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A new government came into power in the last days of 2011. Prime Minister Rajoy announced new taxes and fresh cuts. Europe’s fourth largest economy has a much lower debt pile than Italy and enjoys lower yields.

Yet Spain faces a recession. It will be hit hard during the winter which is low season in tourism. In addition, austerity measures and higher taxes will exacerbate the situation.

This analysis originally appeared in the Forex Outlook for Q1 2012. You can download the full report for free by joining the mailing list in the form below.

Even before the elections, Rajoy discussed some form of aid with Angela Merkel. An option for IMF help or ECB help for banks is at stake.

Spanish banks suffer from the burst of the real estate bubble and has overvalued assets on its balance sheets. By exposing the situation outright, the banking system could suffer badly, and the economy can get another blow.

But without exposing the banks, they remain in zombie mode, not willing to lend until thing get better. Rajoy hasn’t said too much about his plans regarding banks, nor any other issue, expect making general optimistic promises.

Rajoy and Luis de Guindos (ex-Lehman Brothers banker) might be smart by getting external help from banks while cleaning up their balance sheets. But this might not work out.

In addition, the recent elections have not only given an absolute majority to the PP party, but have also exposed regional tensions, with Catalan and Basque parties gaining many seats in parliament.

Regional Friction

Spain’s regions are much more problematic in terms of debt than the central government. The planned cuts will create fresh friction with the regions (or autonomous communities). In addition, also provinces within the regions (such as the region of Barcelona within Catalonia) have debt issues, and so do municipalities.

Any cuts could be viewed through the nationalistic glasses, whether rightfully or not. This may put Spain back in the limelight.

In general, Spain doesn’t face a solvency issue and also its liquidity issues are certainly reduced. The impact of Spain on the euro depends a lot on the level of noise the country produces during the quarter and this also depends on Italy.

If the new policy by the government runs into trouble and if the recession severely deepens, this will weigh on the euro.

If Spain stays in the current dire situation and headlines focus on Italy, it will have no impact on the common currency.