Spain’s Recovery At Risk

Inflation and rising borrowing costs threaten Spain's post-pandemic recovery.

Spain turned a page after the Covid-19 induced recession. GDP, which had fallen 10.8% in 2020 (one of the largest declines of any country that year), rebounded to 5.1% in 2021, and is expected to come in at or above 4% for full-year 2022, according to the OECD.

Spain’s labor market is stronger than before the pandemic; and tourism, a key industry, has almost completely recovered.

“There are at least four aspects of Spain’s macroeconomic outlook that have surprised on the positive front,” says Juan Ignacio Peña, professor of finance at Carlos III University in Madrid. “The labor market has improved, with a record number of active workers; exports did well and are above pre-pandemic levels; investments in machineries, also supported by the European Funds, are sustained; and the ratio of public deficit to GDP is falling.”

In addition to tourism, food, technology and the health/cosmetic industries saw strong expansion. “The elements that penalized Spain during the Covid-19 pandemic–its dependence on services, tourism and entertainment–are now at play in a positive way,” Miguel Cardoso, chief economist for Spain at Banco Bilbao Vizcaya Argentaria (BBVA) Research in Madrid, tells Global Finance. “Second- and third-quarter GDP will be boosted by a renewed spending wave.”

Spain-based food group Carranco, for example, digital consultancy Making Science, and Easo Magno, which distributes beauty products, emerged as among the most dynamic companies in Europe. “Some industries are surprising for their vitality,” Cardoso says. “Machinery, pharmaceuticals, other health products and foods are doing much better than expected and are compensating other sectors more vulnerable to the cost of energy. Renewables and machinery for renewable energy have a competitive advantage in Spain, and are benefiting from the crisis.”

Still, it might not be enough to bring the economy back to pre-Covid levels. In the first half of 2022, inflation soared to 10%, a 37-year-record and well above the eurozone average. Driven by rising energy and food prices, inflation—along with the spectre of recession in larger European economies such as Germany or Italy—could postpone the return of Spain’s GDP to pre-pandemic levels and put the country back in a weak spot, economists say. The Bank of Spain does not expect GDP to reach pre-Covid levels until the third quarter of 2023.

“The outlook is cloudy for Spain. The ongoing war in Ukraine and the erosion of purchasing power due to high inflation are expected to adversely impact economic activity,” says Brussels-based ING economist Wouter Thierie. “Households are becoming more pessimistic as soaring inflation bites, with consumer confidence plunging again in June.”

So far, the impact on exports and supply chains from the Ukraine war and the related surge in energy costs has been relatively modest. “Spain’s trade composition and its dependence on Russian gas are limited in comparison to countries such as Germany or Italy, so Madrid is somewhat protected from these main risk factors,” says Alex Muscatelli, director of Sovereign Ratings at Fitch Ratings.

The labor market—usually a weak spot for the Spanish economy because of the country’s structural high level of unemployment—showed surprising strength. At the end of June, the number of registered unemployed stood at 2.9 million, a 20.3% drop from 2021 and the lowest level since 2008.

“There is an interesting dichotomy in the recovery of the Spanish economy after Covid-19. Spain was one of the countries most affected by Covid-19, with a very, very sharp fall in economic activity in 2020,” Muscatelli adds. “However, the labor market has been much more resilient. Part of it, a lot of it, was due to the use during the pandemic of short-time work schemes so that firms avoided sharp increases in layoffs. The level of employment and hours worked in Spain is higher now than before the pandemic.”

At the start of 2022, a government reform of the labor market came into effect that set limits on temporary contracts, but also introduced a new, more flexible work scheme, that gives more job security than the pandemic short-term contracts but still costs companies less than traditional full-time jobs. Madrid also reestablished the priority of sectorwide over firm-level agreements for wage settlements. These changes are on the one hand positive because they provide “more job security and more certainty around disposable income,” according to Fitch’s Muscatelli but, on the other hand, they will also introduce “more rigidities for corporations and may limit overall job creation.”

“The bad news in Spain is higher-than-expected consumer inflation,” says Peña. Annual inflation rose a preliminary 10.2% in June 2022, up from 8.7% in May and well above market forecasts of 9%.

“Inflation is high, and this is the largest risk so far,” says BBVA’s Cardoso. “Business and workers have realized that core underlying inflation will be steadily above 5%. This will cut disposable income and put pressure on costs for firms. We expect lower growth in the coming months, and high inflation is one of the main reasons.”

Public pensions—the largest category of Spanish government spending—were reformed in 2021 so that payments will be indexed to the CPI. While pensioners will mostly spend any raises back into the economy, some economists, such as Peña, fear that it will “impact public spending in a negative way in the long run.”

Another aspect in which Spain appears more protected than other eurozone countries is the possible future increases in the cost of money that the European Central Bank might decide to stop inflationary pressures–oncoming higher interest rates will increase the cost of funding public debt slower than elsewhere in the eurozone. The country’s 10-year bond yield versus the 10-year German bund did not rise as much as Italian or Greek counterparts.

“Spain’s average debt maturity is at eight years, which limits the impact on the overall cost of debt servicing because it would still take time for the current marginal interest rate to feed through to be above the average interest rate,” Fitch’s Muscatelli says.

The private sector has been deleveraged since the financial crisis and is less reactive to future increases of interest rates, he adds.

Fitch’s long-term sovereign rating stands at A–, with a stable outlook. “Our rating assumes that the debt-to-GDP level is declining, albeit slowly. A weaker economic picture together with increased government support measures may bring about a rise in the government debt ratio. Failure to place debt/GDP on a downward path over the medium term is one of our negative rating sensitivities for Spain,” says Muscatelli.

With the prospect of elections in 2023, uncertainties over economic policies will increase. Spain, one of the largest beneficiaries of the Next Generation European Funds, still has a reform agenda to fulfill in order to cash the money.