RaboResearch - Economic Research

Spain: Economy losing momentum amid political paralysis

Economic Update

  • Spain returns to the polls on November 10, but a radically different election outcome is unlikely
  • A left-leaning minority government led by PSOE with outward support from Podemos is the most likely scenario
  • It is hard to quantify whether years of political instability have negatively impacted economic growth, but it cannot be ruled out
  • Spain may continue to pay the price for political inaction as efforts to make its economy more resilient to negative shocks have stalled
  • Failure to bring down the structural deficit and public debt ratio when the economy prospered have left Spain with little fiscal space to counteract an abrupt slowdown
  • There is no fear of recession as domestic demand is expected to hold up
  • We expect growth to decelerate further in the coming period and forecast growth to be 2.2% in 2019 and 1.7% in 2020

Third time was not the charm in Spain

The political paralysis in Spain is dragging on after acting prime-minister Sanchez (PSOE) failed to assemble a parliamentary majority to approve his appointment. Spain will hold its fourth general election in four years on November 10. The stalemate is a consequence of the fragmented political landscape, which has made it hard to form stable majorities. Many had expected Sanchez to succeed in scrambling together a majority with support of like-minded parties such as left-wing Basque or Catalan regional parties and far-left Podemos. Ultimately, despite months of on-and-off negotiations, talks collapsed after Podemos and PSOE could not agree on Podemos’ role in government. By going to the polls again, Sanchez hopes to strengthen his position in future negotiations.

Will it be any different next time?

It remains to be seen, however, whether fresh elections will be able to break the deadlock. Radically different election results look unlikely at the moment (Figures 1 and 2). Sure, the current polling numbers indicate that PSOE stands to gain, but an absolute majority is still well out of reach and it will need support from at least one, and again possibly multiple other parties. The improvement may not even materialize at all. Mounting election fatigue increases the risk of a low turnout, which is more likely to reflect poorly on left-wing parties than on right-wing parties, given the former’s failure to capitalize on the perfect opportunity to form a left-leaning government. What’s more, if deemed too lenient, the upcoming verdict in the trial of the Catalan separatist leaders could lead to a rise in nationalist sentiment that may drive voters to the right.

Figure 1: Election results (April 28, 2019)
Figure 1: Election results (April 28, 2019)Source: El País, Rabobank
Figure 2: Polls (September 20, 2019)
Figure 2: Polls (September 20, 2019)Source: El País, Rabobank

Nonetheless, a tie-up between Podemos and PSOE remains the most realistic scenario. However, Spain will probably not see a new government installed before year-end, as repairing the PSOE-Podemos relationship will require substantial effort. Podemos refused a coalition offer back in July; when Podemos came round, PSOE took the offer off the table because of a lack of trust. A moderate and pro-business coalition between market-friendly Ciudadanos and PSOE still looks impossible, given the former’s desire to replace PP as the most dominant party on the right. Entering a coalition with left-wing PSOE would not contribute to this long-term strategy. On top of that, the relationship between Ciudadanos’ leader Rivera and PSOE’s Sanchez has severely deteriorated over the past year due to Sanchez’s softer stance toward Catalan separatist parties. That said, a substantial drop in votes for Ciudadanos as a punishment for not seizing the opportunity to govern when it had the chance might make Ciudadanos slightly more receptive to cooperation with the PSOE. But, for now, that remains very much a long shot.

Welfare expenditures versus structural reforms

Conditional on a weaker Podemos and a strong election result for PSOE, we expect a minority PSOE-led government with outside support from Podemos and one or more regional parties, depending on the election outcome. The most likely candidate would be the Catalan Separatist Republican Left (ERC) which is likely to back a PSOE-led government again. Since causing the collapse of the previous Sanchez government, the ERC has adopted a more constructive strategy, perhaps influenced by a poll released in May which indicated that more Catalans oppose independence than support it. Nevertheless, an overly harsh punishment of Catalan separatist leaders may trigger a flare-up in pro-independence sentiment, which could also complicate negotiations between Podemos, ERC and PSOE given that only the former two parties would support an independence referendum.

The policy agenda of this left-leaning government will focus on reforming the tax system to raise funds for a wide range of welfare expenditures. Sanchez has voiced his plans to lower value-added tax on essential goods while raising corporate tax and income tax for the wealthy. He hopes that these measures will finance investments in health, education and green initiatives and yield the funds needed for pension indexation. While these investments would be highly welcome, generally a left-wing PSOE-UP government would focus more on social welfare rather than on the structural reforms required to reduce Spain’s vulnerability to negative shocks, which would likely be a higher priority for a Ciudadanos-PSOE tie-up. In fact, in a last-minute attempt to strike a deal with UP, Sanchez has proposed to roll back some of the labor market reforms implemented by the PP that have made the labor market more efficient.

Is all the political turmoil affecting the Spanish economy?

A frequently heard argument is that the political paralysis has had little impact on the Spanish economy, which has grown rapidly and easily outpaced growth in the eurozone as a whole (Figure 3). However, the impact of policy uncertainty is hard to quantify: growth might have been even higher without the political uncertainty and paralysis. In addition, Spain may continue to pay the price of political inaction in the years to come. Due to its political fragmentation Spain has seen a quick succession of minority governments, making it difficult to shore up the necessary support for structural reforms aimed at increasing Spain’s rather weak growth potential and reducing its vulnerability to negative shocks. For example, although rigorous labor market reforms were introduced between 2010 and 2015, further attempts have stalled and large labor market inefficiencies persist. Meanwhile, the incidence of temporary contracts (with relatively little protection compared to unlimited duration contracts) is on the rise again (Figure 4). Therefore, any abrupt economic slowdown could trigger a fresh unemployment spike if firms can easily lay off temporary employees: this is exactly what happened when Spain’s unemployment rate skyrocketed to 26 percent in 2013.

Figure 3: Spain outpaces other eurozone economies in terms of growth
Figure 3: Spain outpaces other eurozone economies in terms of growthSource: Eurostat
Figure 4: Temporary contracts served as adjustment mechanism during previous crisis
Figure 4: Temporary contracts served as adjustment mechanism during previous crisisSource: Eurostat, Rabobank
Figure 5: Public debt decreased only slightly in recent years; structural budget deficit expected to deteriorate
Figure 5: Public debt decreased only slightly in recent years; structural budget deficit expected to deteriorateSource: IMF

Moreover, the Spanish government may now have less firepower to counteract an abrupt slowdown than before the great financial crisis, given its failure to improve public finances markedly when the economy prospered (Figure 5). The many electoral cycles in recent years have led to considerable fiscal slippage and little focus on setting the government debt ratio on a clear downward trajectory. In addition, as we explained in more detail here, the relatively expansionary 2018 budget was rolled over into 2019, which has probably worsened public finances. Given the absence of a government and the prospect of laborious negotiations ahead, this budget could well be rolled over into 2020. The IMF and European Commission both estimate a structural budget deficit of around 3% in 2019 and predict further deterioration ahead (Figure 5).[1] This suggests that Spain has limited space for fiscal stimulus, which could be a cause for concern given that the economy is slowing and there are growing external risks.

[1] The structural budget balance measures the budget balance adjusted for cyclical movements. In good times, governments receive more revenues and have to pay less for social security, which both improve the budget balance.

Growth set to slow further but no fear of recession

Figure 6: Economic growth is weakening gradually; industry suffering in particular
Figure 6: Economic growth is weakening gradually; industry suffering in particularSource: Eurostat

Economic growth in Spain is starting to lose momentum amid a broader slowdown of the global and the eurozone economies (Figure 6). Industry, in particular, is suffering from the challenging external environment where escalating trade tensions and Brexit are continuing to cause uncertainty. As a result, industrial production has been contracting in y-o-y terms for several months. With the US-China trade war in full swing and the resulting uncertainty already impacting global demand, the important question is how long domestic demand can continue to drive Spanish growth. Although domestic demand had a relatively weak second quarter, we expect it to remain the driving force behind growth in the near future. The strength of domestic demand is underpinned by low inflation, relatively upbeat sentiment and labor market developments that are still rather favorable. Employment is growing at a healthy (although slowing) pace and sentiment among consumers and businesses in the domestically oriented retail trade and services sector is generally positive and more upbeat than in other large eurozone economies. We do note, however, that the Services PMI for the eurozone as a whole declined sharply in September, which may or may not be driven by a weaker Spanish reading. For now we expect domestic demand to stay buoyant in the coming period.

That said, with the global slowdown expected to drag on, it seems only a matter of time before domestic demand also starts to show signs of weakness as reduced demand for Spanish production starts to weigh on labor demand and sentiment. Moreover, relatively limited fiscal space and the high incidence of temporary contracts may intensify an abrupt slowdown. However, assuming an orderly Brexit and no US tariffs on European cars, we expect the Spanish economy to hold up well even when other economies (Germany and Italy) are flirting with recession. Overall, we forecast Spanish GDP growth to be 2.2% y-o-y in 2019 and 1.7% y-o-y in 2020.

Michiel van der Veen
RaboResearch Netherlands, Economics and Sustainability Rabobank KEO
+31 6 8313 4616

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