Spain acts tough on debt, but investors say 'situation could still get ugly'

To be sure, Spain's borrowing costs remain much lower than those of Ireland, which has accepted a bailout, and Portugal, which is teetering on the brink. The yield on Irish debt is now about 8 percent and Portugal's is about 6.3 percent.

The Spanish goal is to keep rates low with a lot of short-term spending cuts that reassure investors. The idea is that if rates come down, its battered banks – many of which were swept up in a real estate bubble – will recover. That in turn, Spain hopes, will bring higher growth and start creating jobs.

If that doesn't work and they're forced to turn to the EU and the International Monetary Fund's $1 trillion bailout fund, rates will likely soar to Irish levels, and the bailout fund might not be enough to stave off a default anyway, with some economists estimating the country would need a further $650 billion, especially to avert the collapse of its banks.

'Situation could get ugly'

Still, most analysts in Spain rate the chances of default as low. "In the short term, financing of Spanish banks has improved,” says Madrid-based Javier Bernat, an analyst at Caja Madrid, a leading brokerage. "Spain is more solvent now, unlike Greece and Ireland. We expect things to be normalized."

“But if that is not the case, the situation could get ugly,” Mr. Bernat says. “Nobody has fallen off the [euro zone] deck of cards, but that could change. Not just Greece or Ireland, but one of the big countries could decide that is not the EU they signed up for.”

The next test will come in the spring, when at least $50 billion in public and private debt mature and Spain seeks fresh cash. If the market premium demanded then is prohibitively expensive, the country might have no choice but to accept a rescue package. Next week EU leaders are expected to consider raising the bailout fund to show markets they are ready even for a Spanish collapse, despite German opposition.

Roberto Ruiz-Scholtes, UBS strategy director and head of wealth management research for Spain, says there's enough cash within Spain to meet the country's needs. “Investment is not essential," he says. "Internal savings have skyrocketed and the available resources are enough to finance the deficit.”

“It’s about sentiment,” says Luigi Speranza, a BNP Paribas market specialist based in London. “Bottom line is that there is a high risk that Portugal will be forced to get funds. We believe Spain can get the funding on the market, albeit at higher rates.... But there is a legitimate concern, and not speculation to profit from instability, as many EU governments contend,” Speranza says. “The so-called speculators did their job with Greece and Ireland, and they were right. In fact, investors have been overly patient.”

Ultimately though, few analysts expect Spain will default on its debt. “There is very low probability of that or of the euro zone expelling a member,” Speranza said. “It would be too costly. The risk would be exceptionally high and everyone is aware of this.”

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