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Madrid—and its supporters in Berlin and Brussels—believes the country starts from a much better place than the market appreciates... The government also believes the economic outlook is brighter than many realise. It argues the fact that Spanish companies have been able to sell bonds since the ECB announced the OMT vindicates its belief that fear over a euro break-up was the biggest threat to the economy. It thinks the market is underestimating the importance of the recent fall in interest rates to the domestic economy, given the vast bulk of mortgages are tied to market rates.
Indeed, Madrid believes it is going beyond what the International Monetary Fund may demand in return for aid. The ECB, European Commission and IMF have already agreed any conditions required in return for ECB support under the OMT would relate to monitoring and deadlines rather than imposing new measures, according to someone involved in the negotiations. The reason Spain hasn't applied for help yet is that it has been assessing the impact of OMT support on its borrowing costs and discussing with its eurozone partners on the procedural issues surrounding a request for aid; Germany, for example, would prefer Spain not to activate the OMT. Madrid strongly refutes the suggestion it is delaying a decision until after regional elections next month; it argues the political advantage lies in getting borrowing costs as low as possible as soon as possible.
But it is the bank recapitalisation plan that holds the key to Spain's fate. The omens aren't good... Depending on how banks decide to close the gap and what assets are transferred to the new national bad bank, it is possible little more than €50 billion of new capital will be injected into the banks. Worse, the recapitalisation plan is unlikely to address the Spanish banking system's core funding problem. Spanish banks are now dependent on the ECB for €400 billion of funding, equivalent to 40 per cent of GDP, and the recapitalisation plan will only reduce this by about €100 billion.
Mr Rajoy must convince markets the stress tests have been rigorous, that problem assets have been properly identified and valued. If he succeeds and foreign money starts flowing back into the Spanish financial system, then the recent rally should be sustained. But another half-baked effort at bank reform that led to yet another recapitalisation exercise being needed next year could be calamitous for Spain and the eurozone. The markets have already given Mr Rajoy the benefit of the doubt twice. They may not do so again.
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