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November 24, 2010, 12:29 PM GMT.

Don’t Underestimate Spain’s Disaster Potential.

Spain can’t really be the next-but-one euro-zone sovereign financial disaster. Can it?

After all, its public finances are much healthier than Ireland’s, or Greece’s, or Portugal’s. And its banking sector has been a rare beacon of probity in amongst a global financial mess. Right?

To be sure, optimists focus on Spain’s relatively modest gross government debt, which the IMF figures will come in at 63% of GDP this year, against Portugal’s 83%, Ireland’s 94%, and Greece’s astonishing 130%. Economists reckon once the debt to GDP ratio breaches around 90%, financial crisis and default become exponentially more likely.

And yes, that ratio will grow over the coming years as Spain battles to deal with its own structural fiscal shortfalls, which, once again, according to the IMF, exceed Portugal’s and Greece’s. But there’s plenty of time before this becomes an issue. After all, Spain’s gross debt will only breach 80% in 2014, by which time economic growth and government belt tightening should get the deficit under control.

And yet some of the estimates underpinning the expectations that Spain won’t be one of the peripheral dominoes seem distinctly…umm…optimistic.

To begin with, take Spain’s unemployment rate. At 20% this year, according to IMF projections, it stands at double Portugal’s rate and is even higher than Ireland’s and Greece’s, which are 13% and 12% respectively. An economy where one in five of the working age population is without a job is not a healthy one, even when factoring in the likelihood that a substantial fraction of these jobless will be employed unofficially to get around rigid labor laws.

What’s more, the economy’s overall unhealthiness is reflected in a current account deficit worth some 5% of GDP, which itself is seen shrinking this year. Like Ireland, Greece and Portugal, Spain has grown increasingly less competitive relative to Germany–whereas German unit labor costs rose by only 5% during the past decade, Spain’s have gone up by a third.

This means that unless German inflation starts to rise substantially, Spain, like the other peripheral euro-zone countries, is condemned to years of deflationary pressure in order to regain competitiveness.

And that’s a serious problem. Because Spain also has one of the most overstretched housing markets in Europe. Like Ireland, Spain suffered a real estate bubble and an associated construction boom. The result is massive overcapacity–vast tracts of empty housing and a crippled construction industry. If anything, Spanish house prices rose even higher than Ireland’s, by the 2008 peak they’d risen 2.4 times from where they were in 2000, while Ireland’s prices merely doubled. But where Irish prices have slumped some 37% since their peak, Spanish prices are only down around 10%.

Unfortunately, Spanish house price indexes are as transparent and as trustworthy as the European bank stress tests run earlier this year. Remember those? That’s right, the ones that passed Allied Irish Banks and the Bank of Ireland with flying colors.

There is every reason to believe (overcapacity, weak economy, deflationary pressure, excess debt, etc) that Spanish house prices have a long way to fall. As they do, all those world class Spanish banks will suddenly find their balance sheets are as ugly as the ugliest American subprime lenders’. Tack on the Spanish banking industry’s exposure to Portuguese sovereign debt and you’ve got the recipe for wholesale financial Armageddon.

Spain is fundamentally ugly. That’s why Spain’s five year credit default swaps have risen from under 100 basis points at the start of the year to over 300 bps now. Remember, Irish CDS started 2010 at 150 bps, pushed up to 200 bps mid-summer and recently hit 600 bps as the country teetered on the verge of bankruptcy.

But unlike Ireland, Greece and Portugal, Spain really is too big to rescue. Spain’s banking sector assets of nearly €3.5 trillion are almost €1 trillion more than three other countries’ combined.

When Spain hits the fan, everybody will know it.