More than a year after Europe's debt crisis erupted, the region has a chance to halt the spread of the instability — but only if governments take more radical action to protect Spain.
Madrid will have to reveal more information about the health of Spanish banks and probably announce fresh steps to cut its budget deficit. The European Union may need to expand the size of its financial safety net for crisis-hit countries.
An international bailout of Portugal, after last year's rescues of Greece and Ireland, now looks almost inevitable. But Europe has better prospects of avoiding a much larger bailout of Spain, widely seen as the next most vulnerable country.
"The real battle will be the battle of Spain — but there I think we have much higher chances of success," a senior official source in the euro zone told Reuters on Sunday.
Many private economists agree the battle can be won. A Reuters poll of 51 analysts last week found 44 predicting Portugal would eventually be forced to seek outside help, while only seven thought the same of Spain.
But upward pressure on Spanish government bond yields this week — Spanish spreads over German bunds rose back near euro zone lifetime highs on Monday — shows investors are not convinced that Europe can summon the political will to act.
BANKS
The most vital issue for Spain is reassuring the markets that losses at its banks will be manageable, as the country continues to suffer from the bursting of its real estate bubble.
If losses at the banks spiral out of control, the debt of the Spanish government, which would eventually have to step in to save the banking sector, could rise much higher than the 71.9 percent of gross domestic product which it projected for 2011.
"Spain is already ticking quite a few boxes to restore market confidence," said Gilles Moec, economist at Deutsche Bank. "The one box that remains to be ticked is their banks — this is very much what the market is focusing on now. It is not so much about the sovereign, now it is really about banks."
Although European Union bank stress tests last July showed Spanish banks in relatively good health, the tests lost credibility after Irish banks, which also did well, subsequently needed billions of euros in aid.
"Spain is tarnished by the association with what happened in Ireland and the theory that large, unprovisioned bank sector losses could hit public debt," said Ken Wattret, chief euro zone economist at BNP Paribas.
"We think this is quite unlikely, but until there is some clear evidence of that, the market will worry that Spain will have to receive some financial support."
To regain market confidence, Spain will need to organise a fresh round of bank stress tests and reveal the projected losses of the banking sector and its recapitalisation needs more fully and transparently, economists said.
It has already moved in that direction, promising new health checks for banks this spring and declaring it will release detailed reports on the value of property on banks' books.
FISCAL STEPS
Madrid may also need to take the politically difficult step of announcing additional austerity measures, preferably combined with economic reforms that could boost its growth rate in the medium term.
The government has pledged to cut its budget deficit from an estimated 9.3 percent of GDP last year to 6.0 percent this year and 3.0 percent in 2013. But stagnating economic growth has put these targets in doubt; an official projection of 1.3 percent GDP growth this year may be too optimistic.
"We think the Spanish deficit reduction and growth targets are too optimistic," said Juergen Michels, euro zone economist at Citigroup.
Last month, Spain announced an 82.8 billion euro plan to stimulate growth in its industrial sector over five years, including liberalisation of energy markets and incentives for research and development. But investors may want stronger action, including labour market reform.
RESCUE FUND
For its part, the EU can help to keep Spain's cost of borrowing down by showing that if all else fails, it has enough money to bankroll Madrid. The EU and the International Monetary Fund together have pledged 750 billion euros to help countries cut off from market financing.
But the effective amount is smaller because of a complex system of guarantees for one of its vehicles, the European Financial Stability Facility (EFSF). BNP Paribas estimates the effective lending capacity of the EFSF, nominally 440 billion euros, at just 255 billion euros.
"If you say that the programmes for Greece and Ireland equalled 40-45 percent of annual GDP and you apply the same ratio to Spain, you are talking about 400-450 billion euros for Spain," said Wattret.
"Because of the reduced size of the EFSF, they are well short. On purely funding requirements for the next two to three years, probably the existing scale of the mechanism is OK. But there is uncertainty and markets don't like uncertainty, and the banking sector is part of the uncertainty."
As a result, Michels said, "If Portugal asks for help, and we think it is going to soon, euro zone finance ministers and heads of state will have to think about EFSF size pretty quickly." He estimated that a facility totalling 2 trillion euros, a large part of that prefunded, would be enough to impress the markets.
Other economists said the increase could be smaller, such as a boost of the EFSF's effective lending capacity to above 1 trillion euros.
But even that could prove politically impossible because of public opposition to paying for indebted euro zone countries in some of Europe's rich countries, especially Germany. Last month EU leaders decided there was no need to expand the EFSF, though they left open the possibility in future by saying they would do anything needed to protect the euro zone.
Political opposition could also block other ideas to make the EFSF more effective. For example, EFSF loans to indebted states carry a penalty margin of 3 percentage points and some economists think the high cost creates more problems for a struggling country.
"You could lower the penalty on EFSF loans so that countries would suffer less, but it would have to be combined with a debt sustainability analysis," said Carsten Brzeski, economist at ING bank.
Similarly, a radical expansion of the European Central Bank's programme of buying government bonds from the market could help to protect Spain. But despite signs of increased buying on Monday, analysts said the ECB remained unlikely to step up the programme drastically because of ideological opposition on the part of many ECB policymakers.
Instead of sweeping, immediate action to protect Spain, "more likely is that politicians will try to do the minimum to deal with this crisis," Wattret said.
In this scenario, "periodically the tensions come back but each time they do, there are more casualties, higher spreads in the periphery economies and in Spain and Italy, and the (ultimate) solution will have to be much more radical."
