Testing Time For Spain, Perhaps

The function of a ratings agency is to provide an honest assessment of the risk associated with investing in a given financial vehicle; the greater the risk, the higher the yield will need to be to attract investors. Standard and Poor’s has just dropped its rating of Spanish sovereign debt from BBB+ to BBB-; a notch above “junk” status. A junk bond is simply an investment which is no longer within the top-tier “investment-grade” category.

Usually, a downgrade of sovereign debt credit rating would be likely to push up borrowing costs when the nation in question comes to the market to raise more cash. Until recently, this would have meant that Spanish borrowing costs would have been pushed beyond what economists regard as a sustainable level. This would renew speculation that Spain would need an EU/IMF bailout and send the Euro lower against other major currencies. However, the ECB policy of supporting bailout recipient nations to restrain their borrowing costs in the market through an open-ended bond purchasing programme is now in place. Whilst Spain is currently ineligible to receive such support from the ECB, it has benefitted from the perceived safety net and seen its borrowing costs fall despite continuing speculation that it will indeed require a bailout in due course.

The Spanish are adamant that they don’t need a bailout – meaning that they are confident that they can continue to meet their borrowing requirements in the financial markets. This is not Standard and Poor’s view: "The downgrade reflects our view of mounting risk to Spain's public finances, due to rising economic and political pressures. The deepening economic recession is limiting the Spanish government's policy options."
With one in four of its workforce idle and a bad debt mountain following the bursting of a property bubble, Spain does have real problems. It is tackling these through employment legislation reform, designed to make hiring and firing easier, and a range of strict austerity measures aimed at slashing government spending and increasing revenue through tax increases. The last thing Spain needs right now is to see its borrowing costs climbing again.