Spanish Prime Minister Jose Zapatero is on a tour of Asia this week playing up the fact that key investors like China are more than willing to buy his government’s debt, despite Portugal’s decision to ask the European Union for support.
The big question for Spain remains whether it can avoid the same fate as Portugal.
For the market, the question is what would happen if a euro zone economy of Spain’s scale found itself on the wrong side of the bond vigilantes.
“Worries that the euro zone debt crisis will enter a more dangerous phase by spreading from the smaller peripheral economies to Spain have recently diminished,” writes Roger Bootle, managing director of Capital Economics, in a research note.
“But we think that it would be premature to conclude that Spain has put its troubles fully behind it. We fear that it could yet be dragged into the crisis, with potentially catastrophic results,” said Bootle.
“If the region’s fourth-largest economy suffers from a liquidity crisis, or worries about its solvency grow, the implications for the financial markets would be huge and may threaten the future of the euro,” he said.
One of the main reasons the wider global market has dismissed the euro zone debt crisis in recent months has been Spain’s ability to stay clear of the same problems as its neighbor Portugal.
Yields on Spanish debt have narrowed against the bund.
The government is pushing ahead with austerity measures and is on target to meet fiscal goals and fears over the country's banking system have eased significantly.
But Bootle believes it is far too early to say Spain is out of the woods.
“It is too soon to conclude that Spain has turned a corner. For a start, Ireland’s experience shows that it is difficult to assess the true scale of problems in the banking sector,” he said.
“The Spanish Government may yet have to spend much more than is widely assumed to fully restore confidence in the banks,” said Bootle.
While Spain’s relatively low level of public debt has shielded it from the bond market so far, Bootle questions whether this can be maintained.
Spain’s “fiscal goals will become progressively harder to achieve, both politically and economically. And in the medium term, it faces a sharp rise in costs associated with the ageing of its population,” Bootle said.
Soaring unemployment, above 40 percent for the young, is a major problem for the Spanish economy and Bootle believes the labor market could become a major problem.
“The economy faces some strong headwinds which will make it tough to eliminate the budget deficit. The dire state of the labor market means highly indebted households are likely to cut spending sharply as the fiscal squeeze intensifies,” he said.
“Meanwhile, given the strong euro and Spain’s poor competitive position, the export recovery is likely to lose steam as global trade growth starts to slow” said Bootle.
“While Spain may avoid needing financial support, there is a good chance that a bout of stagnation may result in it eventually seeking a bailout. Worryingly, given Spain’s size, even this may lead to further political tensions and plunge the euro-zone into a deeper crisis,” he said.