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Spanish economy suffers major contraction due to COVID-19

Economic Report

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  • COVID-19 has abruptly ended almost seven year of continuous growth in Spain
  • In Q1, GDP contracted by 5.2 percent q-o-q
  • The outlook for Q2 is much worse due to lockdown measures and weak demand
  • From Q3 the economy can slowly start to recover
  • But the path of recovery is clouded by a vulnerable sectoral composition and a substantial demand fallout
  • Government support policies will cushion the blow and support the recovery, but cannot prevent spikes in unemployment and bankruptcies
  • Firms and households are better able to absorb shocks to income than back in 2008/’09
  • But the current shock is larger and much more unevenly distributed
  • Government finances are set to worsen significantly, which could endanger public debt sustainability and will hamper longer-term growth

A big minus

Spain’s GDP contracted by 5.2 percent q-o-q and 4.1 percent y-o-y in Q1, according to yesterday morning’s note from Spain’s statistics office INE. Covid-19 has drastically ended almost seven years of growth (Figure 1). Domestic demand subtracted 5 percentage points of quarterly GDP growth and external demand 0.2 percentage points – imports and exports both contracted by 8.4 percent q-o-q. Tourism services export even contracted by 19 percent q-o-q. Meanwhile, the sectoral breakdown shows that activity in all sectors contracted, with construction (-8.1 percent) and services (-5.6 percent) faring the worst. We think the second quarter will show even sharper contractions across the board.  

Assuming most lockdown measures will be lifted from 1 June, the economy can slowly start to recover in the second half of the year. Yet some form of social distancing is likely to stay, which will continue to pose difficulties for some sectors. In our latest forecasting round we projected Spain's economy to contract by 6% this year – in 2009 the economy shrank by 3.8 percent- and to grow by 5% next year. Yet given the first quarter’s figure, incoming data and updated views on the path of recovery, it is inevitable that we will have to downgrade our projections. Full recovery of crisis losses will likely take over two years because of a vulnerable sectoral composition and a substantial demand fallout due to a spike in unemployment and bankruptcies.

Figure 1: Contraction in Q1 was much more severe than during financial crisis
Figure 1: Contraction in Q1 was much more severe than during financial crisisSource: Macrobond, Bank of Spain, RaboResearch.
Figure 2: Service sector activity at record-lows in March
Figure 2: Service sector activity at record-lows in MarchNote: A Figure below 50 indicates output is contracting.
Source: Macrobond, RaboResearch.

Lockdown measures were only introduced at the end of the quarter

For most of Q1, economic damage was mainly related to China’s weakness and lockdown, i.e. to less exports to China and supply chain disruptions. In the car sector, for example, multiple factories have been closed due to a lack of parts. In terms of domestic value added, 3.6 percent of Spanish exports end up in China. The supply shock originating in China has arguably had a larger negative impact on the economy, as 10.7 percent of final goods and 8.6 percent of intermediate imports come from China. But still, the overall impact on the economy was limited when compared to the impact of domestic lockdown measures in place since 14 March (Table 1).

Table 1: Strict confinement measures introduced in March
Table 1: Strict confinement measures introduced in MarchSource: Government website, RaboResearch

Broadly speaking, since mid-March, the travel and tourism sector, restaurants (except for delivery) and non-essential shops have been closed, while school closures and social distancing rules have reduced production activity and productivity in other sectors (Figures 3 and 4). Given the expectation that they will not be lifted before 1 June, domestic containment measures will have a much larger impact on economic activity in the second quarter than in the first (Figures 3, 4, 5 and 7). In addition, domestic demand will be hampered by increased unemployment and uncertainty, while foreign demand will be very weak due to global containment measures and a sharp global downturn.

Figure 3: Commercial flights have dropped by 75 percent since state of alarm
Figure 3: Commercial flights have dropped by 75 percent since state of alarmSource: FlightRadar24, RaboResearch calculations
Figure 4: Sharp drop in electricity consumption in April suggests large drop in activity
Figure 4: Sharp drop in electricity consumption in April suggests large drop in activitySource: Macrobond, RaboResearch calculations

Vulnerable sectoral composition

Not all sectors are equally vulnerable to the virus outbreak and subsequent containment measures. Moreover, not all sectors are equally well equipped to quickly recover to previous output levels. The composition of the economy is therefore a key element in gauging the impact of COVID-19 and the recovery path of the economy. Spain’s economy appears to be especially vulnerable (Figures 5 and 6, and Table 2 end of publication).

Figure 5: In Q2, almost 1/4th of the Spanish economy has to incorporate a shock to activity of over 50 percent
Figure 5: In Q2, almost 1/4th of the Spanish economy has to incorporate a shock to activity of over 50 percentNote: For more details see Table 2, end of publication.
Source: RaboResearch.
Figure 6: Compared to almost 1/5th of the Eurozone economy
Figure 6: Compared to almost 1/5th of the Eurozone economySource: RaboResearch

The government intends to lift lockdown measures step-by-step until life is back to normal by the end of June. In our baseline scenario, most lockdown measures will have been lifted early June, while some form of social distancing will likely persist, owing both to government policy and people’s own judgment. Based on these assumptions and Spain’s sectoral composition, we estimate that almost one fourth of the Spanish economy will suffer a decline in value added of at least 50 percent in Q2 – compared to almost one fifth in the Eurozone economy (Figures 5 and 6). This includes currently prohibited entertainment and hospitality services, for example, which have come to a virtual standstill since mid-March (Figure 7), but also motor vehicle manufacturing, which is suffering from supply chain disruptions and a lack of demand. Domestic trade will likely hover around 50 percent of capacity, due to the closure of non-essential shops.

Figure 7: Hotel occupancy rates have dropped to historical lows in March
Figure 7: Hotel occupancy rates have dropped to historical lows in MarchNote: Seasonally adjusted data.
Source: Macrobond, RaboResearch.

When shops are allowed to re-open this will likely lead to a substantial recovery in domestic trade, but certainly not to an immediate full-swing recovery. The outlook is worse for the entertainment, tourism and hospitality industry. These services are more difficult to perform in a social distancing society and only at low capacity rates. Moreover, even if the restrictions are lifted, the public will likely remain wary of using these services – especially the international crowd. Besides, given the depth of the shock to companies in all the sectors mentioned above, more are likely to go bust than in other sectors, harming the recovery potential.

We estimate that another 56 percent of economic activity, including manufacturing, is also substantially hit, but by less than 50 percent. Even though factories producing non-essential goods were only closed for 1.5 week, manufacturing production is suffering from supply chain disruptions, social distancing rules and weak demand. The scope for recovery for these sectors once lockdown measures are lifted is much larger than for the hard-hit service sectors, although bankruptcies, supply chain issues and muted domestic demand will likely prevent a V-shaped recovery.

Finally, we think that about 21 percent of the economy will remain more or less untouched during the lockdown or even grow at a higher rate. Financial services are an example of the former, while food stores and the health sector are examples of the latter. Sectors in this category are better able to adjust to social distancing measures and/ or exempt from lockdown measures because they provide vital services.

We will assess the ability of sectors to recover and to operate in a ‘social distancing society’ in more depth in a forthcoming piece.

Massive labor destruction

So far, lockdown measures have already had a detrimental impact on employment. Data for April is not yet available, but social security affiliations, i.e. employment, dropped by close to 900.000 in the second part of March. That is a drop of 4.5 percent in the first two weeks after the government declared a state of emergency. Employees on temporary contracts have taken the largest hit, with two thirds of jobs lost being on a temporary basis. For comparison, the drop late March matches the drop in employment over the three months after the collapse of Lehman Brothers. Unemployment jumped from 13.8 percent in February to 15.7 percent by the end of Mach (Figure 8, Spain’s ministry of Economy and Business).

Actual employment destruction has been even worse than official employment data suggests: this data also includes the workers that have entered Spain’s short-time work scheme ERTE, i.e. those workers that have been laid off temporarily or are working less hours. While those workers are not officially unemployed and will get their jobs back after the crisis, there is currently no work or less work for them. By mid-April, about 4 million workers had entered ERTE, i.e. 16 percent of the active population. These workers will receive unemployment benefits, cushioning the impact on income. Still, they are losing about one third of income. And while these jobs are not necessarily permanently lost, uncertainty over what will happen with their jobs in the future will likely have a negative impact on consumption.

Despite the short-time work scheme and government efforts to limit layoffs, we expect unemployment to increase substantially this year and average about 20 percent, from 14 percent last year. This is due to the very large dip in economic activity combined with the large share of temporary contracts (Figure 9), which generally fuels large swings in the labor market. Yet, without ERTE, and based on the correlation between unemployment and GDP growth between 2008 and 2013, the average unemployment rate would likely have approached 30 percent this year.

Figure 8: After years of decline, unemployment is set to increase significantly
Figure 8: After years of decline, unemployment is set to increase significantlySource: Macrobond, Spain’s Ministry of Economy and business, RaboResearch calculations
Figure 9: Spain has a large share of workers vulnerable to a drop in economic activity
Figure 9: Spain has a large share of workers vulnerable to a drop in economic activity Source: Macrobond, RaboResearch calculations

Shock absorbing capacity has improved

The scope for recovery depends on many things, including the capacity of households and firms to absorb income losses. Or in other words, it depends on to what extent businesses will face severe liquidity constraints and bankruptcies and households will be forced to rein in spending if they lose their jobs. Not to mention decisions driven by sentiment and caution. In general, companies and households with low debt burdens (Figure 10), high cash buffers (Figure 11), high saving rates (Figure 12), and businesses with a high profit share (Figure 13), are more resilient. We compare the current figures with data from before the global financial crisis since that financial crisis was caused, or at least intensified, by excessive debt burdens in the private sector.  

On average firms and households seem to be in a better position to absorb income shocks than in 2008, although metrics for firms have been worsening lately[1]. That said, averages mask differences in the distribution of assets, liabilities and income and the nature of the shock is completely different this time around, which makes it challenging to draw strong conclusions. This time around we are dealing with a very large and abrupt supply side shock, which hits many sectors to some extent, but specifically hurts a number of sectors with much weaker than average margins and reserves, such as hospitality and tourism.

Owing to improved balance sheets and government support (see next paragraph), the correlation between the economic contraction and bankruptcies should be weaker than during the financial and debt crisis. Yet, many small-sized firms in the hard-hit sectors will still have a very tough time surviving. As for households, incomes are set to drop on the back of a surge in both official and temporary unemployment. This will stifle consumer demand. However better household balance sheets and the existence of the work hours reduction scheme ERTE will likely pave the way for a less protracted demand downturn and a relatively more rapid recovery than in the aftermath of the financial and sovereign debt crises.

Figure 10: The interest burden on outstanding debt has decreased significantly…
Figure 10: The interest burden on outstanding debt has decreased significantly…Note: The interest coverage ratio of NFC (income over interest payments) stands at 14.8 percent, comfortably above the critical 2 percent level. Compared to just 3.2 percent in 2008.
Source: Macrobond, RaboResearch.
Figure 11: … While the active household saving rate has significantly increased…
Figure 11: … While the active household saving rate has significantly increased…Note: The active saving rate is the saving rate adjusted for debt payments. The higher the saving rate, the easier to uphold spending during a shock.
Source: Macrobond, RaboResearch.
Figure 12: …And so have cash buffers
Figure 12: …And so have cash buffersSource: Macrobond, RaboResearch
Figure 13: Profit shares are better than prior to the GFC, but declining and bankruptcies rising
Figure 13:  Profit shares are better than prior to the GFC, but declining and bankruptcies risingSource: Macrobond, RaboResearch

Government finances to deteriorate significantly

The Spanish government concluded 2019 with a public deficit of 2.8 percent and a debt of 95.5 percent. Public finances are set to worsen significantly due to the deep projected downturn, a COVID-19 fiscal support package and discretionary fiscal policy unrelated to the health crisis. Unrelated to the health crisis are public sector wage increases, pension revaluations and most importantly a conditional minimum guaranteed income scheme at an estimated cost of 5.5 billion euro (0.5 percent of GDP). All in all, we expect the budget deficit to reach double digits and the debt ratio to approach 120 percent (Figure 14).

Crisis measures

In order to combat the economic impact of the health crisis the government has presented (i) a support package worth EUR 18 billion, (ii) a EUR 100 billion line of guarantees on bank loans for companies in distress due to the virus and (iii) a moratorium on mortgages, social benefit payments and tax liabilities for hard-hit households, self-employed and companies at an estimated cost of EUR 26.3 billion.

The EUR 18 billion support package mainly consists of the short-time work scheme ERTE to preserve employment, investments in the health care system worth EUR 4.4 billion, and extraordinary benefits and income subsidies for several economic victims of the crisis. While exact timelines for the conclusion of moratoria differ, all of them must be concluded within the year 2020 and should as such not increase the public deficit. The ultimate costs of government guarantees depends upon the ability of companies to repay their loans.

The fiscal support package is relatively small when compared to Eurozone peers, as the government is trying to find the right balance between supporting the economy and preventing an irreversible deterioration of government finances. Time will tell, whether they have made the right decision. In our view, government support will not be able to prevent a deep downturn but should prevent worse and help the recovery from the second half of the year.

Debt sustainability

Government bond yields have increased, but are still far below levels seen during the debt crisis (Figure 15) – clearly partly because of enlargement of the ECB’s bond buying program. Nevertheless, the expected severe deterioration of public finances will prove a significant challenge for the future and bond yields could well spike when the definite impact of the crisis on government finances becomes clear. We already argued in many pieces prior to the Covid-crisis that Spain was not sufficiently improving its public finances in a rapidly growing economy to be prepared for a subsequent downturn and the costs of its rapidly ageing population. Risking harsh austerity measures and hence weak economic growth in the medium term.

If anything, the expected deficit and debt explosion further clouds the longer-term outlook and European support could be necessary to prevent a negative spiral of austerity, weak growth and deteriorating public finances. As a first step, cheap ESM credit could help if market sentiment deteriorates – and in that scenario the government is likely to apply for this credit with support from parts of the opposition. Yet the maximum amount of this credit line of 2 percent of GDP is only half the support package back in 2012, and it is limited when compared to the expected deficit of over 10 percent this year. Besides, it would still imply more debt to pay off in the future.

The outcome of the discussions on the next EU budget and a pan-European recovery fund will therefore matter a great deal for both Spain’s short-term recovery path and longer-term outlook.

Figure 14: Government finances to deteriorate quickly
Figure 14: Government finances to deteriorate quicklySource: Macrobond, European Commission, RaboResearch
Figure 15: Stocks near debt crisis lows, but bond yields still far below debt crisis highs
Figure 15: Stocks near debt crisis lows, but bond yields still far below debt crisis highsSource: Macrobond, RaboResearch
Table 2: The most hard-hit sectors have a relatively large share in Spain’s economy
Table 2: The most hard-hit sectors have a relatively large share in Spain’s economyNote: An equal sign indicates output at about the same or higher level as in a normal economy. A single minus indicates output between 0 and 50 percent below output in a normal economy. A double minus indicates output more than 50 percent below output in a normal economy.
Source: Macrobond, Eurostat, RaboResearch.

Footnote
[1] According to the SAFE survey of the ECB, the percentage of vulnerable SMEs tripled in the second half of last year to 10 percent.

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