Spain: Reform Momentum Key for Facilitating Recovery after Historic Economic ContractionThe scale of Spain’s recovery from the deepest recession among all euro-area economies is mired in uncertainty but will determine how quickly public finances return to a sustainable path.
The economy in Spain experienced the largest recession among major euro-area economies in 2020. GDP contracted by 11%, slightly better than Scope’s estimate of a 12% contraction, but significantly worse than the 8.9% GDP decline in Italy, 8.3% in France and 5% in Germany.
Significant monetary policy support has helped the financing of sizeable countercyclical fiscal measures to protect the economy. Spain is set to have recorded a double-digit fiscal deficit estimated at 11% of GDP last year, despite better-than-expected tax revenues, resulting in debt rising to nearly 120% of GDP from 96% in 2019.
Despite the deterioration in public finances, the government’s financing costs remain low, with the yield on the 10-year Bono close to 0%. The Bank of Spain holds now more than 25% of Spain’s government debt.
Tackling labour-market inefficiencies, raising productivity vital for sustained recovery
Any fundamental improvement in Spain’s public finances depends on a sustained economic recovery, government efforts to address inefficiencies in the labour market and raise productivity, together with a credible medium-term fiscal consolidation strategy.
The uncertainty on the recovery this year is visible in diverging forecasts, ranging from 9.8% growth by the government, which expects a 2.6pp uplift from EU funds, to the Bank of Spain’s baseline forecast of 6.8% assuming a 1.3pp positive impact from EU funds. Our forecast, in line with the IMF, is for a more modest rebound of 6%.
The government is prioritising growth over budgetary discipline, which for the moment is appropriate given the large output gap. Spain will run a wide budget deficit for some time. For 2021, the authorities forecast a deficit of 7.7% of GDP, which is based on a rather optimistic economic scenario. Thus, should growth be weaker than expected in the coming years, Spain’s public finances would deteriorate further.
Sustainable growth over the coming years will depend, among other factors, on the effective spending of at least the EUR 78bn in grants Spain is set to receive as part of the Next Generation EU recovery fund as well as labour and product market reforms that raise the country’s growth potential. Spain has the highest structural unemployment rate in the euro area (14%) and almost 25% of employment is on temporary contracts, which has adverse effects on job security as well as on companies’ willingness to invest in human capital.
Pension reform would contribute to more sustainable government finances
In addition, reforming the pension system would also contribute to the sustainability of Spain’s public finances as the social security fund has run a deficit for the past 10 years and given the country’s ageing population.
The dire state of the economy and the European Commission’s conditions for access to the funds might spur the minority government’s reform efforts despite Spain’s fragmented politics. Indeed, the government has obtained parliamentary approval for the first full-year budget since 2016.
Given these politically costly reforms, tensions are likely to persist, challenging the minority government’s ability to facilitate Spain’s economic recovery and strengthen the country’s public finances. This uncertainty is captured in our A-/Negative sovereign rating for Spain.
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Alvise Lennkh is deputy head of Sovereign and Public Sector ratings at Scope Ratings GmbH. Giulia Branz, Associate Analyst, contributed to this commentary.