BRUSSELS (MNI) – Spain’s austerity package was passed by lawmakers
Thursday, but with its razor thin majority and unrealistically bullish
growth expectations, markets gave the plan a lukewarm reception.

The market reaction underscores the wider challenges facing many of
Europe’s governments as they attempt to restore their fiscal
credibility.

The Spanish government’s E15 billion package — which aims to cut
the country’s budget deficit to 6% of gross domestic product in 2011
from its current level of 11.2% — was passed by just one vote in the
country’s parliament, with 169 votes in favor, 168 votes against and 13
abstentions.

This tiny margin reflects how political tensions across Europe are
rising, as politicians battle to curtail deficits that ballooned during
the financial crisis, when tax receipts dropped and spending rose
sharply.

On the initial news of the Spain vote, Spanish government bond
spreads tightened against the benchmark German Bund. But they widened
again on Friday morning as fears grew that the current government won’t
be able to enforce the measures, which include cuts in investment and
public sector pay.

“While the (Spanish) measures were approved, the event clearly
shows the high political risks faced by Spain — but also by Portugal —
in the implementation of fiscal consolidation,” Giada Giani, an
economist at Citi said.

“The Spanish government — like the Portuguese — does not have a
clear majority in Parliament and this makes the adoption of politically
unpalatable measures more difficult,” Giani added.

Across Europe, other governments face similar challenges: pushing
through tricky and politically unsavoury reforms in a bid to push their
public budget deficits back below the EU’s stipulated limit of 3% of GDP
and, in so doing, hopefully restore market confidence. Almost all EU
countries are in breach of the EU limits on debt and deficit.

After EMU sovereign securities and the euro itself came under
pressure on worries about burgeoning government debt and deficits,
European Union finance ministers agreed on May 9 to a last-resort
backstop package worth E750 billion to stabilise the Eurozone. At the
same time, they said countries like Portugal and Spain should take more
measures to get their fiscal houses in order.

But sovereign credit default swaps (CDS) — seen as an indication
of market confidence in a particular economy — still trade at elevated
levels. Countries deemed particularly risky are trading at a higher
level than before the backstop package was announced.

The bid-offer spread on Spain’s 5-year sovereign CDS is 225-245
today, up from 140-180 on May 10; Portugal’s is 310-330, up from
280-330; Italy’s 200-220, up from 161-171; and Ireland 235-255, up from
160-190. That suggests weak market confidence in the ability of those
governments to push the austerity plans through. It also suggests that
the market judges the plans to be unrealistically ambitious.

Across Europe, governments are racing to prove their austerity
credentials.

Italy has said it will save E24 billion over the next 2 years.
Portugal has said it will cut public sector pay by 5% and raise taxes.
The UK has announced spending cuts worth almost 6 billion sterling.

Greece — which has accepted aid from the Eurozone and the
International Monetary Fund that could total up to E110 billion — has
slashed public sector wages, increased value added tax and raised excise
duty on fuel, tobacco and alcohol.

Nor is the budget cutting limited to the more troubled countries of
Europe’s periphery. France has pledged to slash its public deficit by
five percentage points of GDP over the next three years to return to the
3% Stability Pact ceiling by 2013. It plans to do so by freezing
government spending, restraining health care costs and closing a number
of tax loopholes.

Even Germany, the Eurozone’s perennial over-achiever and
increasingly its fiscal disciplinarian, is faced with the challenge of
cutting E10 billion a year starting in 2011 to comply with its new
constitutional law, which requires that by 2016 the federal government
deficit not exceed 0.35% of GDP.

Chancellor Angela Merkel recently backed down from the tax cut
promises made during the election campaign, acknowledging that there
does not exist any fiscal leeway for the foreseeable future. While the
government has vowed not to raise taxes, it is looking at abolishing
certain tax subsidies. The Finance Ministry is currently in negotiations
with other ministries about further government spending cuts.

Whether the markets can be convinced that Eurozone governments have
the political will to push through the measures is one thing. A second
stumbling block comes in the form of optimistic growth forecasts often
included in the plans, a problem highlighted regularly by the European
Commission among others.

France’s deficit cutting plan, which assumes a rebound in the
annual growth rate to 2.5% starting next year, undermines the
credibility of the government’s strategy in the view of most observers.
The OECD, forecasting 2011 French GDP growth of 2.0%, predicted this
week that France would overshoot next year’s deficit target of 6.0% by
nearly a full point. “A stronger fiscal framework is needed to rebuild
credibility,” it said.

France is hardly the only case.

The Spanish government expects gross domestic product to grow 0.3%
in 2010 and 1.3% 2011, which is more optimistic than the European
Commission’s forecasts of -0.6% this year and 1.1% next year.

“The [Spanish] official growth forecasts for 2011-2013 appear to be
too optimistic, with the government continuing to believe that a large
chunk of the deficit reduction required by 2013 will arise from a
cyclical return to strong economic growth,” Raj Badiani, an economist at
Global Insight said.

“The recovery in tax receipts is likely to be weaker than
anticipated by the government,” Badiani said, adding that the shortfall
would have to be covered by more spending cuts or higher taxes if the
targets are to be achieved.

Olli Rehn, the European Commissioner for Economic and Monetary
Affairs, has repeatedly exhorted national governments to use more
realistic growth assumptions. But politicians have a fine line to tread
between market confidence and voter confidence.

“The debt burdens that have been and are being accumulated call for
a stronger approach on fiscal consolidation than pursued so far,” Rehn
said at a conference this week. “The most indebted countries, who have
turned out to be most vulnerable to market reactions need to take the
speediest and strongest measures,” he said.

It remains to be seen how long it will take to convince the markets
that Europe’s governments are capable of rising to the challenge. In the
interim, the market mayhem could continue.

–Brussels: 0032 487 (0) 32 803 665, echarlton@marketnews.com

[TOPICS: MT$$$$,M$$FX$,M$$EC$,M$X$$$,M$$CR$,MGX$$$]