ANALYSIS-Higher Spanish yields could force deeper austerity

By Manuel Ruiz MADRID, Nov 12 (Reuters) - Rising yields on Spanish bonds could force the country to extend austerity measures though timing will be key in markets increasingly nervous over other euro zone periphery countries, such as Ireland and Portugal. On Friday the spread between benchmark 10-year Spanish and German bonds, a key indicator of investment risk, hit 230 basis points, the highest level since the euro zone was formed in 1999, although they later fell back. The aversion to Spanish debt was mostly due to spillover from Ireland, whose 10-year yields were above 8.5 percent on fear its high deficit and troubled banks could force it to seek a bailout. Ten-year Spanish bonds were trading at yields around 4.6 percent on Friday, up from 4.16 at the last bond auction of 10-year bonds on Sept. 16. The next Spanish bond auction is Nov. 18, for 10-year and 30-year bonds. "If 10-year yields rise above 5 percent, the government will have to adopt new measures to compensate the higher financing costs. That would have, more than anything else, a psychological meaning," said Estefania Ponte, economist with Cortal Consors brokerage in Madrid. Higher borrowing costs will test Spain's tough 2011 budget, which cuts costs by 8 percent in an effort to trim the budget deficit to 6 percent of gross domestic product from 11 percent last year. But Jo Tomkins, economist at 4Cast, said announcements of further austerity measures could be counterproductive unless timed very carefully. "The market is spooked well and truly by Ireland and, especially before Ireland announces its budget Dec. 7, Spain won't want to be making any announcements which would spook the markets any more," she said. ECONOMY STAGNATING Spain's economy pulled out of recession earlier this year, but has since stagnated and is lagging the growth in the core euro zone. In May, when the Spanish-German spread jumped to more than 226 basis points, on fear it could follow Greece in needing emergency funding, the government responded with austerity measures, government funds for unhealthy savings banks and a labour market reform. The measures restored market confidence to such an extent that in August the government rolled back some spending cuts on infrastructure as borrowing costs came down. The Socialist government of Prime Minister Jose Luis Rodriguez Zapatero passed the toughest budget in decades, but many economists say it is based on an overly optimistic economic growth forecast of 1.3 percent for next year. "If Spain begins to lose confidence it won't have any choice but to take (additional) measures. The government, businesses and the people all understand that," said a banking executive, who asked not to be named. Spain's treasury has scheduled auctions of 35 billion euros in debt, including short-term bills, between now and the end of the year, and analysts said it would not have trouble raising the funds. David Keeble, global head of fixed income strategy for Credit Agricole, said yields would have to give another large jump to force Spain to further cut spending . "As long as the T-bill areas are intact and don't spike up too much, you won't see too much pressure for them to change their budget," he said. (Additional reporting by Paul Day; Writing by Fiona Ortiz; Editing by Toby Chopra) (; +34 91 585 2167) COPYRIGHT Copyright Thomson Reuters 2010. All rights reserved.

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