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Forget About Italy and Greece, Spain Next on Agenda

Spain has come to the forefront of the European markets agenda again this week as yields on its debt soared and it prepared for a new government.

Spain
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Spain

"In a lot of ways it's more worrisome than Italy," Megan Greene, senior research analyst at Roubini Global Economics, told CNBC.com.

The euro zone's fourth-largest economy had fallen into the background whileItalyand Greece dominated the headlines. Now concerns are growing about the country's banking sector, its sovereign debt, high unemployment and stagnant GDP growth – and the social unrest they may cause.

The center-right People's Party (PP), led by Mariano Rajoy, is predicted to win an overall majority in next week's elections, defeating the incumbent Spanish Socialist Worker's Party (PSOE). The prospect of a government with a strong mandate to enforce reforms should, in theory, reassure markets, yet yields on Spanish 10-year bonds hit 6.38 percent their highest level for a year, this week.

Concerns that Spain's budget deficit is higher than the 6 percent of GDP target for 2011 are widespread. The European Union target is 3 percent – and Spain's deficit was 9.2 percent of GDP in 2010.

"What's likely to happen is that the People's Party take control and say: 'Oh my God, we have looked at the books and it's much worse than we thought,'" Alistair Newton, senior political analyst at Nomura, told CNBC. "There is a huge degree of uncertainty over how high it will be."

He said that the PP was "fully on board with the International Monetary Fund, Berlin and the European Central Bank" on the need to get the deficit under control.

Yet reducing the deficit will be a long, grim task for Spain and the Spanish people, already suffering from declining property prices and youth unemployment at close to 50 percent.

Economists at Credit Suisse believe Spanish workers need to have an 11 percent cut in wages over the next 5 years to restore competitiveness.

Many argue that its property market, where the average house price is down around 26 percent from its peak compared to 43 percent in Ireland, has still further to fall. The banking system has yet to recover from financing the property boom, and the fallout from the ensuing bust, and there are murmurs that its biggest banks may have to be recapitalized.

Unlike Italy, Spain has already enacted a series of harsh measures to tackle its deficit, without huge success so far.

"It has already picked off a lot of low hanging fruit with reforms and it still isn't supporting growth," Greene said.

Growth in the third quarter stalled, according to official statistics released on Wednesday, as demand for Spanish exports slowed and domestic demand continued to shrink. The domestic economy is still recovering from the decline in construction, according to Gustavo Bagattini, analyst at RBC Capital Markets. "We do not expect a robust bounce-back in the near term," he wrote in a note.

"The banking sector and worries about contagion are undermining the future," Greene said."The property market has a lot further to fall and we haven't seen all of the mortgage defaults yet."

"The very simple, linear logic is that we are going to see more austerity measures next year and that's going to put an even tighter squeeze on households," said Newton.He also pointed out that the PP plans to offer companies tax breaks for hiring, which will have to be paid for elsewhere.

Greater cohesion between the regional and national governments is expected after the election, as the PP controls Madrid and Catalonia and is predicted to gain control of Andalucía in March next year. If it takes power in Andalucia, it will control Spain's three biggest economic regions, which account for almost half of total regional expenditure.

Looming over the political and economic landscape is the danger of social unrest. The Occupy movement currently hitting headlines around the world has its roots in the Indignados movement in Spain, which has occupied squares in cities around Spain.

"The Indignados are very orderly but very large and, with a right-of-centre government imposing cuts, that could change," said Newton, who warned there could be further strike action.

"Unions have been very restrained over the last few months because they didn't want to damage the PSOE's re-election chances, but they're not going to do that with a new PP government in power."

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