Spanish fears stoked by genuine concerns over banks and regional government spending

We've got a piece over in City AM today looking at the reasons behind the increased financial market jitters over the state of the Spanish economy. Despite the usual EU protestations that Spanish fundamentals are sound, there are definite areas of concern present in the Spanish economy - not least, as always, the banking sector. That's not to say a bailout is assured but simply that more needs to be done to ensure the stability of the Spanish economy and convince the markets that Spain is on the path to a full recovery.

See below for the full piece and see here for our full briefing on Spain:

WITH a sense of inevitability the spotlight has landed on Spain. Though the headlines proclaimed that the Eurozone crisis has returned with a vengeance, the truth is it never left. Spain is not Greece, but, many of the market fears surrounding the economy are still both well-founded and expected. There are three major causes of concern: the exposure of Spanish banks, regional governments’ fiscal profligacy and a risk that structural reforms won’t reap benefits soon enough.

The vulnerable banking sector remains the likely trigger for any future downturn in Spain. One in five of the loans by Spanish banks to the bust real estate and construction sectors is seen as “doubtful”, i.e. at serious risk of never being repaid. Against some €136bn (£112bn) in potentially toxic loans, Spanish banks hold only €50bn in loss provisions. And things are likely to get worse. House prices have declined quickly over the past six months and may fall by another 35 per cent, if there is to be the same level of adjustment as seen in Ireland.

This is troubling, firstly, because Spain cannot afford to bail out its banks. And, secondly, because Spanish banks have been the main recent buyers of Spanish sovereign debt. If these banks don’t have the cash to buy Spanish debt, then who will? This massively increases the prospect of a self-fulfilling bond run on Spain and the chances of an ill-fated Spanish bailout.

Not to be outdone, the regions look to be harbingering plenty of problems of their own. The regions have seen the amount of unpaid debt on their books rise by €10bn (38 per cent) since the start of the crisis. The total in unpaid bills now tops €36bn. Yet again, this cost is likely to be transferred to the central government, which can ill afford it, and risks the country missing its deficit target, further fuelling market jitters. The regions are also expected to contribute 44 per cent of the planned deficit reduction this year. But with the budget still hot off the press, the largest and wealthiest regions are already rejecting Madrid’s ordered spending cuts.

The good news is that the new Partido Popular government is pushing through some much needed structural reforms. Unfortunately, it will take time for the benefits to be felt, and in the short term they are likely to increase already skyhigh unemployment while doing little to boost lagging demand.

Spain remains a serious and diverse economy, with relatively good administration and infrastructure – talk of a full bailout programme is premature. The most likely outcome is some sort of aid for the banking sector – probably with the help of the European stability mechanism. As much as we hate seeing risk being transferred to taxpayers, it might be better for Spain to swallow this bitter pill now and ask for aid for its banks, than risk it dragging the whole economy – and the euro – over the edge.