Spain’s Deficit Struggle Shows Threat to ECB Rally

Spain’s bid to meet its budget-deficit target for the first time in five years is running into trouble, fueling concerns that increased financial stability is masking deeper economic problems.

The shortfall for the central government in the first seven months of the year was 4.38 percent of Spanish output, compared with a 3.8 percent goal for the year, government data show. Economists at the savings banks’ foundation Funcas, Mizuho International and Bank of America Merrill Lynch said Spain may miss the European Union’s overall goal for this year of 6.5 percent as benefit spending climbs and tax income falters.

German Finance Minister Wolfgang Schaeuble, campaigning ahead of this month’s national general election, has cited signs of economic recovery in Spain as evidence that Chancellor Angela Merkel’s prescription of forcing budget cuts on euro-area countries in exchange for support is bearing fruit. The unraveling of Spain’s consolidation program may undermine his case and jeopardize the 13-month rally in Spanish debt that set the spread with German bunds at a two-year low last month.

‘Lack of Progress’

“Probably influenced by crisis fatigue and criticism of European austerity policies, the European Commission has overlooked the lack of progress this year in some structural reforms and the deficit,” said Ruben Segura-Cayuela, a former Bank of Spain economist who works at Bank of America Merrill Lynch in London. “The key question is whether rating agencies will also look the other way.” He forecasts a 7 percent deficit this year.

Spain sold 10-year bonds with the lowest borrowing costs in three years at an auction in Madrid today. The yield on the 10-year benchmark bond rose 10 basis points at 4.61 percent at 3:47 p.m. in Madrid while the spread with similar German Bunds was 258 basis points.

That compares with a euro-era record spread of 650 basis points in July 2012, before European Central Bank President Mario Draghi pledged to do “whatever it takes” to protect the euro. Draghi today reiterated that while the ECB stands ready to take appropriate action as needed, countries shouldn’t unravel reform efforts. The ECB maintained its benchmark interest rate unchanged at a record low.

Spanish Rating

“Draghi’s remarks may continue to cap funding costs,” said Neil Williams, a London-based chief economist at Hermes Fund Managers Ltd., who declined to say whether he owns Spanish debt. “It will do little to address the underlying problem.”

Standard & Poor’s, which rates Spanish debt at BBB-, its lowest investment grade, said in July that missing the target may result in a downgrade. Should Spain lose its investment-grade status, some funds will be forced to sell their holdings of Spanish debt and investors could face steeper haircuts when presenting the securities as collateral with lenders.

Prime Minister Mariano Rajoy is struggling to cut Spain’s deficit after raising levies on income, savings and property since taking office in December 2011. Last year, he increased the sales tax, with the main rate rising by 3 percentage points to 21 percent, and he reduced corporate-tax deductions in July.

“We expect to end the year meeting the deficit target for the public sector overall,” Deputy Budget Minister Marta Fernandez Curras said in an e-mailed response to questions. Spain’s reforms are likely to “produce a greater increase in revenue in the last part of the year,” she said.

Greece to Ireland

The EU’s ability to ensure Spain honors its budget commitments has a knock-on effect for its negotiations with governments across the rest of the periphery who are struggling to meet European demands in the face of domestic resistance.

Greece needs as much as 4 billion euros ($5.3 billion) of extra help, Portugal will have to extend its bailout program beyond next year and Ireland may be the first nation to test the ECB pledge to lend to governments granted aid by the bloc’s rescue fund, Williams said.

Spain’s economic reforms have created “very strong export dynamism,” Schaeuble said in an Aug. 29 interview. “Everyone is on the right track.” A German Finance Ministry spokesman declined to comment further yesterday.

Rajoy has until Oct. 1 to ensure the deficit program is moving ahead and EU officials will assess the outlook in the fall, Simon O’Connor, the Brussels-based spokesman Economic Affairs Commissioner Olli Rehn, said by e-mail.

Subsidizing Security

Spain’s central government deficit fell by 1.5 billion euros to 45.1 billion euros in the first seven months of 2013, compared with the year-earlier period. Revenues, mainly taxes, increased in the same period by 7.3 billion euros. That was mostly offset by a 5.7 billion-euro increase in expenditure.

The government almost doubled its subsidy to the social security system to 13.8 billion euros in the first seven months as falling employment reduced contributions from workers by 3.6 percent. That transfer explained part of the increase in the central government’s deficit, Fernandez Curras said.

Catalonia, Spain’s largest region, is challenging the deficit target the central government approved July 31, the region’s president Artur Mas said Aug. 6.

“Tax receipts are increasing less than forecast,” said Angel Laborda, chief economist at Madrid-based Funcas, who is considering raising his 6.5 percent deficit forecast. “Social security is doing worse than last year and there are doubts over the regions.”

Mizuho International plans to update its projection for a 6.5 percent deficit in October, said its London-based Chief European Economist Riccardo Barbieri.

“Given the trend in the central government budget in the first seven months of the year, I see upside risks,” he said.

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