Spain | Pitfalls On The Road To Recovery

Spain’s economy suffered for years following the global financial crisis, so its current respite comes as a welcome relief. The country managed to avoid accepting an international rescue package in 2010 when the deficit skyrocketed and the then newly elected administration decided to comply with the Troika’s (the European Central Bank [ECB], the European Commission and the International Monetary Fund) requirements to undertake substantial reforms.

Economic recovery has since gained steady traction, while agreed-upon policy measures have led to renewed optimism in the European periphery. “Looser monetary policy from the European Central Bank, with the implementation of quantitative easing, has also added huge liquidity as another feature to boost confidence,” says Jordi Gual, chief strategy officer and chief economist at CaixaBank and professor of economics at IESE Business School.

Progress has been achieved from a short-term perspective. But has enough been accomplished to sustain a path of longer-term stability and growth? Antonio Barroso, a senior analyst focused on the eurozone at global advisory firm Teneo Intelligence, is doubtful. “Spain is coming off a low bottom, so it is only natural to see acceleration at the current rate,” he notes. But looking ahead, not enough may have been done to solve more-entrenched challenges such as the deficit and to repair the basis of the country’s business and economic model. Meanwhile, risks of both internal economic imbalances and possible external shocks “may not be fully appreciated, and it’s too soon to sound the all-clear,” warns Jennifer McKeown, senior European economist at Capital Economics.

FACING AUSTERITY, DELIVERING GROWTH

Having swallowed the bitter medicine of market reforms and fiscal consolidation, Spain is finally returning to economic health. Policy mix has been slightly expansionary at the margin; fiscal austerity has been applied with looser monetary conditions, which have been transmitted to the credit market. “The successful combination of monetary loosening and fiscal restraint has been one of the lessons of the credit crisis,” says Fernando Navarrete, chief financial officer at Instituto de Crédito Oficial, a state-owned bank attached to Spain’s Ministry of Economic Affairs and Competitiveness.

Exports have increased their market share, which has provided the other major economic tailwind. In past cycles, “the engine typically starts with competitive gains from the external sector,” says Navarrete. But this time devaluation is off the table in the eurozone. Spain’s diversified export base should nonetheless continue to benefit from lower energy prices for at least another 18 months, according to Gual, which will boost the current account by reducing fuel costs. However, Gual adds the caveat: “Aggregate figures will look good, but the challenge is to take advantage of oil prices to continue to restore competitiveness for non-oil exports.”

Raj Badiani, senior principal economist at IHS Global Insight, is pleasantly surprised by predictions for Spain’s economic growth this year. He foresees expansion at 2.6% this year, and 2.5% for 2016. The government is unlikely to reduce spending prior to elections, scheduled for late in the year, and may actually impose new austerity measures after the vote in the hope that higher growth will produce a recovery in tax receipts, leading to a virtuous cycle. “But given the unemployment rate and high social security expenditures, fiscal numbers are still not under control,” Badiani cautions, adding that the authorities missed the net lending target in 2014 and will probably do so again this year. 

Despite the austerity measures undertaken, Spain’s public debt ratio stood at 98% of GDP in 2014, which ranks among the highest in Europe. It still needs to be brought down to 60% of GDP to comply with European Union rules. Cuts have not resolved a fundamental shortfall in revenues, which do not capture sufficient funds from an inefficient economy and tax system. Gual would also like to see investment rebalance toward a higher proportion of equity than debt: “In general, countries like Germany should grow with higher debt, while those like Spain, which carried excessive past debt, should be more reliant on their own generated funds,” he explains.

Given the unemployment rate and high social security expenditures, fiscal numbers are still not under control.

~ Raj Badiani, IHS Global Insight

Spain has made critical gains, however. It has taken advantage of structural funds from Brussels to develop its poorest regions by constructing bridges, roads and tunnels. It has also compelled regional authorities to address their payments arrears. What is needed now is a much more extensive overhaul of the country’s economic model.

“Consumption and tourism alone won’t save the day, while Spain needs higher value-added products to export across the world,” Barroso suggests. “If we want to go higher up the value chain, we need an educational system to support that goal and a structure for capital markets to provide funding for entrepreneurs too.” Budgets for research and innovation are still lacking, and regulatory hurdles impede the launch of new firms. Moreover, economists observe that Spain, like neighboring Mediterranean countries, suffers from its small average firm size, since 95% of businesses consist of fewer than 10 employees. “Medium or larger firms could generate better economies of scale,” according to Barroso. Internal consumption has helped fuel growth, with pent up household demand expressed for items like cars and electronic goods. “Firms are also replacing obsolete machinery,” says Badiani. “At some point they still need stronger sales, and industrial numbers have been disappointing. To sustain the recovery, we need real development.”