Spain in eurozone crisis crosshairs

Spain, a eurozone behemoth, is in the crosshairs of Europe's financial crisis. The country is suffering from soaring borrowing costs, a banking system leaking cash and unemployment rates at devastating levels.

Greece might be teetering toward expulsion from the eurozone but Spain's situation is now the focus of concern. If such a major economy were to fail, the repercussions could cause unprecedented havoc across Europe -- and the globe.

Just how bad is the pain in Spain?

This week Spain's treasury minister Cristobal Montoro bluntly admitted it was "technically impossible" for Spain to bail itself out, and that the country needed help to access funds.

The country is facing a credit freeze after its financial problems were thrown into sharp relief by the bailout of Bankia, the country's fourth-largest bank.

Bankia last month called for €19 billion ($23.7 billion) of assistance, panicking markets. It sent Spain's cost of borrowing (for the sovereign ten-year bond) toward 7% -- a level which is regarded as unsustainable and has precipitated bailouts of other euro countries.

Spain's former Prime Minister Felipe Gonzalez last week warned the country is in a state of "total emergency" and that the crisis is proving to be the "worst we have ever lived through."

But Spain -- in its second recession since 2009 -- has been dubbed "too big to bail, too big to fail."

The Spanish economy is the eurozone's fourth-largest -- after Germany, France and Italy -- making up around 11% of the bloc's GDP.

To put that in perspective, Greece, Portugal and Ireland -- the three eurozone countries which have already been bailed out -- combined make up less than 6% of the bloc's economy.

How did Spain reach this point?

Spain's banking sector is facing up to years of bad investments, largely in real estate, which was buoyed by cheap credit and the country's sunny climate.

Its housing boom-times of 2002 to 2008 were fed, in part, by retired north Europeans buying up second houses in places such as Valencia and Murcia, according to political scientist Julio Embid, of think-tank Fundación Alternativas.

Families also bought up expensive houses with long mortgages during this time, he said. When the economy collapsed in 2008, people lost their jobs -- and with them their homes.

Real estate prices have now fallen some 30% to 50% from their highs, leaving Spain's banks, or cajas with housing stock on their books whose current value is much lower than the original.

Meanwhile hundreds of thousands of houses built during the boom remain unsold, and people wanting to buy may find it difficult to get credit.

Embid also points to the cajas' politically-driven executive appointments as a contributing factor to the crisis. "Many senior bankers were low-profile regional politicians or majors, without any financial experience or bank background," he said.

What has Spain done to try and sort through this mess?

The government set up the FROB (Fund for Orderly Bank Restructuring) in 2009, to help reorganize its banking sector, and has received international recognition for its efforts to date.

According to April's International Monetary Fund report, the country has reduced the number of financial institutions from 45 to 11. The report noted: "The authorities are, rightly, focusing on strengthening the banking sector."

It said the authorities were showing "an appropriate sense of urgency" but also warned that "unless the weak institutions are quickly and adequately cleaned up, the sound banks will suffer unnecessarily by a continued loss of market confidence in the banking sector."

As it stands, the banks have an estimated €300 billion of problem loans on their books, with the full cost of recovery not yet clear.

What other headaches does Spain face?

In addition to the financial sector's problems, Spain could be liable for the debts of several regional governments, which have been hit with ratings downgrades.

Spain also has an unemployment crisis, with more than half those under 24 out of work, and almost one in four people overall. Spain's jobless rate has helped pushed the eurozone's total unemployment rate to 11% -- its highest since the eurozone was created in 1999.

The IMF is now in the country for its annual economic review, with the mission expected to last until the middle of the month.

Why is the economy collapsing now?

The situation in Spain is developing like a "perfect storm," with money being pulled out of the country, despite the desperate need to stem capital flight and support its banking system.

This leaves Spain in a precarious financial state, driving investors away, pushing up its borrowing costs and making it more likely to need a bailout.

It's a reminder of how governments are inextricably tied to their country's banking systems, essentially the lifeblood of their economy.

In Ireland, the banking sector's similar gorge on property forced the country to take a €67.5 billion bailout in 2010.

The mood of the markets may, ultimately, dictate Spain's ability to pull itself from its financial hole. Investors already twitchy about the prospect of a "Grexit" -- a Greek exit from the euro -- will react badly to further bad news out of Spain.

Ratings agency Standard & Poor's has put the chance of Greece exiting the euro at around one in three, but says the impact of such an outcome on other countries is not yet clear.

While it seems likely to increase the chance of other countries departing, S&P says other countries "would be unlikely to follow ... having witnessed the resulting economic hardships and long delay in harnessing benefits from national currency devaluation."

The struggles in Europe were exacerbated by miserable news out of the U.S. last week, with official figures showing just 69,000 jobs were gained in May compared to expectations of 150,000.

Where does Madrid stand when it comes to making cuts to public services?

Spain's emergence as the crisis epicenter has again fed debate over the value of austerity over stimulus.

Greece, the first euro country to take a bailout, has been swallowing austerity medicine since 2010. But its economy has slid further into recession, and initial hopes it could detach itself from external life-lines within two years now look wildly optimistic.

The ruthless drive to cut costs has instead created a backlash against the politicians that support the plans. Greeks head back to the polling stations on June 17 after the first election in May failed to deliver a government, and it is not clear if voters will fall behind their European paymasters, or vote to reject their demands.

Spain has also been implementing austerity measures to try and combat its crisis. The retirement age has been raised from 65 to 67, while public sector wages and welfare payments have been cut.

Conservative Popular Party leader Mariano Rajoy, who won a landslide victory over the Socialist Party in November 2011, focused on cost cutting and labor reforms. But, as with other fragile countries within the euro bloc, Spain's economy remains weak and its unemployment levels continue to rise.

Some European leaders are now voicing concerns against austerity measures, including Italian Prime Minister Mario Monti who has warned of a backlash against such policies.

Academics and financiers are also wading into the policy debate, with billionaire George Soros saying in a speech this month that the "wrong remedy" has been applied to the crisis. "You cannot reduce the debt burden by shrinking the economy, only by growing your way out of it," he said.

Soros said he believed there was just three months to correct mistakes and reverse trends. And that, he said, would require "extraordinary policy measures."

So what's next for Spain?

Spain's auction of government bonds -- to fund government spending -- was Thursday, and raised just over €2 billion. Spain's 10-year borrowing costs went up to 6.1%, compared to 5.8% the last time such bonds were auctioned.

The country also faces a bond repayment of almost €13 billion next month, with another €20 billion due in October. While the July repayment is expected to be covered, the October bill could prove problematic, according to Symonds. "By this time we should have some more of an idea of just how much will be required to recapitalize the Spanish banks," he said.

In a much-awaited report, the IMF estimated Friday that Spain's banks need at least €40 billion (about $46 billion) in fresh capital to preserve the country's financial stability.

The IMF assessment -- roughly in line with that of ratings agency Fitch -- comes on the eve of critical talks between the Spanish government and European institutions over the terms of aid to Spanish banks, which are saddled with bad debt.

Across Europe, policy makers continue to try and stem the crisis, including plans announced Wednesday for a coordinated banking union that would deal with future crises rather than national governments. European Commission President Jose Manuel Barroso said the proposal was "an essential step" toward a banking union that would make the sector more responsible. But it won't be in place in time to tackle Spain's immediate banking crisis.

Focus also remains on Greece as it heads towards the election, playing what Schroders chief economist Keith Wade calls "financial chicken" with the European Union.

But is not yet clear who will blink first -- or what the outcome will mean for Greece, Spain, and the future of the euro.