Country Report Spain
Despite the improvement of the short term economic outlook, several bottlenecks of the Spanish economy (rigid labour market, weak banking sector) desire policy urgency. Unfortunately, upcoming elections are clearly weighing on the political support to continue with necessary reforms.
Strengths (+) 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.
(+) Robust reform implementation
Spain will reap the fruits of several structural reforms (labour market, pensions, financial sector) which have been implemented in recent years by the Rajoy government.
(-) 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. Macroeconomic adjustment process on track
With modest GDP growth in 13Q3 and 13Q4 (+0.1% and +0.2% q-o-q respectively) Spain has finally ended its nine-quarter recession (figure 1). The positive news is that the economy is able to grow while the macroeconomic rebalancing process continues. Firstly, foreign demand is still the most important growth driver, which is encouraging given the need to adjust towards a more export-driven growth model. Secondly, the relatively modest growth of negotiated wages –which came down in line with inflation- is good news as it pushes down labour costs, although it comes at the cost of purchasing power. While sentiment indicators point to a gradual recovery going forward, we believe the government’s GDP growth forecast of 1% this year is too optimistic. Given the ongoing private sector deleveraging and the requirement by the European Commission to improve the structural budget balance by 0.9%-GDP on average until 2016, we believe GDP growth of around 0.5% this year and 1% next year is more realistic. The modest economic recovery is also visible on the labour market. After 22 quarterly contractions in a row, employment finally grew in the last quarter of 2013 (+0.6% q-o-q, figure 2). Unemployment dropped to 25.8% in January, from a peak of 26.5% last August, but this decline was also helped by a further drop in the labour force (most likely discouraged worker effect). Looking forward, we stress that a further quick decline of the unemployment rate this and next year seems unrealistic. Firstly, the gradual drop of the labour force since 2012 cannot continue forever, especially as the retirement age is rising gradually towards the age of 67 in the coming years and we cannot rule out that ‘discouraged’ workers will return to the labour market when the outlook improves. Secondly, the decline in construction activity has created a mismatch between supply and demand in the labour market, which might result in long term unemployment among construction workers.
2. Election cycle and political fragmentation
The political landscape this and next year is highly dominated by the upcoming European elections (May 2014) and general Spanish elections (end 2015). Despite attempts by the governing Partido Popular (PP) to claim credits for the economic recovery and the ongoing drop in government bond yields (to 3.2% on 10-year bonds), the public discontent with the current socioeconomic policy remains large. Please note that a continuation of the general drop in government bond yields across the eurozone periphery –which can be partly attributed to a return of confidence after the ‘whatever it takes’ pledge by ECB-president Draghi- cannot be taken for granted as it also depends on political stability and liquidity in global financial markets. The persistent public discontent is reflected by the loss of confidence in the two traditionally large parties, the PP and the Socialists, which has led to increased political fragmentation. According to recent polls, the PP would receive around 31% of the votes -compared to the 45% at the parliamentary elections of November 2011- and the socialists around 29%. Two parties are benefitting from this development, the left IU (13%) and the centre-left UPyD (8%). Please note that the latter is strongly opposed to Catalan independence, which might influence Rajoy’s position in the Catalan conflict. Recently, the Spanish parliament voted down the possibility of a legal referendum on Catalan independence. As a result, the Catalan government led by Arthur Mas will try to negotiate a new deal with premier Rajoy on more Catalan autonomy and a future legal framework for holding a referendum. Confronted by the risk of losing electoral support to the UPyD, premier Rajoy is not expected to play soft with the Catalans, risking early Catalan elections in case the deal fails, which is our base case scenario.
3. Limited further reform appetite
The election cycle and the waning support for the PP are expected to limit the reform potential this year and next year, after a steady reform agenda in 2012 and 2013. Two reforms are planned for 2014: a third labour market reform (after reforms in 2010 and 2012) and a fiscal reform. However, the recently proposed plans for the labour market are far from substantial. The government wants to stimulate hiring on permanent contracts (versus temporary contracts) via lower social security contributions. This is a step in the right direction, but does not solve the root of the problem: high redundancy payments and a significant administrative burden in case of ending a permanent contract. Regarding the fiscal reform, an expert group has advised to reduce taxes for lower incomes and corporates (SME), which should be funded by broadening the VAT base and by a higher effective tax rate for large companies. However, as the finance ministers has ruled out a higher VAT, it remains uncertain how the tax cuts will be funded, risking fiscal slippage from 2015 onwards. On a more positive note, report the IMF recently stated that all measures under the banking program (via the European Stability Mechanism, which expired end 2013) have been implemented. The upcoming Asset Quality Review by the ECB –an admission test for the Single Supervisory Mechanism- should further boost transparency. However, as long as there is no credible solution for banks with a substantial capital shortfall, we emphasize that such an admission test will lead to uncertainty among investors and will not speed up the necessary clean-up of the banking sector.
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 build-up 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 end 2013 around 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.