Greece is the sideshow, a warm-up act. Spain is the main event, the country that will have a huge impact on the future of the euro and on whether a new governance system will be put in place to control euro-zone members' budgets. The pain in Spain will fall, well, just about everywhere. That's why key figures from the world's financial institutions converged on Madrid late last week.
Spain matters because its economy is the euro zone's fourth largest, four times larger than Greece's. In the words of Goldman Sachs economists, if Spain were to experience a real financial fiasco, "the degree of cross-border financial exposure for the entities based in the larger euro-area economies would multiply dramatically." Spain's banks are already frozen out of interbank loan and capital markets, and are now the European Central Bank's largest customer. Last month they borrowed €85.6 billion ($105.9 billion) from the lender of last resort, up from €74.6 billion in April. Spain's banks account for roughly 10% of the euro zone banking system, but account for 16% of all net euro-zone loans. Next stop, the €440 billion European Financial Stability Facility, created by the euro zone powers-that-be as part of a €750 billion rescue package aimed at reassuring markets that there will be no defaults.
The need for a bailout is hotly denied by all of the players in this financial drama. A U.S. Treasury delegation joined International Monetary Fund head Dominique Strauss-Kahn in Madrid to meet with Spanish Prime Minister José Luis Rodríguez Zapatero and key government officials in what was represented as a rather routine, long-scheduled affair to discuss growth prospects over the next decade. European Council president Herman Van Rompuy stressed the "normality" of the meeting. No emergency measure was even discussed. Speculators and others circulating rumors that the EFSF is preparing a €250 billion rescue package are tilting at windmills.
"I am really confident in medium- and long-term prospects for the Spanish economy," announced Mr. Strauss-Kahn as he emerged from the Madrid meeting, adding, "providing the efforts that have to be made will be made." Quite a proviso, given Mr. Zapatero's long period of denying that a crisis exists, his initial refusal to cut the size of the public sector and the one-vote margin by which some of his reforms passed a parliament convinced that his future prospects are about as bright as those of Tony Hayward's.
The markets remain appropriately skeptical, nervous that the premium that Spain has been paying over safe(r) German bunds will balloon when it taps the debt markets for some €50 billion over the summer. Even more important, with Spain's government in no position to help its banks, failures would rain pain throughout Europe and on the U.S. and Britain. Miguel Ángel Fernández Ordóñez, governor of the Bank of Spain, hopes to calm the financial waters by releasing the results of the stress tests some of Spain's banks have undergone. He claims these will show that the nation's banks are adequately capitalized to withstand defaults by over-borrowed construction and property companies, and individual mortgagees. Markets are not reassured: the tests are confined to a handful of banks, and contain not very stressful assumptions.
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