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January 30, 2012

Spain vs. Italy: Why Spain May Have a Larger Problem

Back in August, as the debt crisis was heating up, the interest rates on 10 year Spanish and 10 year Italian bonds were moving in tandem. Then, in December, the gap between Italy and Spain began to widen. At times this month, the gap was near 200 basis points. Recently, the gap has narrowed, but my research is showing Spain's debt problem could be worse than Italy's.

Spain: Still High Deficits

Spain's new government cut its deficit from 8% of GDP to 6% of GDP. Unfortunately, that's not enough to sustain fiscal stability. Typically, a country would want a deficit less than the GDP growth, so they can still borrow money and the debt to GDP ratio declines. In comparison, Italy's deficit is projected to go to around 2% in the next fiscal year and near 1% in future years. The below chart best illustrates this difference:

Spain's Unemployment and Economic Output

Spain's unemployment is over 22% compared to 8.6% in Italy. This severely constrains Spain's ability to grow their economy in future quarters. In fact, I'm surprised that Spain had 0% instead of negative growth in 2009. However, the forward trend is looking like Spain is heading into a deeper recession than Italy. This also has an impact on the country's debt to GDP ratio and its ability to pay its debts.


With Italy so much closer to a balanced budget than Spain and the 'conservative' Spanish government saying they cannot increase austerity further from a 6% of GDP deficit, Spain makes me more nervous than Italy. I believe the interest rate gap will close over the next several weeks, move in parity, then Spain may switch Italy in higher yields. Don't be surprised, because you'll have read it here.

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