Can Jose Luis Rodriguez Zapatero save the euro?

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Talk about being on the hot seat. The economic fate of Europe and the future course of the euro crisis could very well rest in the hands of Spain’s Prime Minister Jose Luis Rodriguez Zapatero. Why is that? Financial markets are already assuming that Portugal will be the third member of the infamous PIIGS to fall into a European Union/International Monetary Fund bailout, following Greece and Ireland. Next in the uncomfortable spotlight will be Spain, a country beset by crazy-high unemployment, big budget deficits and a housing/banking crisis. If Spain at some point requires a bailout as well, the entire nature of the euro debt crisis will change – for the much, much worse. The crises in Greece, Ireland and now Portugal have already been a terrible strain on Europe’s economic health and a threat to the stability of the euro, even though those three are very peripheral economies in Europe. So a sovereign debt crisis in Spain, the world’s 9th-largest economy, would cause unimaginable chaos. It could put the entire European monetary union at risk, and perhaps alter investor sentiment towards government debt in general.

So what happens in Spain in coming months will impact the entire global economy. With the leaders of the euro zone divided and unlikely to do much more to help the struggling PIIGS, the pressure is on Zapatero to halt the crisis at Spain’s borders. If he can restore investor confidence in Spain, he could snuff out the entire debt crisis.

Can Zapatero play the hero? The good news is that he seems to be making progress in solving Spain’s problems, and even more, in at least stabilizing investor sentiment towards his country. That could change in a flash, of course, but for now, it appears Madrid may be in the process of throwing up a barrier between the weakest PIIGS and the rest of Europe.

There has always been some thinking in financial circles that the shellacking Spain was taking in bond markets wasn’t completely justified. Unlike Greece, Spain has no history of fiscal irresponsibility, and its government debt relative to the size of the economy is lower than in the other PIIGS. But nevertheless, investors have had good reasons to be worried. Spain’s economy is in awful shape. Crushed by a housing bust, Spain’s unemployment is nauseating, at more than 20%, while the economy still contracted in 2010 (by 0.1%). With a yawning budget deficit and meager growth prospects, investors feared the country’s economic woes could pressure the finances of the state and come to threaten its solvency.

But there are clear signs that those fears have somewhat abated. As Portugal sinks deeper into crisis — its bond yields continually reaching new records, its leadership in chaos after the resignation of the prime minister last week – Spain has been generally untouched by contagion. Spain’s bond yields (though still high) have fallen in recent months, while the spread between Spanish and German bonds has been narrowing. That’s a sign that investors perceive Spanish government debt as less risky to hold than they did just a few months ago. Rather than bunching all of the PIIGS together, investors are beginning to realize not all PIIGS are created equal (or equally disgusting), and that is a very positive sign for Europe.

Zapatero deserves a good chunk of the credit. When I was reporting in Spain last May, analysts and businessmen had little faith that Zapatero had the political muscle to push through the reforms that the country so badly needed. That lack of confidence in Spain’s prime minister has proven misplaced. His government has been working hard to get its financial house in order through a series of politically sensitive austerity measures, and as a result, the budget deficit shrunk to 9.2% of GDP in 2010 from 11.1% in 2009. He plans to reduce it further to 6% this year. In January, Zapatero approved a pension reform after tough negotiations with Spain’s unions that hiked the retirement age to 67, among the highest in Europe. He has also introduced reforms to make the distorted labor market more flexible in order to create jobs and bring down unemployment. Perhaps most importantly, the government has been tackling the problems of Spain’s weak financial sector, especially the savings banks, called cajas, which were hit hard by the property bust. The central bank ushered through mergers that greatly reduced the number of cajas, and then in January, the government ordered all banks to increase their capital or face partial nationalization. Of course, Spain is just at the starting point of fixing a very broken economy, but the slate of reforms taken by Zapatero is pretty solid work in a short period of time.

There is a wild card out there though – and that remains the banking sector. The Bank of Spain estimates that the country’s banks require around 15 billion euros (or $21 billion) in new capital; Moody’s projects that in a high-stress scenario, the banks could need as much as 120 billion euros. Who ends up being right will determine how much pressure Spain’s banking crisis may place on the financial standing of the state, and therefore the course of the debt crisis in Spain and Europe overall. Nor is Spain’s economic pain likely to end any time soon. The IMF forecasts Spain’s economy will grow a mere 0.6% in 2011. Spain is not out of the woods just yet.

So Zapatero has more work to do. If he can maintain the government’s reform momentum, however, he could one day be known as the Man Who Saved the Euro.

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