Spain faces a lost decade

“Against this backdrop, the Government will struggle to reduce its budget deficit over the coming years,” CE stated.
“If it is also forced to implement an expensive bailout of the banking sector, public debt might eventually peak at around 120% of GDP – on a par with the current level in Greece.”

Despite all this, CE believes Spain can still get its public debt down to a more sustainable level in the medium term without defaulting.

“But it is questionable whether it will be willing to accept a decade of deflation in order to restore full competitiveness,” CE cautioned.

“For now, there remains a strong political will to remain in the euro-zone and the Government is optimistic about the prospects for growth, meaning that Spain is unlikely to abandon the euro any
time soon. But if Spain is still mired in recession a few years down the line, with no end in sight, support for the euro could begin to disintegrate.”

If, say, Spanish government debt reached a level of 100% of GDP or more, it would simply be too costly to leave the single currency and continue to service its euro-denominated debt.

“Accordingly, the Government would almost certainly be forced to restructure its debts by converting them from euros to Spain’s new currency,” CE posited.

“While this would certainly lead to frictions in financial markets, the likely losses would probably not be big enough to prompt a financial market meltdown, unless it prompted other economies, such as Italy, to abandon the single currency too.”

While it is doubtful that Spain would be the first euro-zone economy to exit the euro-zone, B&L think the benefits of leaving may outweigh the costs.

“If another peripheral economy abandoned the single currency and thrived, we think that Spain would probably follow suit,” CE concluded.