Monday, August 24, 2009

Spain's deficit target a polite fiction

Repeats story transmitted on Friday)

By Paul Day

MADRID, Aug 14 (Reuters) - Spain has little chance of meeting its oft-repeated promise to cut its budget deficit to European Union limits by 2012, but economists believe the government is right to pay lip service to the target.

As a massive public works scheme, designed to stop the Spanish economy slipping into a coma, threatens to push the deficit close to 12 percent of GDP in 2009, the government has tried to reassure debt markets that it will swiftly return to fiscal prudence.

"When we make a promise, we like to keep it," said Economy Secretary Jose Manuel Campa last week, asked whether the country would really rein in the deficit to the 3 percent of gross domestic product limit, called for by Europe's Stability Pact, within three years.

"This goal is linked to cyclical (economic development) and we expect cyclical growth of above 2 percent in 2012. A deficit of 3 percent is consistent with this," Campa said.

But therein lies a fallacy, economists say. If Spain withdraws fiscal stimulus (to cut the deficit) while it still lacks a motor of growth to replace the subsiding construction industry, it can't hope to grow above 2 percent.

On top of that, 2012 is an election year in Spain, a period seldom associated with spending cuts.

"The bottom line is all the European countries have got to pay lip service to these rules, but it's a nonsense," says economist at Commerzbank Peter Dixon.

"When you have the situation that we are in now, allowing the deficit to rise is the least worst option."


Over the last month, credit rating agencies Fitch and Moody's have expressed doubt that Spain's deficit target is achievable while at the same time restating the country's top triple-A sovereign-debt rating.

For Moody's, this marked a more optimistic attitude towards Spain, where recent data, including second quarter GDP and unemployment, has shown some improvement thanks to one of the worlds' largest stimulus plans in relative terms.

In January, Moody's had tagged Spain as "vulnerable" amid fears surrounding the global economy and the local housing market. It now believes such worries have dissipated.

"Moody's immediate concerns in this regard have been largely allayed," Moody's said in its press note in July.

"Although there is a good chance that the government will fail to get the deficit down to 3 percent of GDP by 2012 ... it should be able to do so roughly a year or so later."

Markets, so far, seem unconcerned by the speed with which Spain's public debt is rising.

The government says that its debt as a proportion of GDP will jump by 15 percentage points to 60 percent by the end of 2010.

Yet the spread on 10-year bonos against German bunds dropped to around 42 basis points last week, the lowest level since the time of the collapse of Lehman Brothers.

"The deficit's high, but debt in relation to GDP is expected to rise to around only 70 percent (over the next few years), which is relatively low compared to other European countries," said economist at Capital Economics Ben May.

"We certainly feel the fears of a Spanish default at the start of the year were overblown. The decline in bond yields has shown this worry is unfounded," said May.

Nonetheless, while markets are expected to be tolerant of Spain's actual fiscal performance, they still expect the government to talk the talk.

"A 3 percent deficit by 2012 would be difficult, but it doesn't really matter (if they meet it). What's important is the trend," said Standard and Poor's Senior Director of Sovereign and Public Finance, Myriam Fernandez.


Spain is especially vulnerable to a sudden withdrawal of state-support because the downturn has been largely due to domestic, structural failings and, as such, it won't find immediate relief from a global recovery.

Aggressive moves by the government to counter the downturn over the last six months, including around 15 billion euros ($21.40 billion) of infrastructure projects and tax breaks, has helped stem lay offs and encouraged talk of the green shoots of recovery.

Pull this life-support away too soon and the ailing economy could relapse.

"Public finances should be geared toward the medium term but tighten too quickly and you won't get what you're hoping for. A double dip recession could easily occur if you tighten too early," said economist at BNP Paribas Dominic Bryant.

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