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Spanish bonds risky business before deficit numbers announced

While Spanish prime minister Mariano Rajoy is confident that the upcoming deficit levels will highlight Spain’s dedication to fiscal consolidation, analysts at CreditSights argue that the goal might be out of reach. Investors should show caution when it comes to Spanish debt.

Investors would be wise to reconsider their exposure to the Spanish government, banks and credit risk, as the government could fail to hit budget deficit targets later this month, warn analysts at CreditSights.

Spanish prime minister Mariano
In a press conference in Madrid on Tuesday, Spanish prime minister Mariano Rajoy said “public deficit data for 2012 to be published in the coming weeks will show unprecedented fiscal consolidation efforts have been made”.

However, according to David Watts and John Raymond, analysts at CreditSights, the deficit has the potential to exceed the government’s prediction, having the potential to “undermine Spain's borrowing position, especially in the longer part of the curve which is unsupported by the ECB's bond purchase promises”. After numerous rounds of austerity measures, hitting the 6.3% deficit target fixed for Spain in 2012 by the EU is out of its grasp, argue Watts and Raymond, and was only possible if the government had balanced its budget in the fourth quarter 2012 due to the staggering 9.9% deficit reached between the third quarter in 2011 and the third quarter in 2012.

Instead, the economy contracted by 1.7% in the fourth quarter compared with the same period a year earlier. Spain last ran a balanced budget in 2008.

Moreover, investors should show caution for a “cyclically adjusted budget deficit” model for Spain too. While fiscal deficits are strongly cyclical – falling when an economy is strong and rising in periods of weakness – in times of economic upheaval, such as the European debt crisis, “cyclically adjusted budget deficits often underestimate the dramatically worse state of public finances,” said Joerg Kramer, chief economist at Commerzbank.

When the crisis began, the long phase of strong economic growth in Spain, Greece, Ireland and Portugal came to an abrupt end," said Kramer. "However, the estimation of potential output is largely dependent on the strong economic data of past years. Consequently, the estimation procedures are likely to overestimate the potential output of the peripheral countries and currently indicate an exaggerated under-utilization of the potential output [negative output gap]. This means that too large a part of the high budget deficit is presumably being excused as being due to cyclical factors, and cyclically adjusted deficits are estimated too low.

“In Ireland, Greece and Portugal [as well as Spain], cyclically adjusted budget deficits are probably glossing over the actual state of budgets.”

Last February, Spain’s budget deficit was published for 2011, reaching a disappointing 8.5% – 2.5 points more than the stated target. Following the announcement, Spanish government bond yields rose continuously until Mario Draghi’s unconditional support of the euro, despite the issue of the second three-year long-term refinancing operation, pumping €114 billion of liquidity into the country. Indeed, Spain has missed every budget goal set by the European Union since 2009.

Rajoy and Draghi are due to meet on Wednesday in Madrid.

If the deficit target is reached, bonds are likely to carry on trading the same, but if the deficit is missed the “bonds are likely to sell off and that is likely to be most pronounced in longer-dated instruments given the lack of support from ECB bond purchases”, said Watts and Raymond.

Spanish bonds are rated Baa3 at Moody’s Investors Service and BBB- at Standard & Poor’s, just one notch above junk.