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Analysis
Spain – the bellwether of monetary union

Spain – the bellwether of monetary union

ECB December measures would boost Rajoy

by David Marsh

Mon 2 Nov 2015

Spain tells us more than any other European country about the state of economic and monetary union. Both the positive and the negative aspects of Spain’s EMU record are exemplary.

In the run-up to the 20 December election in which Prime Minister Mariano Rajoy is bidding for a second term, Spain is demonstrating a much better recovery from recession than many expected. GDP growth this year and next is expected at close to 3%, roughly 1 percentage point above the euro bloc average.

On present polling, Rajoy and his conservative Popular Party look likely to come out on top, but may have to govern in a coalition.

Burdened by exceptionally high foreign debt resulting from earlier EMU excesses, Spain is profiting more than any other large European country from the triple boost of low oil prices, low European Central Bank-inspired interest rates and the weak (and probably weaker) euro.

Should the ECB, as looks likely, decide to extend the scope and size of quantitative easing on 3 December, keeping euro area interest rates depressed for still longer and pushing the euro down further towards parity against the dollar, Rajoy will get an important pre-election boost.

In EMU’s initial relatively untroubled years, Spain’s headline-commanding job creation – Spanish employment rose 3.7% annually between 2000 and 2009, against only 0.2% for Germany – was held up by euro protagonists as evidence that the single currency was working. The country registered GDP growth rates of 3%–4% up to 2007, 1–2 percentage points above the euro area average.

Partly for fear of provoking unwanted disturbance, the ECB and the European Commission made light of the alarming counterpart to the positive growth and employment picture: a dramatic build-up of the current account deficit to 9% of GDP in 2006–08, reflecting sharp falls in competitiveness. The upshot was a massive build-up of foreign indebtedness as cross-border lending – via the bond markets and the banking system – flowed into Spain and then, with great alacrity, departed again as creditors’ love affair with peripheral euro members abruptly ended.

Since then, Spain – the European Union’s fifth largest economy and the 14th in the world – has shown an impressive turnaround. Spain has benefited from an EU-sponsored restructuring of the banking system, yet, crucially, has not had to go to the International Monetary Fund for a general bail-out.

It has slashed public spending in mid-recession, and returned to the competitiveness level at which it joined EMU in 1999 – a consequence of declining wages, structural efforts to boost productivity and a landmark labour market reform in 2012 to make it easier for companies to hire and fire workers and opt out of collective pay bargaining.

Unemployment at around 5m, well above 20% of the labour force since 2011, is a major blackspot but could fall towards 3m in the next two years. Employment will grow annually in 2015–18 by almost as much as in the earlier euro boom, according to generally credible government projections, while annual wage compensation throughout the economy could rise 4–5% as Spaniards return to work (albeit in more precarious jobs than before).

The good news is that Spain is due to remain in current account surplus despite above-average GDP growth. The ministry of economy and competitiveness, in forecasts that roughly match the OECD’s, is predicting annual surpluses of around 1% of GDP to 2018, part of yearly euro bloc current account surpluses of around 4% of GDP. This is a sharp contrast to the disastrous Spanish current account deficits up to 2009 (when EMU as a whole showed a small surplus or rough balance), and underlines Spain’s structural improvement since then.

The bad news is that, despite better overall Spanish balance, net foreign debt remains worryingly high. According to the ministry’s projections, Spain’s net negative international investment position has remained at around 100% of GDP since 2010, reflecting the ‘snowball effect’ of interest rates on its debt above the country’s recent low nominal GDP growth.

All this could change if, in the next few years, Spain can increase GDP at above its neighbours’ growth rate, while profiting from low interest rates, stemming from an unusually positive combination of domestic and international circumstances. A lot is riding on what the ECB decides on 3 December, how Spain votes just over a fortnight afterwards – and the policies of whoever is governing Spain in 2016-17.

David Marsh is managing director of OMFIF.

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