Will Spain's Austerity Budget Calm Markets' Nerves?

The new Spanish government will present its first budget Friday, with austerity expected to be the overriding theme.

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The problems facing the euro zone’s fourth-largest economy have not dissipated since the government, led by Mariano Rajoy of the center-right People’s Party, took office last year, and there are now worries that the Spanish population is increasingly resistant to austerity measures.

The People’s Party failed to win a majority in crucial regional elections on Monday, sparking fears about the level of support for Rajoy’s austerity program. Friday’s budget is expected to reinforce his commitment to cut the deficit, despite worries about its impact on growth and a general strike planned for Thursday.

“Now it is crunch time for the Spanish government, the countdown to convince the markets that Spain is fully committed to execute a fiscal plan consistent with the very ambitious fiscal deficit targets has effectively begun. In our view, the new conservative government is indeed committed to fiscal consolidation (at least that is what the government track-record shows), yet weak growth in Spain will make achieving those targets not a trivial task,” Antonio Garcia Pascual, chief southern European economist at Barclays Capital, wrote in a research note on Tuesday.

Spain’s GDP is forecast by the Spanish government to fall by 0.7 percent this year, but many economists believe that this is too optimistic.

There is increasing speculation that it may be the next euro zone country to seek a bailout from the troika of the International Monetary Fund, European Union and European Central Bank.

Willem Buiter, chief economist at Citi , believes that Spain will have to enter “some form of a troika program” later this year.

Most economic metrics for the country look less than pleasant, and investors are increasingly concerned that the boost provided by the European Central Bank’s long-term refinancing operation has merely provided breathing space. Tuesday’s bond auction of 3- and 6-month bills showed weaker interest and higher yields than expected, indicating that investors are more worried about Spanish debt.

“While the government is trying to contain debt, unemployment is rising, workers are increasingly leaving the country and consumers are struggling,” strategists at RBS wrote in a research note.

With almost half of the country’s young workers without a job, demand and exports falling and deficit reduction not proceeding according to the plan agreed with the rest of the euro zone, Spain’s economy is still in intensive care.

“The reforms are going in the right direction but there’s huge resistance. The political result hasn’t been good for this government. The pressures haven’t eased in the slightest,” Richard Portes, founder and president of the Centre for Economic Policy Research (CEPR), told CNBC.

“The banks have used much of the money the ECB provided to buy Spanish government bonds – which are falling in price. Yes, it’s a nice carry trade but we have seen in Greece and elsewhere that this might not be the right move in the long term.”

Spanish banks were among those who increased their government debt holdings the most after the ECB's twin funding operations which were aimed at averting a credit crunch. They also have a relatively high exposure to the Spanish property market, which many fear is headed for a second major correction.

There are a lot of concerns that the Spanish banking sector is effectively putting off foreclosing on mortgages by restructuring loans instead, potentially leaving much of its pain for a later date. The rate of non-performing loans, where customers have fallen three months or more into arrears, is now lower than in 2009, despite rising unemployment and the start of a new recession – indicating that banks are postponing foreclosure by restructuring.

“We still haven’t seen the bottom of the Spanish housing market and the banks are very exposed to that,” Portes warned.

Analysts at Goldman Sachs argue that the Spanish government and the EFSF should work together to support the recapitalization of the banking sector, rather than have Spain resort to expanding its banking bailout fund the FROB.

“In this way, Spain could take advantage of EFSF funds, avoiding the ‘stigma’ of a macro-economic adjustment program, while the planned restructuring/recapitalization would be reinforced by external incentives and controls, and EMU-wide resources would be directed at one of the obvious sources of weakness of the common currency area,” they wrote in a research note.