Spain warned financial markets not to bet against its debt. Spanish prime minister José Luis Rodríguez Zapatero last week ruled out any rescue package for the country. Nevertheless, bond yields continue to creep up in Spain, whose economy is twice the size of Portugal, Greece and Ireland combined. The Irish bailout is already yesterday's news and financial markets are now betting that Portugal and Spain will need a bailout.

Spain looks vulnerable due to its banking sector and weak fiscal position. If investors continue to sell its debt it will have problems early next year. This is because it has sizable chucks of debt repayment due during the first half of 2011. The Spanish government needs to raise €30 billion in the first four months of 2011, whilst the Spanish banks need to raise €40 billion. The combined total of €70 billion looks demanding especially if investors' appetite wanes further.

If Portugal and Spain goes, the current amount in the European stability rescue fund worth €750 billion will not be sufficient to stem an escalating sovereign debt crisis in Europe. ECB council member Axel Weber said governments can increase the size of the EU led bailout fund if necessary in order to restore confidence in financial markets.

Renewed financial market tension in peripheral euro zone countries increases means the ECB will postpone its gradual withdrawal of nonstandard liquidity measures for banks. The central bank is due to decide whether it should continue to provide one week, and one- and three-month loans at its key refinancing rate of 1%.

Meanwhile, Irish bond yields continue to be under pressure. Possible haircuts on senior bonds of its banks will lead to systematic banking risk cross the European banking sector. The amount of the bailout package is still under negotiation which is creating a lot of uncertainties. Parliament will still need to approve its four year austerity plan. The euro continues to get hammered as investors short sell and bet that the sovereign debt crisis will escalate.

One way to placate the markets is for banks to do another bank stress test as was done in July. The assumptions used then were too lenient. However, this may be too late. Investor risk aversion will only ease once Portugal and Spain get a bailout.

 

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