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Ernst & Young Eurozone Forecast

Summer edition June 2011

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Ernst & Young Eurozone Forecast Summer edition June 2011

Outlook for Spain

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Highlights
Spain still fighting to distinguish itself from the smaller peripherals

The economic landscape remains fragile, with a rapid turnaround unlikely amid ongoing fiscal tightening, together with deleveraging in the private sector. Domestic demand will contract this year under the burden of the fiscal squeeze and the ongoing weakness of the labor market, leaving net trade as the driver of growth. We forecast GDP growth of just 0.7% in 2011 as a whole, picking up only modestly to 1.2% in 2012. Activity in the Spanish economy continued to expand in the first months of 2011, driven by strong exports and a surprise rebound in public expenditure, which likely reflected temporary overspending before the regional and local elections in May. GDP grew by 0.3% in Q1 when compared with the previous quarter, bringing the annual rate of growth to 0.8%. The near-term outlook appears particularly unfavorable for investment expenditure, which we forecast to contract by 4.5% this year, representing the fourth consecutive annual decline. While business capital outlays are expected to decline by 3%, residential investment is forecast to fall by more than 13% as the construction sector continues to shrink.

Consumer spending growth will also remain sluggish while the dire situation in the labor market persists. Unemployment rose to a 14-year high of 21.3% of the workforce in Q1, up from 20.3% in the previous quarter. With inflation running at an annual rate of 3.5% in April, this will act as a further drag on incomes. These factors, combined with the need for households to reduce debt, are expected to limit consumer spending growth to just 0.1% in 2011, with only a modest acceleration to 0.6% in 2012. Spain made good progress with its fiscal consolidation last year, cutting the budget deficit by 1.9 percentage points (ppt) to 9.2% of GDP. Even more aggressive fiscal tightening is planned for 2011, with the Government targeting a 6% deficit. We remain cautiously optimistic about the outlook, forecasting a deficit of 6.6% of GDP, only narrowly higher than the Governments target. Nevertheless, such achievements are threatened by political uncertainty, the surfacing of more deficits from local governments and slow progress with reforms.

Much of the markets worries about Spain relate to the state of the banking sector and the potential for spillover into public finances. In this regard, the latest data is not reassuring, with the bad loans ratio having soared to a 15-year high of 6.2%. The Spanish Government has unveiled a second round of restructuring for the regional savings banks (cajas) to restore confidence in the financial system. On top of the 15 billion already spent on their recapitalization, the Bank of Spain estimated in March that the banking system needs an additional 15 billion of capital. Although this sum appears manageable, independent analysts estimate that the cost of recapitalizing the cajas could actually be as high as 120 billion. If these higher estimates prove correct, this could potentially derail the fiscal consolidation effort.

Ernst & Young Eurozone Forecast Summer edition June 2011 | Spain

Spain still fighting to distinguish itself from the smaller peripherals

The Spanish economys slow recovery continued in Q1

Activity in the Spanish economy continued to expand in the first months of 2011, albeit at a sluggish rate. GDP grew by 0.3% in Q1 when compared with the previous quarter, bringing the annual rate of growth to 0.8%.

putting GDP on track to expand by just 0.7% in 2011 as a whole

Foreign trade continued to provide the main impetus to the expansion, courtesy of relatively robust export growth combined with a meager expansion of imports. But public expenditure also rebounded, perhaps reflecting temporary overspending before the regional and local elections in May. Other components of domestic demand remained weak, however, reflecting the ongoing fiscal tightening at the federal level. Consumer spending remained flat on the quarter, while fixed investment continued to contract sharply, falling by 1.4%.

The economic landscape remains fragile, with a rapid turnaround unlikely amid ongoing fiscal tightening, together with deleveraging in the private sector. Domestic demand will contract this year under the burden of the fiscal squeeze and the ongoing weakness of the labor market, leaving net trade as the main driver of the recovery. We forecast GDP growth of just 0.7% in 2011 as a whole, picking up only modestly to 1.2% in 2012 as domestic demand begins to recover. In fact, we expect growth in Spanish GDP to remain below 2% per year to 2015, as the rebalancing of public finances and restructuring of the economy will be a prolonged process.

fourth consecutive annual decline. Positive growth of 1.6% is expected in 2012, however, driven by corporate investment as spare capacity in the economy begins to tighten, especially in the export sector. Recent surveys signal that the business environment continues to be challenging, despite rising demand for Spanish exports. The May Purchasing Managers Index (PMI) for the manufacturing sector signaled a contraction for the first time in eight months as both output and new orders declined. The services PMI was also downbeat, showing only a fractional increase in activity in May, with new business continuing to fall. Both sectors reported ongoing job cuts. Against this background, we forecast business investment expenditure to contract by 3% this year, although positive growth of 2.8% is expected in 2012.

Investment to contract for the fourth consecutive year

The near-term outlook appears particularly unfavorable for investment, which we forecast to contract by 4.5% this year, representing the

Table 1

Spain (annual percentage changes unless specified)

2010 GDP Private consumption Fixed investment Stockbuilding (% of GDP) Government consumption Exports of goods and services Imports of goods and services Consumer prices Unemployment rate (level) Current account balance (% of GDP) Government budget (% of GDP) Government debt (% of GDP) ECB main refinancing rate (%) Euro effective exchange rate (1995 = 100) Exchange rate ($ per ) -0.1 1.2 -7.6 0.4 -0.7 10.3 5.4 2.0 20.1 -4.5 -9.2 62.0 1.0 120.7 1.33 2011 0.7 0.1 -4.5 0.6 -0.7 10.2 4.2 3.3 20.5 -4.4 -6.6 67.4 1.3 122.4 1.42 2012 1.2 0.6 1.6 1.0 -1.4 6.0 4.4 2.0 19.9 -3.0 -4.7 70.6 2.3 121.8 1.38 2013 1.6 0.8 3.7 1.0 0.1 7.4 6.2 1.4 19.1 -2.8 -3.4 71.8 3.1 119.5 1.33

Source: Oxford Economics 2014 1.6 0.8 4.3 1.0 1.4 6.5 6.4 1.5 18.5 -2.6 -3.1 72.6 3.5 115.2 1.27 2015 1.9 1.1 3.9 1.1 2.3 6.6 7.0 1.5 17.6 -2.1 -2.7 72.8 3.9 113.3 1.24

Ernst & Young Eurozone Forecast Summer edition June 2011 | Spain

By contrast, residential investment is forecast to contract by more than 12% this year, with positive growth not expected to return until 2013. Activity in the real estate sector will continue to shrink as construction firms are burdened by strained balance sheets, a stock of over one million unsold homes and falling house prices. Indeed, the pace of house price declines appears to have accelerated recently, with prices down by 4.6% in the year to Q1, compared with a 3.5% annual pace of decline at the end of last year. This may be linked to a number of factors, including the end of a tax allowance for mortgage interest payments and rising interest rates. Between the beginning of the year and early May, the one-year Euribor rate, a money market measure that most Spanish mortgages use as a reference rate, had risen by over 60 basis points (bp). With house prices still overvalued on several measures, further price declines are expected this year and next.

It should be borne in mind that, although the number of Spanish unemployed appears very high, the labor market situation in Spain is rather more benign than the headline numbers would suggest. This is because unregistered employment represents a large and growing share of total employment in Spain. Many small- and medium-sized enterprises have employees whom they pay fully or partially in cash to avoid tax and social security obligations. Although the discrepancy is hard to quantify, this means that the effective unemployment rate is somewhat lower than the reported data. The implications for consumer spending are therefore somewhat less dire than the official unemployment rate would suggest, although this situation does make the ongoing fiscal consolidation more difficult by lowering tax revenues. This is partly why, despite a much higher official unemployment rate, we forecast more robust private consumption in Spain than in Ireland, for instance.

Labor market situation remains dismal, but conditions are stabilizing

Consumer spending growth will also remain sluggish while the dire situation in the labor market persists. Unemployment in Spain rose to a 14-year high of 21.3% of the workforce in Q1, up from 20.3% in the previous quarter. We think that the unemployment rate is close to its peak, especially if new labor market liberalization measures come into force. A return to positive, albeit sluggish, employment growth is likely toward the end of the year, helped by positive spillovers from the exports sector. However, this forecast remains subject to a high degree of uncertainty.

High inflation will act as a further drag on consumer spending

Rising inflation is acting as a further drag on household incomes. The harmonized consumer price index (HICP) for April showed inflation running at an annual rate of 3.5%, up from 3.3% in March. Although higher energy prices have contributed to the rise in the headline index, core inflation (which excludes volatile energy and food components) also picked up to 2.1% in April from a 1.7% rate of increase the previous month. However, with domestic demand remaining weak, unemployment high, and the start of a new rate-hike cycle by the European Cental Bank (ECB), we expect inflation to moderate later this year, especially after July when the VAT rise falls out of the year-on-year comparison.

Figure 1

Figure 2

GDP and industrial production

% year 10 GDP Forecast

Unemployment rate
% 25 Forecast

5 20

-5 Industrial production 15

-10

-15

10

-20

-25 1980 1984 1988 1992 1996 2000 2004 2008 2012

5 1980 1984 1988 1992 1996 2000 2004 2008 2012

Source: Oxford Economics

Source: Oxford Economics

Ernst & Young Eurozone Forecast Summer edition June 2011 | Spain

Spain still fighting to distinguish itself from the smaller peripherals

Nevertheless, these factors, combined with the need for households to reduce debt, are expected to limit consumer spending growth to 0.1% in 2011, with only a modest acceleration to 0.6% in 2012.

Fiscal problems in Greece have placed renewed focus on Spain

Spain made good progress with its fiscal consolidation last year, cutting the budget deficit by 1.9ppt to 9.2% of GDP. Even more aggressive fiscal tightening is planned for 2011, with the Government targeting a 6% deficit. We remain cautiously optimistic about the outlook, forecasting a deficit of 6.6% of GDP, only slightly higher than the Governments target. Spains rapid and decisive action to tackle its public finances, together with structural reforms to boost competitiveness and trend output, have not gone unnoticed by financial markets. Since mid-2010, spreads on Spanish sovereign debt appear to have decoupled from government bond spreads in the rest of the periphery. Still, concerns that Greece may be moving toward a restructuring of its government debt have recently hit broader investor sentiment in Eurozone bond markets and revived fears that the debt crisis could envelop Spain. Spreads on Spanish government bonds had risen back above 220bp in early May, and there remains a risk of further contagion that would increase the chances that Spain could also require rescue loans.

Indeed, the path to fiscal sustainability is not without risk, in part due to the role of fiscal decentralization in Spain. Most of the improvement in Spains public finances has so far been delivered by the central Government, while only eight of the countrys 17 regional governments met their deficit goal for last year. The ability of the regions and municipalities to stick to their fiscal consolidation strategies remains a concern going forward.

The health of the banking sector remains a key risk

Much of the markets worries about Spain relate to the state of the banking sector and the potential for spillover into public finances. In this regard, the latest data is not reassuring. While ECB lending to Spanish banks has continued to contract, falling to 48.7 billion in February compared with a peak of 145 billion, the bad loans ratio has soared to a 15-year high of 6.2%. Bad loans held by Spanish banks now amount to over 112 billion. The deterioration in credit quality is closely linked to the bursting of the house price bubble. With further house price declines likely, this will have a particularly large impact on the cajas that are heavily exposed to the construction sector. The Spanish Government has unveiled a second round of restructuring for the cajas to restore confidence in the financial system. On top of the 15 billion already spent on their recapitalization, the Bank of Spain estimated in March that the banking system needs an additional 15 billion of capital. Although this sum appears manageable, independent analysts estimate that the cost of recapitalizing the cajas could actually be as high as 120 billion. If these higher estimates prove correct, this could potentially derail the fiscal consolidation effort.
Figure 4

Figure 3

Contributions to GDP growth

% year 8 6 GDP 4 2 0 -2 Net exports -4 -6 -8 1985 1988 1991 1994 1997 2000 2003 2006 2009 2012 2015 Domestic demand Forecast

Government balance and debt

% of GDP 4 2 0 -2 -4 -6 -8 -10 -12 1992 1995 1998 2001 2004 2007 2010 2013 Government budget balance (left-hand side) Government debt (right-hand side) Forecast % of GDP 80 70 60 50 40 30 20 10 0

Source: Oxford Economics

Source: Oxford Economics

Ernst & Young Eurozone Forecast Summer edition June 2011 | Spain

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Ernst & Young Eurozone Forecast Summer edition June 2011 | Spain

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