Is a Spanish bail-out viable?

As Spain edges closer to a full sovereign rescue, economists have begun to doubt whether the EU bail-out machinery can raise such large sums funds at viable costs on global capital markets.

While the International Monetary Fund thinks Spanish banks require €40bn (£32bn) or so in fresh capital, any loan package may have to be much larger to restore shattered confidence in the country.

Megan Greene, from Roubini Global Economics, says Spain's banks will need up to €250bn - a claim that no longer looks extreme. New troubles are emerging daily. The Bank of Spain said yesterday that Catalunya Caixa and Novagalicia will need a total of €9bn in new state funds.

JP Morgan is expecting the final package for Spain to rise above €350bn, while RBS says the rescue will "morph" into a full-blown rescue of €370bn to €450bn over time - by far the largest in world history.

"Where is the money going to come from?" asked Simon Derrick, from BNY Mellon. "Half-measures are not going to work at this stage and it is not clear that the funding is available."

In theory, the European Financial Stability Fund (EFSF) and the new European Stability Mechanism (ESM) can raise a further €500bn between them, beyond the sums already committed to Greece, Ireland, and Portugal.

"There is sufficient firepower available. In addition, the EFSF/ESM can leverage resources," said Christophe Frankel, the EFSF's chief financial officer.

It may not prove so easy to convince global investors to mop up large issues of debt. "Our clients won't touch the EFSF because nobody knows what it really is. They have cut it out of their benchmarks altogether," said one bond trader.

The Chinese issued their own verdict yesterday. The country's sovereign wealth fund said it will not buy any more debt in Europe until the region takes radical steps to restore credibility.

"The risk is too big, and the return too low," said Lou Jiwei, the chairman of China Investment Corporation.

"Europe hasn't got the right policies in place. There is a risk that the eurozone may fall apart and that risk is rising," he told the Wall Street Journal. The EFSF had hoped to sell yuan "Panda bonds" but this may prove hard.

Eric Dor, from the IESEF School of Management in Lille, said Spain would have to step out of the EFSF as a creditor the moment it asks for funds. This has instant effects on the residual core. Italy's share rises from 19pc to 22pc, and Italy is in no shape to face extra burdens. France's share rises from 22pc to 25pc, and Germany's from 29pc to 33pc.

"The credibility of the guarantees given to EFSF bonds would collapse. This would cause an incredible turmoil on the European sovereign debt markets," he said. Mr Dor said it would be wiser to let the EFSF recapitalise Spanish banks directly, but Brussels said yesterday that this would be illegal. Germany has in case blocked any move towards the mutualisation of eurozone bank costs, fearing a slippery slope towards eurobonds and debt pooling.

Any rescue must be a loan to the Spanish state, even if the money goes to the bank restructuring fund (FROB). The cost will push Spain's sovereign debt even higher.

Chancellor Angela Merkel said yesterday that she was willing to use the EU's "existing instruments" to tackle the debt crisis. This means use of a precautionary credit line from the EFSF for countries that are deemed healthy but suffering "limited access" to markets.

This "decaffeinated" rescue - as it is known in Spain - avoids the humiliation of EU-IMF "Troika" inspectors and draconian terms. It is a loan package with dignity, but it still entails a painful volte-face by premier Mariano Rajoy. He vowed a week ago that Spain would not need external help.

The EFSF had trouble raising funds last year. The spread on 10-year EFSF yields over German Bunds reached 177 basis points in November. Moody's said at the time that the EFSF "cannot meaningfully support the euro area's large government bond markets".

The fund placed a three-year bond last week at 1.116pc, compared with 0.15pc for German three-year debt, or 0.69pc for French debt. In effect, the EFSF is already paying a premium, and that was before the Spanish crisis had fully metastasized.

The permanent ESM may have more luck when it comes into force next month, since it will have €32bn of paid-in capital and a stronger mandate - but it still bears the stigma of EMU break-up talk.

"If they want anybody to the buy the rescue bonds, they should make them redeemable in the German currency on the day of the redemption: let us call them D-Mark bonds," said Charles Dumas, head of Lombard Street Research

The EFSF's Mr Frankel told Euromoney that the financial media was "biased towards the Anglo-Saxon approach" and had not properly taken into account the great improvement in the current account deficits of Club Med states.

Perhaps, but it is China, Japan, and Saudi Arabia he has to worry about.