Why Spain’s 7 percent bond yields have the world on edge (again!)

Is it time to start worrying about Europe once more? On Thursday, Spain found itself struggling to borrow money from investors again. As a result, yields on the country's 10-year bonds rose to 7 percent. Alarming headlines ensued. It's that scary number again! So why does 7 percent always put the world on edge?

The horror, the horror. (ANDREA COMAS - REUTERS)

Let’s recall the basic situation: The Spanish government is running a large budget deficit. It needs to borrow at least $42 billion this year alone to fund its day-to-day operations. To raise those funds, the country sells various types of bonds, including 10-year-bonds. In return for cash from investors, the Spanish government promises to pay a fixed rate of interest — say, 5 percent — every year for 10 years. At the end of that period, the investors get all of their original cash back.

Now, when investors are nervous that the Spanish government might not repay in full, they demand higher interest rates on these bonds as a sweetener. And that’s what is happening right now. Investors are skeptical about Spain’s ability to repay, especially since the country has a yawning budget deficit and is enacting new tax hikes and spending cuts that could sink its economy deeper into recession. So, investors aren't willing to buy up Spanish bonds unless they come with a 7 percent interest rate. A very big, very fat sweetener.

The trouble is that 7 percent rate is likely to be unsustainable if it persists for too long. If Spain has to pay that much to borrow money, its deficit will grow even bigger — especially since euro zone inflation is low and Spain can't just print more money to repay its debts. That, in turn, makes investors even more leery. So they demand even higher interest rates. A cycle of doom starts swirling.

This is exactly what happened to Greece, Ireland and Portugal — once those nations' 10-year bond yields crossed the 7 percent threshold, they quickly launched into the stratosphere, as the graphic below from Reuters shows. The rest of the euro zone had to step in to bail out all three countries:

So, whenever Spanish bonds hit 7 percent, it triggers concerns that Spain could hit that point of no return—and that Italy could soon follow. Unlike the three smallish countries above, Spain and Italy are too large for the rest of the euro zone to fully bail out. The euro zone rescue fund has only about $293 billion to play with between now and September (when a bigger bailout fund is expected to be approved). And European officials have already pledged $120 billion to prop up Spain's troubled banks. That doesn't leave much to prop up the Spanish and Italian economies.

So that's why 7 percent is so worrisome. For one, it suggests that the measures taken at the most recent E.U. summit in July didn't put an end to the euro crisis after all. But more generally, it's an unnervingly short hop from "Spain's 10-year bonds hit 7 percent" to "broader cataclysm that could ripple through the global economy."

Related: From Krugmania to Draghia, five ways to save the euro zone.

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Sarah Kliff · July 19, 2012