Spain’s economic resurgence has exceeded even the most optimistic expectations. But how sustainable is it, given structural inefficiencies, stubbornly high unemployment and the threat of external shocks?
Spain’s economy suffered for years following the global financial crisis, so its current respite comes as a welcome relief. The country managed to avoid accepting an international rescue package in 2010 when the deficit skyrocketed and the then newly elected administration decided to comply with the Troika’s (the European Central Bank [ECB], the European Commission and the International Monetary Fund) requirements to undertake substantial reforms.
Economic recovery has since gained steady traction, while agreed-upon policy measures have led to renewed optimism in the European periphery. “Looser monetary policy from the European Central Bank, with the implementation of quantitative easing, has also added huge liquidity as another feature to boost confidence,” says Jordi Gual, chief strategy officer and chief economist at CaixaBank and professor of economics at IESE Business School.
Progress has been achieved from a short-term perspective. But has enough been accomplished to sustain a path of longer-term stability and growth? Antonio Barroso, a senior analyst focused on the eurozone at global advisory firm Teneo Intelligence, is doubtful. “Spain is coming off a low bottom, so it is only natural to see acceleration at the current rate,” he notes. But looking ahead, not enough may have been done to solve more-entrenched challenges such as the deficit and to repair the basis of the country’s business and economic model. Meanwhile, risks of both internal economic imbalances and possible external shocks “may not be fully appreciated, and it’s too soon to sound the all-clear,” warns Jennifer McKeown, senior European economist at Capital Economics.
FACING AUSTERITY, DELIVERING GROWTH
Having swallowed the bitter medicine of market reforms and fiscal consolidation, Spain is finally returning to economic health. Policy mix has been slightly expansionary at the margin; fiscal austerity has been applied with looser monetary conditions, which have been transmitted to the credit market. “The successful combination of monetary loosening and fiscal restraint has been one of the lessons of the credit crisis,” says Fernando Navarrete, chief financial officer at Instituto de Crédito Oficial, a state-owned bank attached to Spain’s Ministry of Economic Affairs and Competitiveness.
Exports have increased their market share, which has provided the other major economic tailwind. In past cycles, “the engine typically starts with competitive gains from the external sector,” says Navarrete. But this time devaluation is off the table in the eurozone. Spain’s diversified export base should nonetheless continue to benefit from lower energy prices for at least another 18 months, according to Gual, which will boost the current account by reducing fuel costs. However, Gual adds the caveat: “Aggregate figures will look good, but the challenge is to take advantage of oil prices to continue to restore competitiveness for non-oil exports.”
Raj Badiani, senior principal economist at IHS Global Insight, is pleasantly surprised by predictions for Spain’s economic growth this year. He foresees expansion at 2.6% this year, and 2.5% for 2016. The government is unlikely to reduce spending prior to elections, scheduled for late in the year, and may actually impose new austerity measures after the vote in the hope that higher growth will produce a recovery in tax receipts, leading to a virtuous cycle. “But given the unemployment rate and high social security expenditures, fiscal numbers are still not under control,” Badiani cautions, adding that the authorities missed the net lending target in 2014 and will probably do so again this year.
Despite the austerity measures undertaken, Spain’s public debt ratio stood at 98% of GDP in 2014, which ranks among the highest in Europe. It still needs to be brought down to 60% of GDP to comply with European Union rules. Cuts have not resolved a fundamental shortfall in revenues, which do not capture sufficient funds from an inefficient economy and tax system. Gual would also like to see investment rebalance toward a higher proportion of equity than debt: “In general, countries like Germany should grow with higher debt, while those like Spain, which carried excessive past debt, should be more reliant on their own generated funds,” he explains.
Given the unemployment rate and high social security expenditures, fiscal numbers are still not under control.
~ Raj Badiani, IHS Global Insight
Spain has made critical gains, however. It has taken advantage of structural funds from Brussels to develop its poorest regions by constructing bridges, roads and tunnels. It has also compelled regional authorities to address their payments arrears. What is needed now is a much more extensive overhaul of the country’s economic model.
“Consumption and tourism alone won’t save the day, while Spain needs higher value-added products to export across the world,” Barroso suggests. “If we want to go higher up the value chain, we need an educational system to support that goal and a structure for capital markets to provide funding for entrepreneurs too.” Budgets for research and innovation are still lacking, and regulatory hurdles impede the launch of new firms. Moreover, economists observe that Spain, like neighboring Mediterranean countries, suffers from its small average firm size, since 95% of businesses consist of fewer than 10 employees. “Medium or larger firms could generate better economies of scale,” according to Barroso. Internal consumption has helped fuel growth, with pent up household demand expressed for items like cars and electronic goods. “Firms are also replacing obsolete machinery,” says Badiani. “At some point they still need stronger sales, and industrial numbers have been disappointing. To sustain the recovery, we need real development.”
TROIKA’S STAR PUPIL UNDERTAKES REFORMS
Spain has undertaken a slate of reforms unmatched among neighboring periphery nations in the eurozone. Key regulations have been enacted pertaining to the labor market, pension system, fiscal framework and financial sector. First, new labor market regulation addresses collective bargaining at the firm level. That adjustment has provided greater flexibility for adjusting wages, which are now either static or weakening. Labor demand rose in 2014, after having fallen continuously since mid-2008, resulting in a decline
in unemployment, which dipped to 23.7% versus 25.7% at the end of 2013. “Unemployment remains high, but the rhythm of the decline gives confidence to the population,” Gual comments.
Meanwhile, the Spanish government faces accusations that it has fostered a duality between those inside the protected economy, who have fixed-term contracts, and a growing segment working under part-time or temporary contracts. “The type of service sector and temporary jobs which were created have helped in the short term but are not enough to sustain a recovery in consumer spending,” Badiani explains.
Jobs that offer no security also do little to build credit for mortgages, which accounts for a leveling off in the languid real estate revival. Badiani estimates a glut of around half a million unsold properties remains, especially in the suburbs. Who will buy them? Young people cannot get mortgages to join the property ladder, and many 30-somethings still live with their parents. Although coastal areas are attractive to purchasers, much construction remains unfinished. “It’s hard to know whether investors will make their money back on those,” McKeown observes. “Incomplete buildings lose value, so projects may need to be restarted.”
The banking industry, which has seen its share of restructuring, takes its cue from the real estate and construction sectors. Meanwhile, the transmission channel has finally been repaired, conveying the benefits of ECB monetary loosening to the Spanish credit market. “Banking union and consolidation, comprehensive assessments and recapitalization have brought back confidence to lending,” says Navarrete.
Although Spain did perform relatively well in ECB stress tests, the overhang of bad debts casts a shadow, and business is still barely profitable. “A gradual reduction of provisions and losses associated with real estate will help the recovery,” Gual anticipates. That process began last year, with the ratio of nonperforming loans drifting downward since late 2014, and should gain momentum, leading to normalization in 2016. Gual says the current return on equity of the average Spanish bank stands at 4%, but that number could double in a couple of years.
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A SUSTAINED REVIVAL
Just as consumer confidence has jump-started the economic rebound, the reverse dynamic could have the opposite effect. For now, shoppers judge that the brunt of the crisis is over and that it is safe to release pent up demand with renewed purchasing power. What will transpire, however, if either inflation or deflation sets in? McKeown, who perceives a significant risk of deflation, acknowledges that falling prices have had a benign impact. Yet she cautions that consumers may begin to put off purchases. So far this year the consumer price index has already fallen by 0.2%, and is expected to rise by only 1.2% next year. Spenders have reacted positively to take advantage of discounts, but they might become more hesitant if prices keep sliding.
By contrast, inflation could prove problematic if energy or food prices rally. Income would be rapidly scaled down or even neutralised. Although the recent uptick has in part been funded by reduced household saving, at some point rising real income must take over the stress of higher consumer spending. That can only be accomplished through continued employment growth, longer-term contracts, higher wages and rising profit margins for firms. “Benefits need to trickle down, so that firms don’t need to squeeze workers,” says Badiani.
Spain’s revival is partly owing to internal devaluation and cost control. It is critical that the process of wage and cost formation between unions and employees maintain that discipline to avoid resuming excessive cost increases that might undermine competitiveness. Oil prices in particular, which have provided a bonanza, could reverse course at any time. Last, the danger of an external shock is always unpredictable. Countries in the periphery appear to have built in protection with internal reforms and ECB policies, “but a shock would lead us into unknown territory,” Gual notes. Likewise, a US interest rate rise could create turmoil in emerging markets with global consequences. Assuming no unforeseen stumble, Spain’s resurgence will have exceeded even optimistic expectations. The next chapter will demonstrate whether the country can move beyond a test of textbook theory and emerge as a sustainable success.
GFmag.com Data Summary: Spain
Central Bank: Bank of Spain |
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|---|---|---|---|
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International Reserves |
$50.2 billion |
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Gross Domestic Product (GDP) |
$ 1,406.9 billion |
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|
Real GDP Growth |
2012 |
2013 |
2014 |
|
GDP Per Capita—Current Prices |
$30,278 |
||
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GDP—Composition By Sector* |
agriculture: |
industry: |
services: |
|
Inflation |
2012 |
2013 |
2014 |
|
Public Debt (general government |
2012 |
2013 |
2014 |
|
Government Bond Ratings |
Standard & Poor’s |
Moody’s |
Moody’s Outlook |
|
FDI Inflows |
2011 |
2012 |
2013 |
* Estimates
Source: GFMag.com Country Economic Reports
