Gain or more pain in Spain?

Gain or more pain in Spain?

Policy brief
19 October 2015
  • Spain is the eurozone's latest poster child for austerity and structural reforms. The country's economy is growing robustly on the back of strong employment growth, recovering real wages and a pick-up in business investment. Indeed, Spain is on course to be the fastest expanding big economy in the EU this year.
  • Spain’s return to growth is good news, but there is little evidence that it is the result of austerity and reforms. Moreover, the economy’s outlook is cloudier than the dominant narrative would suggest and the challenges facing the country remain formidable.
  • Inflation will be too low to erode the real value of the country’s daunting debt burden. Unemployment will remain high for many years and continue to bear down on prices. And the ECB will shy away from the aggressive monetary easing needed to raise Spanish inflation.
  • Real borrowing costs are highest in weak eurozone countries such as Spain (where inflation is lowest), and lowest in the strongest (where inflation is highest), leading capital and skilled labour to flow to the eurozone’s stronger economies. The Spanish government cannot boost government spending to counter this effect and the eurozone lacks fiscal mechanisms to compensate weaker member-states for it.
  • Spain needs stronger productivity growth if living standards are to converge with those in wealthier EU countries. But there is little sign that investment is switching from lower to higher value-added activities. Most of the jobs created over the last couple of years have comprised poorly-paid service sector employment, especially in tourism.
  • Spain’s relatively strong export performance since the depth of the crisis has been powered by sectors such as fuel and food rather than a move into higher value-added sectors. Recovering domestic demand will lead imports to rise more rapidly than exports, causing a renewed current account deficit and worsening of Spain’s already very weak net external asset position.
  • Construction activity has bottomed out, but is set to stagnate at low levels of activity given Spain’s poor demographics and the country’s overhang of empty homes, some of which are being demolished but many of which will continue to weigh on the market.
  • One of the lowest birth rates in the world and net emigration means that Spain’s working age population is set to shrink rapidly. This might not sound like a problem for a country with mass unemployment, but countries with shrinking workforces tend to suffer weak economic growth, which makes public and private debt harder to pay back.
  • Spain is likely to enter the next downturn having barely recovered from the previous recession, with high levels of public and private sector indebtedness, and unemployment well above pre-crisis levels. Crucially, it will have few policy tools available to combat a renewed weakening of domestic demand, which increases the likelihood that the next recession will be a deep one.