Why Worry About Spain?

As the Spanish election came and went without any reprieve from the financial markets (why did anyone expect anything different is still a puzzle to us) we are being bombarded by financial articles asking why the markets perceive Spain as risky as Italy given that the former's national debt, at 61% is much lower than the latter's comfortably over 100%.

For instance, look at what Der Spiegel says today:,

Still, Spain is not just another victim of the euro crisis. The country's relatively strict banking regulations allowed it to survive the international financial crisis with only light damage. And in the current debt crisis, the Spanish have been model students: With a national debt at some 61 percent of gross domestic product, Spain lies far below Greece (145 percent) and Italy (118 percent) -- but also comfortably below Germany (83 percent).
"Even panic-mongers can't find terrible stories to tell about Spain," says Nicolaus Heinen, an analyst at Deutsche Bank. "The level of national debt isn't critical and important reforms have been put in place." But none of that seems to have helped. "The markets are now punishing any country vulnerable to even a whiff of doubt about contagion," Heinen said.

Except Argentina went bankrupt with a debt to GDP of 55% and Japan has already crossed the 200% barrier while comfortably borrowing, in Yen, at less than 1% for 10 years (the lowest borrowing cost in the world).

Markets are complex mechanisms which journalists, politicians, and investors often oversimplify with disastrous consequences. The reasons why Spain may be riskier than it looks are not too obscure, however.  First, Spain still has a budget deficit of about 9% which means the debt keeps growing.  In addition, it is well known (at least in Spain) that the so-called cost cutting measures are mostly comprised of forced financing from government suppliers (i.e. the government doesn't pay their bills on time) and other accounting gimmicks.  Second, unlike Japan, Spain runs a structural current account deficit, which means they need foreign financing.  Foreigners can be notoriously fickle in their risk perceptions.  Last, but not least, Spain's total debt (i.e including non-public) is at the level of Italy's.  The 61% quoted on the article above accounts only for the debt of the Kingdom of Spain (excluding the bills they do not pay which are not counted anywhere) and ignores the debts of the Comunidades Autonomas and other politically connected entities, like the local banks.  Ireland was at one point the country with the lowest debt to GDP ratio in the eurozone until they decided to bailout the banks. 

As we have seen recently in Ireland, the UK and the US, when the crisis comes and the politicians have to decide between bailing out a locally relevant entity (a bank, a state, a car company, or a defense contractor) and respecting the promises made to the bondholders, many of whom are foreign and, thus, do not vote, the latter don't stand a chance.