Just about the time that investors have been able to put the European sovereign debt crisis in the rearview mirror, it appears that it may be déjà vu all over again in Spain.

Spanish bond yields were up sharply last week as the yield on the 10-year spiked more than 0.5% to above 5.5% and the spread to German bunds (a measure of risk) rose to the highest level seen in two months.

The source of the renewed concern appears to be the Spanish banking sector. Led by problem loans in real estate, the bad loan ratio continues to rise and at 7.9% is the highest level seen since 1994.

The weakness in the banking sector coupled with the fact that Spain is currently in a recession has meant there has been next-to no rebound in Spanish stocks. Compare the action in the EU ETF to that of the Spanish ETF shown below.

Due to the lagging economy, Spain’s debt-to-GDP level has continued to rise and is now well above the levels seen as viable by the Eurozone.

Italy’s Prime Minister Mario Monty warned Monday that Spain could reignite the European debt crisis if EU officials do not take action in the near term.

Bloomberg reports that Monti pointed to Spain’s inability to control its public finances as a reason for concern.

“It doesn’t take much to recreate risks of contagion,” Monti said over the weekend. Monti also advised Spanish leaders to focus on cutting national spending. Spain “hasn’t paid enough attention to its public accounts,” he said.

The FT reported that Olli Rehn, the EU commissioner for economic and monetary affairs, also called on the Spanish government to push through additional austerity measures to bring its budget deficit down to 5.3% of GDP this year and 3% next year. Rehn said that the recent backup in Spanish borrowing costs has been a function of market concerns about Spain's commitment to the deficit targets.

The concern over Spain comes as EU finance ministers are preparing to meet in Copenhagen on March 30th where it is expected the group will see to increase the current €500 billion ceiling on the region’s bailout fund.

Germany, which has up to this point vehemently opposed any such increase, appears to be wavering on its stance. Reuters reported Monday that German Chancellor Merkel said can “imagine” the €200 billion left in the EFSF being run in parallel with the new €500 billion ESM set to commence operations this summer.

There have been a number of reports over the last few days suggesting that Germany has backpedaled on the opposition to a larger firewall, while Finland, another key holdout, has indicated a willing to compromise. The path of least resistance now seems to revolve around a creating a joint bailout fund in the €700-€740 billion range via a temporary combination of the EFSF and ESM that would fall back to the current €500B cap once the EFSF expires in mid-2013.

But for now, it is probably a good idea to keep your eye on Spanish bond yields and debt spreads.

 

  iShares Spain - Last 12 Month

 

 

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