Spain "too big for bailout!

Ted Scott, director of UK strategy at F&C Investments, believes that if investors continue to be nervous about Spain's ability to manage its debts it could pose a serious threat to the European Union.

'If Spain failed, it would be too large for the eurozone institutions to rescue and could bring the edifice of the euro project down with it,' warned Scott.

While the main focus in recent days has been on Ireland and Portugal, investors have become increasingly worried about what would happen if the market's attention switched to Spain's financial problems.

 Spain’s economy is bigger than Greece, Ireland and Portugal combined and represents about 11.5% of the euro area’s GDP (gross domestic product), according to Scott.

He estimated there is around €460 billion (£390 billion) of bank assets tied up in Spain. Shoring up the banking system by giving financial aid to Spain on top of the €80-90 billion loan currently being negotiated with Ireland and around €50-75 billion that Portugal would need would exhaust the €440 billion European Financial Stabilisation Facility set up in the wake of the Greek crisis earlier this year.

Scott said Spain needs to refinance around €300 billion of borrowing by 2013 and €192 billion in 2011 alone which he said is 'too big for the safety mechanisms to cope with.'

The interest rates investors are demanding to lend money to both Portugal and Spain have leapt in recent weeks amid growing fear that these countries will not be able to stick to planned debt reduction targets and may need international aid.

Scott pointed out the Iberian governments have also had to pay more to attract would-be investors in recent bond auctions.

While most commentators now believe it is just a matter of time before Portugal takes a handout, Scott like others is concerned it won’t be long before market fears turn to Spain, which most agree would test the desire of European nations to stay in the EU.

'While the market could cope with another bailout to Portugal, because of its negligible size compared to the total euro zone, Spain is the elephant in the room that the market fears,' Scott said.

He said the European Union needed to pre-empt this possibility by taking decisive action soon but said that was unlikely.

Scott argued it was unlikely Germany would pump more money into the EU bailout fund. He said chancellor Angela Merkel knew that would be too much for the German population to stomach and would be rejected by the German high court.

He pointed to the Lisbon Treaty, which states no country is allowed to get a bailout if their deficit is higher than 3% of GDP, far below the current levels in many European countries where deficits as a proportion of GDP are in double figures.

Scott said he expected rates on Spanish government bonds to rise to uncomfortable levels in 2011 as growth disappoints. He said it was the inevitable consequence of austerity measures being foisted on economically weaker eurozone nations.

He argued that at some point bondholders will have to take a so-called haircut (a reduction in the rate they get on their loan), something which has been given renewed relevance by the decision on Friday of the subordinated bond holders of Anglo Irish banks to accept an 80% haircut on their holdings.

He said many European countries are effectively insolvent and therefore, as has been the case in emerging economies in the past, bond-holders will have to share some of the pain, a move German's political leaders have already made clear they favour.