushing through the deepest austerity measures in three decades and borrowing costs have declined since officials last month published stress tests on Spanish banks.

The regions’ borrowing difficulties will likely complicate their relationship with the Madrid government. While Catalonia is pushing for more autonomy and Spanish law prevents the central government from bailing out the provinces, some investors expect it would do so if necessary.

‘Big Brother’

“There’s a certain perception that there’s a big brother standing behind,” said Diego Fernandez, a fund manager who helps oversee 240 million euros at Inverseguros in Madrid and is cutting holdings of regional debt. “There could be a region that has more difficulties and so would need some help, which wouldn’t materialize as a bailout but as some kind of larger transfer.”

The EU got around its own no-bailout clause in May and backstopped countries threatened by contagion from Greece’s crisis. Letting a region fail would also push up Spain’s own bond yields and would be “suicide,” said Jose Carlos Diez, chief economist at Intermoney Valores, Spain’s biggest bond dealer.

“It would be absurd -- you don’t let a bank fail but you let a region fail?” he said.

Catalonia isn’t the only region that may hurt Spain’s budget battle. The autonomous community of Madrid postponed a bond sale on July 30 because of “market conditions.” Galicia is lobbying Finance Minister Elena Salgado to put a moratorium on 2.6 billion euros it owes the central government and to double the time it has to pay the money back. Salgado refused on July 27.

Debt Load

Regional debt has soared since the end of the decade-long real estate boom that provided local leaders with a surge in tax revenues. While provinces are required by law to balance their books, their overall debt load rose to 9 percent of GDP in the first quarter compared with 5.5 percent at the peak of the boom.

The regions have agreed to cut their combined deficit to 2.4 percent of GDP in 2010 instead of 3.2 percent planned at the start of the year. The shortfall will widen to 3.3 percent of GDP next year compared with a previous forecast of 4.2 percent. Zapatero forecasts the national deficit will narrow to 6 percent next year from 11.2 percent in 2009.

That hasn’t stopped Fitch Ratings giving four provinces a negative outlook on Aug. 4, meaning it now has all 10 of the regions it covers on notice for possible downgrades. Its ratings range from A+ for Catalonia and Valencia -- the lowest since Fitch started rating them -- to AA for Madrid, while the Basque Country is the only region rated AAA. Fitch cut its rating on Spain to AA+ May 28.

Any deterioration in the regions’ credit quality, coupled with one of the highest private debt loads in the euro area, could undo Zapatero’s efforts and push up Spain’s own borrowing costs, Penninga said.

“This crisis can come back to haunt Spain again,” he said.

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