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  Tension in Europe's sovereign debt markets is not diminishing; quite the opposite, in fact. Increasingly more countries are being asked to pay higher interest rates on their public debt by the market. This phenomenon is no longer restricted to the so-called peripheral countries but others such as Austria, Belgium and France have also seen their risk premium go up considerably throughout November. Spain has not been left out of this phenomenon and has also seen a significant rise in the yields demanded for its debt. Consequently, this has made it difficult to adjust public expenditure at a particularly critical time. Reducing the public deficit must be a top priority to stop public debt from entering an expansionary cycle but, at the same time, higher risk premia make this goal difficult to achieve. Within such a situation, two questions become especially relevant: what is the impact of rising risk premia on Spain's public treasury? And, particularly, how much leeway does the Spanish economy have?

  This rise in interest rates has been general for all maturities of Spanish public debt, reaching levels similar to 1997. The interest rate for one-year bills, in particular, has risen by 435 basis points (b.p.) since the summer of 2009, standing at 5.1% in November. The increase for 5 and 10-year bills has been less severe, namely 287 b.p. and 256 b.p. respectively. In this last case, of note is the different trend for their German counterparts, whose yield has fallen by 156 b.p. since August 2009. This fall is because German bonds (the bund) are seen as a safe haven, perceived as being risk-free assets. Consequently, they're more in demand at times of greater uncertainty in the markets, making them more expensive in exchange for greater stability. As a result of these different trends, the spread between both yields (commonly known as the risk premium) has increased by 412 b.p. over the last two years.

  Given this situation, it's no surprise that the cost of debt due to interest payments is rising. In the first half of 2011, for example, this increased by 26.3% compared with the same period a year ago, partly due to the higher financing costs for debt issues. Another important factor has been the rise in the volume of debt over the last few years: between 2007 and 2010, public debt as a percentage of GDP rose by 25 percentage points, up to 61.0% of GDP.

  However, it's important to note that, in spite of this significant increase, debt is still at a relatively moderate level. The average for euro area countries in 2010 was equivalent to 85.6% of GDP. This means that, to date, Spain's cost of public debt has been smaller than in other countries. In 2010, this cost remained stabled at 1.9% of GDP, only above Denmark and at the same level as the Netherlands. Even Germany, with lower financing costs, had a higher interest burden, namely 2.5% of GDP that same year.

  However, according to European Commission forecasts, Spain will be one of the countries where this figure will rise the most between 2010 and 2013, specifically by seven tenths of a percentage point of GDP. Only Italy and the three countries bailed out by the European Union (Greece, Ireland and Portugal) will see a higher increase. Given that public deficit adjustment will be progressive, public debt will continue to rise until stabilizing, very probably, at around 75% of GDP.(1) The increase in public debt will therefore be much less than the one seen between 2007 and 2010, but it will continue to push up expenditure due to interest payments.

  On the other hand, the interest rate demanded for Spanish public debt is unlikely to fall very quickly to pre-crisis levels and will consequently continue to put pressure on the cost of the debt. In order to determine how much leeway the Spanish economy has, we will analyze three different scenarios.(2) The first assumes that tension in the public debt markets will gradually dissipate throughout 2012 and that, as from 2013, the consolidation of Europe's economic revival will lead the European Central Bank (ECB) to gradually raise the official interest rate. The interest rate for public bonds and bills would therefore fall slightly over the next two years due to the lower risk premium, and would rise again as from 2014 due to the higher ECB reference rate. Within this scenario of gradual recovery, in the long term the yield on 1, 5 and 10-year bonds would be 4.2%, 4.8% and 5.2% respectively, gradually pushing up the average cost to 5.0%, and the interest burden would stabilize at around 3.4% of GDP, a similar level to the one recorded at the end of the last century. Although far above the figure for 2010, this would allow public debt to start to adjust as from 2015.

  (1) For more information see Pina J. D.: «Perspectivas de la deuda pública española». "la Caixa" Working Papers.

  In our second scenario, we analyze what would happen if the interest rate for public debt remained at today's levels. These are 5.1% for 1-year bills, 5.6% for 5-year bonds and 6.3% for 10-year bonds. Within this context, the average financing rate would be higher than 5.5% and the interest burden would be 7 tenths of a percentage point higher than in the previous scenario, reaching 4.1% of GDP. In this case the public debt does not increase much more than in the first scenario but the higher interest burden makes it more difficult to correct over the long term.

  Lastly, we have also analyzed the performance of these variables within a much more adverse context. We therefore assume financing costs for public debt at similar levels to those for Ireland, Greece and Portugal when they were bailed out, with yields of around 6.7%, 11.0% and 10.2% for short, medium and long-term maturities, respectively. Within this scenario, the average cost of public debt would rise rapidly to 9.0% and would lead to an explosion of debt, which would quickly exceed 90% of GDP.

  (2) In these three scenarios, we assume that real GDP growth increases gradually, going above 2.0% as from 2014, and that the ECB's reference rate starts to rise as from January 2013, reaching an equilibrium level of 4.0% by 2015.

  This last scenario is obviously less likely but it serves to illustrate just how fast public accounts can deteriorate on encountering rough seas. Both the level of Spain's public debt and its costs are lower than most developed countries. This gives the Spanish economy significant leeway but that doesn't mean it is all plain sailing from now on. The utmost discipline is required in terms of the economy.

  This box was prepared by Joan Daniel Pina

  European Unit, Research Department, "la Caixa"

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