Bailout doubts

Spain's Jose Luis Rodriguez Zapatero and Angela Merkel may not have the closest of relationships, but when the German chancellor expressed on Tuesday her "great respect" for the reforms her counterpart has implemented in recent months, it was a rare moment of relief for him.

The last few days have been tough for Zapatero, with the Spanish bond yield rising on news of Greece's economic problems and opposition politician Cristobal Montoro declaring that Spain is "on the edge of the abyss."

Once again, speculation has started to mount over whether Madrid will be forced to follow Greece, Ireland and Portugal and request an emergency bailout from the European Union.

On Wednesday, Zapatero described Montoro's claim as "untrue, irresponsible and disloyal" and Merkel's show of support for the prime minister's reforms was a boost as he attempts to convince Spaniards of their necessity.

But while the Socialist government has started to rein in an unwieldy deficit by raising taxes, cutting public sector pay and introducing labor reforms, Spain still has enough problems to spook the markets every time economic uncertainty rears its head in the EU.

"Greece has received a lot of help from the EU over the last year and there are still doubts about whether it will need further help," said Ismael Sanz, an economic analyst at Madrid's King Juan Carlos University.

"There are also doubts over whether Greece will be able to pay back its public debt. So the financial markets start to wonder whether this might also be the case for Spain."

Spanish weaknesses

Spain does not have the enormous debt levels the likes of Greece, Ireland and Portugal: at 62 percent of gross domestic product, its debt is well below the EU average. However, its deficit remains high, as does its unemployment rate, which is the EU’s largest at 21 percent.

These weaknesses, in addition to a slow economic growth rate, raise concerns about the country's long-term sustainability and make interest on its debt more expensive. This vicious circle leads the markets to wonder whether Spain can finance both its debt and the deficit.

A further difficulty is created by Spain's 17 regions, which enjoy varying degrees of autonomy. Their ability to get into debt, especially ahead of local elections such as those scheduled for the end of this month, is a further fiscal headache for the central government in Madrid.

So, will Spain go under? While the government does not hide its frustration at the apparently fickle nature of the markets, it insists the economy is robust enough to survive the ongoing European financial crisis.

Sanz says Spain’s failure is possible, but only if a perfect economic storm keeps blowing through Europe.

"If the financial crisis goes on, if Greece has a lot of problems and finally restructures its debt, if Portugal is not able to consolidate its economy and Ireland continues to have problems, maybe there is a possibility of a contagion effect in Spain," he said.

Tricky prospect

That's a lot of ifs. But the real issue with Spain appears to be related to the size, rather than the weakness, of its economy. So far, the EU has managed to absorb the impact of bailing out three of the bloc's smaller economies.

Portugal's bailout is reported to be worth 78 billion euros. But Spain, the eurozone’s fourth-largest economy, would be a different challenge altogether if it failed.

"The impact on the rest of the countries would be much higher, the amount of the bailout would be much higher and all the economies of the European Union - and even the rest of the world - would be affected," said Sanz.

This would help explain the interest that other world leaders, such as Merkel and US President Barack Obama, have taken in Spain's reform program.

Analysts across the world are also taking a new interest in the southwestern corner of Europe, in the wake of the Portugal's bailout. American Economist Nouriel Roubini last month appraised the risks that a Spanish collapse could imply.

"I think the big question is not Portugal - that is too small - but whether the contagion could spread, over time, to Spain, a country that is on one side too big to fail but from the other side too big to be saved," he said.

Author: Guy Hedgecoe, Madrid
Editor: Martin Kuebler