Country Report Spain
The short term pain of the macroeconomic rebalancing process is clearly weighing on the political support to continue with necessary reforms. Without a more vigorous cleanup of the banking sector, it will remain a large drag on the recovery going forward.
Strenghts (+) and weaknesses (-)
(+) Political stability
Spain has a history of relatively stable governments, which is a large advantage during potentially destabilizing periods of large economic contraction and very high unemployment.
(+) Reform appetite
The government of premier Rajoy has –without the conditionality of a bailout program- implemented several structural reforms and also the reform agenda for the coming years is ambitious.
(-) Banking sector
The sector remains weak and it is realistic that more capital is needed to stabilize the banking system. The deleveraging process hampers the economic recovery while potential capital needs might deteriorate public finances.
(-) Power autonomous regions
The relatively large political autonomy of the 17 regions makes it difficult to control budgetary spending and to implement reforms which aim to boost competition across these regions.
1. Recovery not strong enough to bring down unemployment
There are several signs that the Spanish economy is slowly moving towards recovery (figure 1). Our expectation of a cautious return to growth next year as a whole (0.25) is partly based on a less tough austerity package compared to previous years, while the budget 2014 has a focus on the expenditure side. However, as the budget is based on an overly optimistic growth outlook (0.7%), Spain risks missing its budget target of 5.8%-GDP. We stress that the housing market is clearly lagging the recovery. Based on the monthly house price index of valuation agency Tinsa, the downward price trend continued in September (figure 2). It is important to note that lower house prices will act as a drag on growth via e.g. negative wealth effect, deteriorating bank balance sheets and lower construction activity. On a more positive note, the unemployment rate stabilized in recent months, albeit at a very high level (26.2% in August). However, this development was mainly owing to a decline in the labour force and not a result of employment growth. Looking forward, we do not expect the unemployment rate to come down quickly.
2. National and regional political unrest
Although the corruption allegations have receded somewhat in recent months, it still hurts the position of both Prime Minister Rajoy and his Partido Popular (PP). However, we believe these allegations are unlikely to lead to new elections (and political instability) as neither the PP - which has an absolute majority in parliament- nor the main socialist opposition party –which scores very poorly in the polls- will benefit from new elections. According to recent polls the PP would receive around 34% of the votes, compared to the 45% they received during the parliamentary elections of November 2011, and the socialists around 29%. Nevertheless, the allegations and the poor polls have undermined the public support for the PP and its austerity and reform agenda. Besides the national political unrest, there remain tensions within some of the autonomous regions. In September, there were large demonstrations for independence in Catalonia. The Catalan government led by Arthur Mas is still trying to establish a legal framework for holding a referendum. As this will be considered unconstitutional by Madrid, another option for Mas would be to hold a non-binding vote on independence or on a constitutional reform. Although non-binding this could provide Arthur Mas with more leverage in negotiations with Madrid and might be another step towards a referendum on independence, possibly coinciding with the Catalan elections in 2016. Madrid will try anything to prevent such a referendum, both as Catalonia (19% of national GDP) is an economically important region and as Catalonia’s initiative might be followed by other regions like Galicia and the Basque Country.
3. Further delay in cleaning banking sector
Since 2012, the establishment of the bad bank SAREB and the Oliver Wyman-stress test have increased the transparency about the asset quality and potential capital needs of Spanish banks. Further, the Banco de España made an important step in May 2013 by setting new criteria for determining whether refinanced loans should be classified as non-performing. Nonetheless, the IMF has expressed its concerns that some banks still do not take full provisions for expected losses.
The upcoming Asset Quality Review (AQR) and stress test by the ECB –an admission test for the Single Supervisory Mechanism (SSM)- will further increase this transparency. However, we emphasize that such an admission test will lead to uncertainty among investors as long as there is no credible solution for banks with a substantial capital shortfall. Such a solution should preferably comprise of both bail-in and access to a sufficiently large European Stability Mechanism (ESM), of which €60 bn has already been earmarked for direct bank recapitalizations. Note that the current financial assistance via the ESM (maximum €100 bn, of which €41.3 bn has been used) will end 31-12-2013 and there is yet no agreement on an extension of this facility. Both the Spanish government and the European creditors hope to avoid an extension, although we believe further assistance is desirable as many market participants –including us- believe it is realistic to prepare for further capital shortfalls. On a more positive note, Spain has taken many steps to improve its supervisory and regulatory framework and the IMF stated in September 2013 that nearly all measures under the banking program have been implemented.
4. Implementation of structural reforms
Regarding the implementation of structural reforms Spain remains on track, but future progress might be hampered by the low public support for the current government. Although the labor market reforms in 2010 and 2012 were substantial, more needs to be done to tackle the remaining duality in the labor market. However, such a follow up should not be expected in the coming years, both out of fear for the impact in a low growth environment and because there is limited political support. Regarding the necessary pension reform, the government proposed measures in September 2013 in which pensions will be linked to GDP growth and life expectancy from 2019 onwards.
Between the introduction of the euro in 1999 and the start of the financial crisis in 2008, the relatively closed and services-oriented Spanish economy experienced a rapid deterioration of its current account balance. The dominant reason for this deterioration was a rise of imports, which was partly due to the buildup of the construction boom during those years. When house prices started to fall in 2008 and construction activity came to sudden halt, this had major consequences for economic activity, bank’s balance sheets and public finances. Increased worries on public debt sustainability and the solvency of Spanish banks led to a large outflow of foreign capital. A robust austerity effort, private deleveraging and weak external demand have resulted in a long and deep contraction of economic activity, which was mid 2013 almost 7% below its pre-crisis peak. On a more positive note, Spain has implemented several structural reforms in recent years, which will enhance its long term growth potential. As a condition to the ESM-rescue package for Spain’s most vulnerable banks (potential help of €100bn), there has been good progress in reforming the banking sector. Although the country will eventually reap the fruits of these reforms, the short term costs of this adjustment process are extremely high. Partly due to high structural unemployment and a pro-cyclical labour market, the unemployment rate (around 26%) is one of the highest in Europe. Although there have been protests and strikes, the intensity of social unrest has remained fairly under control until now. Together with Spain’s history of stable governments –since the transition to democracy after the dictatorship of Franco ended in 1975- this is encouraging regarding political stability, which is crucial for public support to continue with necessary reforms.