Europe News

Madrid in ‘Game of Chicken’ With EU

Miles Johnson and Patrick Jenkins, Financial Times

When Mariano Rajoy climbed the victory podium in November, having won the biggest electoral majority in his party’s history, he would never have imagined that six months later his country’s destiny could be slipping out of his hands.

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With yields on sovereign debt rising and the economy falling deeper into recession, the second in three years, the veteran Galician politician is battling harder than at any other time in his short premiership to prove his country can sort out its finances without an international bailout.

Mr Rajoy and his government are facing growing domestic criticism over repeated errors of strategy and communication, which that have given an impression that Madrid has run out of ideas on how to handle its financial and economic crises.

“It now looks like they are playing it by ear and the problem is that if you have done that for the last three or four important things you have announced you lose credibility and it is very difficult to get that back,” said Santiago Carbó, a professor of economics at the University of Granada.

A sweeping declaration that no more public money would be put into Spain’s banks in February was followed by the 19 billion euros rescue of Bankia . The size of Spain’s budget deficit has been revised upwards twice during Mr Rajoy’s time in office.

The news over the weekend that Madrid was considering directly injecting government bonds into Bankia to pay for the rescue, sidestepping the markets, was interpreted as a signal that Spain could no longer tap investors – sending the interest it pays on debt compared with Germany to a euro-era high and forcing a rapid reversal of policy.

Madrid added to the sense that it was improvising when the government admitted on Monday that it had not contacted the European Central Bank about the possibility of recapitalizing Bankia using liquidity obtained in return for posting the debt as collateral.

“They just seem to be doing everything to shoot themselves in the foot,” said one London-based investment banker with close involvement in the Spanish market.

Even so, government insiders said there was method behind the apparent madness. Mr Rajoy repeatedly insists Spain will not accept any form of international rescue. People familiar with his thinking said this reflected a growing frustration within the government that Spain has not been rewarded for “doing its homework” – a quick-fire overhaul of its labor market, banking sector reform and the first full scale attempt to control spending by Spain’s regional governments.

For Nicholas Spiro of Spiro Sovereign Strategy, a consultancy, the Rajoy government’s management has been “a tragedy”.

“Books will be written chronicling the history of crisis management in Spain over the past two years,” he said. “I can’t think of another country that has ticked all the right boxes and yet has nothing to show for it”.

But Spain has not been rewarded for its efforts. Seven months after winning the election on a promise of sweeping change, Spain’s 10 year bond yield – a crude but unforgiving barometer of his success – is back near the record highs seen under his socialist predecessor.

The possibility of any outside intervention, where Madrid would lose sovereignty, one government adviser said, was unacceptable for Mr Rajoy.

“It would be the greatest catastrophe in the history of Spanish democracy – the Popular party would be out for power for generations,” he said.

Within the government there is an increasing determination to avoid being forced into a bailout by what Madrid sees as the refusal by the ECB, under German pressure, to act as a true lender of last resort.

The floating of Madrid’s plan to recapitalize Bankia using ECB liquidity was seen by some observers as a high-stakes bet to put extra pressure on euro zone policy makers.

By putting the onus on the ECB to turn Spanish government debt into cash through its repurchase, or repo, facility, Brussels and Berlin would get the message that Madrid means business.

That in turn would encourage euro zone leaders – and, above all, Germany’s Angela Merkel – to agree to Spain’s main demand: a change in the remit of the European Stability Mechanism, the bloc’s new rescue fund, to allow it directly to recapitalize banks.

“It’s like a massive game of chicken,” one Spanish banker said.

Madrid now appears to be on a collision course with Berlin. Spain, government hardliners argue, is too big to be rescued without pulling down the euro zone.