On Monday Spain's 10-year bond yield rose by more than 20 bp, to above 7.50%. This is a record-high level in the history of Spanish presence in the euro area. Yields of Italian bonds increased as well, by 20 bp, above 6.35%. The bond market sell-off was supported by Spanish newspaper El Pais reporting yesterday that the Balearic Islands and Catalonia are among six Spanish regions, which may request assistance of the central government, as Valencia did last week.
Moreover, Bank of Spain said Monday that GDP shrank in Q2’12 by 0.4% from Q1’12. The central bank said it was due to a "substantial contraction" in public and private spending. Having already fallen by 0.3% in Q1'12, Spain is now considered to be in recession and Bank of Spain expects GDP to shrink this year by 1.5%. Faced with equity market selloff, Spain said Monday that shortselling of all stocks will be banned for three months. Also Italy banned short selling of financial market stocks for one week. Importantly, Finance ministers of Spain and Germany will meet today for crisis talks in Berlin.
Spain's economic situation is deteriorating, which puts into question government's ability to get tax revenue and raises concern among financial market investors. Paradoxically, worsening GDP dynamics in Spain stems partly from significant budget cuts the country is putting through to show financial markets that it is a credit-worthy borrower. Spain needs to issue ca. EUR28 billion more in bonds this year to finance its deficit and repay maturing debt, and ca. EUR50 billion in short-term T-bills. What’s more, Spain’s financially troubled regions may need help from the central government, which could add another EUR30 billion to financing needs.
Record-high level of 10-year bond yields in Spain shows that tension around the country builds up. The EUR100 billion aid package to Spanish banks formally approved by eurozone finance ministers last Friday proved not much of a help. The 10-year bond yield level of 7% is the so-called safety threshold. Above such yield level countries such as Greece, Ireland and Portugal were previously forced to seek financial aid. With financing cost now at above 7.5% Spain will likely need a bailout within the next few months. Another option for Spain would be for the ECB to intervene in the Spanish bond market by purchasing bonds through SMP (Securities Market Programme).
Continued euro zone turmoil weakens emerging market currencies, including the zloty, and puts downward pressure on equities. Escalating problems of the euro zone also means a risk of further deterioration of sentiment on the side of Polish entrepreneurs and consumers, which may negatively affect investment and private consumption, and hence, Poland’s GDP dynamics.