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Commentary

4 Things to Watch for in Spain

Spain is unlikely to face a Greeklike implosion in the near term, but things could continue to get worse for the country.

Once again, the flood of mostly decent earnings this week was mostly overshadowed by happenings in Europe. The sovereign debt crisis that had been on the back burner for a few months has began to bubble again as investors began fretting that Spain is lurching toward more trouble and would need to be bailed out like Greece, Portugal, and Ireland before it.

So is it time to start the bailout negotiations? Not quite yet. Europe is much farther from the brink then it was just a few months ago. The latest Greek bailout has mainly done its job; it has bought some valuable time. And the news this week was far from catastrophic. Although Spain's borrowing costs rose, the country was able to successful auction off a fairly large chunk of bonds, and demand for the auction wasn't anemic. In short, there is still private-investor appetite for Spanish bonds. Spain (unlike Greece) still has the liquidity to keep making payments and rolling over debt as long as rates don't explode.

However, just because investors are willing to buy the bonds today doesn't mean that the country is out of the woods forever. There are still plenty of potential pitfalls in the months ahead, and investor mettle will likely be tested multiple times. Here are four areas I'm keeping a very close eye on to gauge Spain's health and to assess if the crisis is ready to fully spread across the Iberian Peninsula.

Rates
Observing how much investors are demanding to hold Spanish bonds is one of the most straightforward ways to gauge perception of Spain's economy. As the fear that Spain won't be able to repay all of its obligations ebbs and flows so does the yield on the Spanish bonds.

During the last few weeks the yield on the benchmark 10-year note has been on a serious upward swing, and it now is hovering precariously close to 6%. This is better then the huge spike during the end of last year, but it's still disturbingly high. If Spain's borrowing costs rise, it is that much more expensive to refinance its large debt load, making it that much more likely the country won't be able to afford the payments. This self-reinforcing cycle can quickly spiral out of control, which could cause conditions to be near impossible to refinance debt. At that point the European community will have essentially no choice but to either bail out the country or allow a messy default.

Government Will
Debt yields don't exist in a vacuum. Bond investors are reacting to the fundamentals of the economy and their perceptions of how the crisis is going to unfold. One of the biggest questions marks on that front is how effective the Spanish government will be in implementing fiscal reforms and what the appetite of the Spanish people is to accept those reforms. The current conservative Spanish government came to power in late 2011 and has offered solutions to reduce spending and bring debt levels down. The cost-cutting programs have become slightly less ambitious recently, but if everything went according to plan, Spain would be able to find its way back to more stable footing.

The problem is things often don't go to plan. Will public protests against proposed cuts force the government to change track? Will spending by Spain's regional governments derail progress? Are the projections widely optimistic and unattainable? Can the government effectively organize a recapitalization of the struggling banking sector? Seeing how Spanish political leaders react to speed bumps along the way will help bring in to focus how much power they have to stave off some of the worst-case scenarios.

Growth
However, cost-cutting along won't nurse Spain back to health. Growth needs to be a big part of the picture, too. So far, Spanish growth hasn't totally fallen off the cliff yet. The country is likely in the midst of a mild recession, but it's nothing approaching the falling-off-the-cliff levels of Greece. But as the government reins in spending and the rest of Europe also plods along, there is a very real chance that a mild recession will become a more severe downturn. If growth were to slow too much, for too long, it could become very difficult to balance the budget and would severely exacerbate the entire situation. Trying to squeeze more money from an ever-shrinking base is hardly a winning long-term strategy. Signs that the economy is losing its competitiveness would be a red flag that Spain is in real trouble.

Unemployment
Joblessness is also a very important metric to watch. Spain already has a significant unemployment problem. In 2006, the unemployment rate was already sitting at 9.6% and has since skyrocketed to nearly 30%. The youth (age 15-24) situation is even more dire; 47.6% of those looking for work can't find any. If the employment situation erodes even further, the outlook for the country could decline even further. The unemployed are unlikely to be politically docile, so as their ranks swell it will be harder to govern the country. High unemployment is also hugely problematic for future growth. When workers are idle, their skills atrophy and many will become permanently discouraged. It makes it that much harder to really get the Spanish growth engine restarted.

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