Spain's Unrealistic Expectations
- The Spanish government expects the recession to come to an end by mid-2013. In an environment of fiscal tightening and sliding house prices, that appears to be wishful thinking.
- Even if Spain manages to deliver the anticipated -0.5% growth in 2013, this does not justify the government's expectations that the unemployment rate should decline slightly in 2013. It is simply at odds with the empirical evidence.
- We expect that the Spanish economy will contract 1.5% or more in 2013, that Spain will miss its fiscal target and that the unemployment rate will rise to at least 26.5%.
The Spanish government expects an export-driven recovery that will bring Spanish growth back into positive territory by mid-2013. The assumption is that Spanish exports can grow 6-7% annually in 2013-15. This may materialise if global growth picks up notably or Spain manages to win global market shares, e.g. in services and green energy. We find that it is an ambitious target that may prove difficult to reach, though not impossible. A driver for winning market shares is to become more competitive. The new government has undertaken a lot of reforms during the last 10-11 months. But it is no time for complacency. Looking at the business climate and unit labour costs, we believe that Spain is really only halfway through the needed reform agenda.
However, our real concern is that even if exports grow as much as anticipated, the contraction in domestic demand will be much bigger than the government anticipates.
Austerity and fiscal multipliers
The Spanish government needs to reduce the fiscal deficit by at least 1.8% of GDP next year to reach its target. This will have a substantial negative impact on growth. In an economy operating close to its capacity constraint the fiscal multiplier is probably close to zero, as the private sector will replace public sector cuts. However, when demand is lacking, as is the case in Spain, there is little reason why cuts in the public sector should cause an increase in private sector production. Until recently, IMF consensus was a fiscal multiplier around 0.5, but in October IMF chief economist Olivier Blanchard and Daniel Leigh emphasised that during recessions the multiplier is probably in the range of 0.9 to 1.7. In the absence of a central bank response, the multiplier is probably at the high end of this range. Assuming a fiscal multiplier of 1.5 means that a 1.8% cut in the budget deficit should pull GDP growth down by as much as 2.7%.
Housing market downturn
At the same time, we expect house prices to continue to slide in Spain, which will dampen domestic demand further. Declining house prices are a drag on private consumption - not only because it reduces wealth, but also because uncertainty about the extent of future house price declines causes substantial precautionary savings. Spain has seen a housing bubble comparable with that of Ireland, but for now the decline in official house prices has been much more modest. We would not be surprised to see another 20% decline in Spanish house prices over a 3-4 year period. This may amount to an additional drag of about 1% in annual GDP growth (assuming that the elasticity of GDP to house prices is 0.2). All in all, we expect these two headwinds to drag growth down by around 3.7%.
On top of this, the Spanish banks are expected to continue to deleverage. Spanish banks have a lot of bad assets on their books and we expect credit conditions to remain tight. An ongoing credit contraction is an important headwind too, although difficult to quantify.
With all these headwinds we really have a hard time seeing how Spain can return to positive growth by mid next year. It is pretty much the same as saying that Spain would be able to grow at least 4-5% next year in the absence of headwinds. We do not think so.
Unemployment likely to continue to rise
Even if the Spanish government manages to deliver the -0.5% growth anticipated for next year, it is unlikely that it will succeed in reducing the unemployment rate by 0.3%-points as foreseen. The historical relationship between GDP and unemployment suggests that with a 0.5% contraction in GDP the unemployment rate should rise 2.6 %-points. The government's expectation is four standard deviations away from this. On top of this, we would argue that growth is much more likely to be -1.5% or less, which suggests an increase in the unemployment rate of 4.0% or more. We agree that the impact on the unemployment rate is probably lower at the end of a recession than at the beginning. Taking this into account we would still expect the unemployment rate to increase at least 1.5%-point next year. The government's expectations of a 0.3%-point decline in the unemployment rate are just wishful thinking.
Complacency is a risk
It is of course worrying that economic growth might be worse than one could wish for. But it is even more worrying, in our view, that large parts of official Spain appear complacent. The new government has delivered important reforms during the past 11 months, but we think it is too early to believe that the work done is sufficient. If the Spanish government does not continue its reform efforts constantly, its problems could grow much bigger.
We expect that Spain will eventually have to ask the ESM for a precautionary credit line, which will pave the way for the ECB to start buying Spanish government bonds. The Spanish government would be well advised to adjust its fiscal targets for 2013 before asking for help. The ECB will, in our view, not refrain from buying Spanish government bonds when it becomes clear that Spain is likely to miss its 2013 targets, but fiscal targets and consolidation efforts will then have to be renegotiated. In such a negotiation process the European partners might demand additional reforms.