Special Report - Espania

Special Report | January 2015 1

Special Report

AMIR KHAN ECONOMIC RESEARCH | LONDON T: +44-(0)207-577-2180 E: [email protected]

The Bank of Tokyo-Mitsubishi UFJ, Ltd.

Spain – Getting Back on its Feet

A member of MUFG, a global financial group NUARY 2015 JA

he Spanish economy has, in the aftermath of the financial crisis, gone from being one of the Euro Area’s perennial laggards to now being among the region’s frontrunners, at least if the headline figures for growth are anything to go by. While this has given rise to

hopes that the country has turned the corner and, as such, will make a more positive contribution to the region’s economy going forward, a lot will also depend on the evolving political environment in the country, with polls suggesting that the next government is unlikely to enjoy single party majority amid the rise of the new far-left party Podemos, a factor which could well be indicative of greater political uncertainty in Spain looking ahead. With this in mind, this note will look at how far Spain has progressed since the depth of crisis and whether it is safe to sound the all-clear on the country, as things stand.

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Spain gets its “mojo” back…

The Spanish recovery gained traction through the course of last year, with the latest data revealing that GDP rose by 0.5% on a quarterly basis in Q3 2014. This is in line with the previous quarter’s reading and marks the fifth consecutive quarter of positive q/q real GDP growth. On an annual basis, real GDP rose by 1.6% in Q3, the fastest yearly growth since Q2 2008 and above that of the other big Eurozone economies (see Chart 1).The composition of the growth has also been encouraging with growth shifting away from its recent heavy reliance on the external sector towards domestic demand (see Chart 2).

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Chart 2:...While it has also seen a broadening of its economic recovery away from net exports

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Chart 1: Spain has gone from being an unperformerto an outperformer...

Source: Eurostat, IHS, BTMU


Although this is welcome news and appears to suggest that Spain is over the worst, the country’s recent recovery needs to be put into some perspective. Of particular note here is the fact that while Spain’s recovery seems to be gaining traction, the country has still not regained it pre-crises level of output, which some of its larger neighbours, such as Germany and France, have already done, though it is encouraging to note that it is somewhat ahead of its closest comparator country – Italy – in this regard (see Chart 3). Furthermore, with unemployment and total indebtedness of the Spanish economy still at elevated levels, we are of the view that this will to some extents slow the pace of the current recovery (see “key challenges & what next?” section below).

Chart 3: Although Spain has come a long way it has still not regained its pre-crises level of output

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Notwithstanding such challenges, if we look at forward-looking surveys of the Spanish economy – which have historically been rather good predictors of the future path of the economy (see Chart 4) – we expect the economic fortunes of Spain to continue to gain further traction going forward, as domestic demand starts to pick up pace. Additionally, falling oil prices – with Spain being a net oil importer – and the sharp depreciation of the euro recently will also add to the recovery momentum. As such, we anticipate economic growth for this year to firm to the tune of around 2% from an estimated reading of 1.3% in 2014 and -1.2% the year before that. While this will help to ensure that looking ahead Spain continues to outperform its Eurozone peers as a whole – according to Bloomberg consensus estimates the region as a whole is expected to record GDP growth of 1.1% for 2015 – the point to note is that Spain’s growth will still undershoot the levels which were evident in the pre-crises period, which averaged around 3% on annual basis in the five years to 2008. This, in our mind, will be due to a number of factors including the ongoing weakness in the Eurozone – Spain’s main trading partner – which will hinder the country’s export performance, as well as the reduced contribution that the construction sector will make to the overall Spanish economy in the aftermath of the country’s housing market collapse1. 1 At its peak in 2007, construction expanded to a massive figure of around 16% of Spain GDP versus something in the region of under 10% today.


Chart 4: The composite PMI survey for the Spanish economy points to continued growth ahead

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…And this is underpinned by a number of factors There are a number of factors – both internal and external – that have spurred Spain’s recent recovery. Central to these include: i) the increased confidence in the integrity of the Euro project, thanks to the action taken by the ECB back in 2012; and ii) the advancement of structural reforms and the correction of internal imbalances, a process that is helping Spain to mitigate the loss of competitiveness, as well as external vulnerability which it experienced in the run-up to the financial crisis. We will endeavour to look at both these factors, in turn, in the section below. i) Increased confidence in the integrity of the Euro project With the future of the Eurozone increasingly in doubt in the aftermath of the Greek debt crises, the ECB president, Mario Draghi, notwithstanding opposition from some of the central bank’s governing council members, finally mustered the courage in 2012 that the ECB would do “whatever it takes” to backstop the euro project and prevent the crises from spreading further through contagion effects. This pledge, helped to convince the markets that the ECB was serious about averting the potential break-up of the Eurozone. Consequently, this served to ease the worsening perception of risk toward peripheral countries, such as Spain. While all the peripheral countries have benefited from this prolonged “relief rally”, the point to note is that the market has shown greater willingness to discriminate between the likes of Spain and Italy. This can be seen from the behaviour of Spanish and Italian government bond yields and their CDS spreads since they reached their high point as at July 2012 (see Chart 5). What this is telling us is that while the market’s perception of risk towards both these countries has moved in the right direction, Spain has, on the whole, outperformed Italy. This signifies that the market has been more convinced by Spain’s willingness and ability to implement the necessary economic and structural reforms than in the case of Italy, where such reforms have in general been


rather lacking, in part, because of the “political paralysis” that characterised Italian politics before the arrival of the current premier, Matteo Renzi, at the start of 2014.

Chart 6:...But a comparative view leads us to believe that this process may have gone

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Chart 5: Spain has outperformed Italy in terms of how its bond yields & CDS spreads

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(Change in bond yields/CDS spreads since July '12, bps)Dragi's "whatever ittakes" speech


While we welcome the greater willingness on the part of the market to discriminate between different countries on the basis of their reform progress, we think that the market may have got ahead of itself somewhat on two counts: Firstly, Spain’s sovereign bond yields are trading lower today than they were in the pre-

crises period (see Chart 6) when the country had better growth and public debt dynamics. Secondly, from a cross-country perspective, the country’s government debt yields are

broadly in line with that of Ireland, a country whose adjustment process is in our minds more advanced than that of Spain2.

Against this backdrop, we take issue with the pricing action in the market recently. Indeed, we feel that, if anything, the recent fall in yields/spreads was primarily the result of the market pricing in the likelihood that the ECB would go down the road of full-scale QE at the governing council meeting on 22 January, a factor which in anticipation of this move caused a further biding-up of Spanish bond prices (and a lowering of their yields) rather than necessarily being reflective of the country’s underlying fundamentals. ii) The advancement of structural reforms and the correction of internal imbalances Structural reforms and the correction of internal imbalances has been central to the recent improvement in sentiment towards Spain and key to this include the following:

2 A case in point is the Irish housing market, which after experiencing peak to trough price falls of more than 50%, has been experiencing y/y growth since the latter half of 2013 according to data from Macrobond. In the case of Spain, the peak to trough adjustment has been more muted, at around 30%, and house prices have just recently moved into positive territory on a y/y basis.


Labour market reforms Spain’s malfunctioning labour market – in part because of its relatively high reliance on the hard-hit construction sector (see Table 1) – during the course of the financial crisis saw a more than three-fold increase in the official unemployment rate to over 26%, though this figure has moderated slightly more recently. Mindful of this, the current centre-right government of Mariano Rajoy, in the early part of 2012, set about pushing through the long-awaited reforms of the Spanish labour market, with the aim of giving companies more flexibility to set wages and working conditions themselves, rather than through sector-wide bargaining. Additionally, cuts to severance payments for unfair dismissals, which placed Spain at a relative disadvantage to its peers (see Table 2), also formed a key part of these reforms. Those changes, buttressed by a deal between unions and employers, has helped to stem the growth in unit labour costs in Spain (see Chart 7), thereby helping the country to reverse some of the lost competitiveness it has experienced in the years preceding the onset of the financial crisis. The other point also worth mentioning is that – in part thanks to the aforementioned labour market reforms – it appears that Spain is creating jobs at lower rates of GDP growth than before (see Chart 8).

Table1: Employment in Spain by sector (million)

2007 2008 2009 2010 2011 2012 2013 2014Services 13.59 13.83 13.38 13.40 13.19 12.71 12.71 13.27Industry 3.27 3.04 2.68 2.62 2.52 2.38 2.27 2.35Construction 2.69 2.18 1.80 1.57 1.27 1.07 0.97 0.97Agriculture 0.90 0.80 0.78 0.80 0.80 0.78 0.79 0.73Total jobs 20.45 19.85 18.64 18.40 17.80 16.95 16.75 17.35

Source: INE, BTMU

Table 2: Severance payments for fair & unfair dismissals prior to recent reforms (Months of salary)*

Unfair dismissals

9-month tenure 4-year tenure 20-year tenure 20-year tenureAustria 0.0 0.0 0.0 6.0Belgium 0.0 0.0 0.0 14.0Denmark 0.0 0.0 1.5 9.0final and 0.0 0.0 0.0 14.0France 0.0 0.8 6.7 16.0Germany 0.2 1.0 5.0 18.0Greece 0.3 1.0 6.0 6.0Ireland 0.0 0.4 1.9 24.0Italy 0.0 0.0 0.0 15.0Luxemburg 0.0 0.0 6.0 5.0Netherlands 3.0 3.0 9.0 7.0Portugal 0.5 4.0 20.0 15.0Spain 0.0 2.7 12.0 22.0Sweden 0.0 0.0 0.0 32.0UK 0.3 0.5 2.3 8.0EU-15 0.3 0.9 4.7 14.1

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*The large majority of dismissals are treated as unfair in Spain; average over all types of workers.

Source: IMF, BTMU


Chart 8:...Helping to reinvigorate the labour market despite weak GDP growth by

historic standards

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Chart 7: The growth in Spanish unit labour costs has moderated rather sharply in the

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(Index rebased, Jan'00 = 100)Jobs are being created at lower rates of GDP growth than in the past


Although we welcome such moves, this process needs to go further. For one thing, while unemployment has started to edge downwards, at slightly over 23% (versus 11.5% for the Euro Area), it remains unacceptably high. Adding to these woes, long-term unemployment, at 12.9% (vs. 6.1% for the Eurozone as whole), also remains at elevated levels, something which will require the Spanish authorities to look to overhaul the role of the country’s education system and strengthen the training and retraining measures, which will ultimately help to better match the skills of the country’s labour force and the sort of jobs that are available to them.

Reduction in the current account deficit & an uptick in FDI inflows Given that Spain – by virtue of having the euro as its national currency – is not able to devalue its currency to restore its competiveness, it has instead had to undergo the painful process of so-called “internal devaluation” which, as alluded to above, entails a reduction in wages/prices. Thanks to this process, Spain has seen a marked improvement in the fortunes of the country’s external sector (see Chart 9). This, coupled with the fact that domestic demand in Spain has softened relative to the pre-crises period, has helped to suppress imports and, thereby, improve the current account position of the country, which has gone from being in persistent deficit territory to now being in overall surplus (see Chart 10), a factor which, if sustained, will help to reduce Spain’s external vulnerability going forward.


Chart 9: Spanish exports have stolen a march over their larger Euro Area peers...

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Chart 10:...Allowing its current account position to move into positive territory

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The other factor worth mentioning here is that on the back of the improvement in competitiveness that Spain has seen recently, FDI inflows into Spain have started to improve somewhat, reflecting greater confidence in the country and the attractive pricing of potential assets, particularly in the depressed property and banking sectors. Net inward FDI rose 52% in 2013 according to UNCTAD (see Table 3).

Table 3: Net FDI inflows by country, 2008-2013 (US$m)

2008 2009 2010 2011 2012 2013

France 64,184 24,215 33,628 38,547 25,086 4,875Germany 8,109 23,789 65,620 59,317 13,203 26,721Ireland -16,453 25,712 42,804 23,545 38,315 35,520Italy -10,835 20,077 9,178 34,324 93 16,508Netherlands 4,549 38,610 -7,324 21,047 9,706 24,389Spain 76,993 10,407 39,873 28,379 25,696 39,167UK 89,026 76,301 49,617 51,137 45,796 37,101

Source: UNCTAD, BTMU

A final point of note here is that, in terms of individual FDI transactions, the largest investment in Spain 2014 was Vodafone’s €7.2bn acquisition in May of cable operator Ono. While we view such investment inflows as a vote of confidence in the Spanish turnaround story, also of significance perhaps is the fact that investment has started to return to country’s beleaguered real estate sector. A case in point is the recent investment by Intu Properties of the UK, a commercial real estate investor, in Puerto Vanecia – a large shopping mall and retail park in Zaragoza – for a reported sum of €451m. Elsewhere, the improved outlook for FDI flows in Spain is also evident from the automotive sector, where according to press reports, some automotive manufacturers have started to shift their operations in order to benefit from the reduction in the country’s lower unit labour costs3.

3See FT article, entitled: “Spain’s car industry at heart of nascent recovery”, November 3, 2013.


Consumer sector starts to regain its poise In light of the improvements in the Spanish labour market and the economy in general, consumer confidence has exhibited an upward bias through much of 2013/14, a factor which is closely correlated to the recent recovery in private consumption and, more specifically, retail sales (see Chart 11).

Chart 11: The recovery in consumer confidence has given a leg up to household spending

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With the recovery in the labour market expected to continue to play out in 2015, we are of the view that the consumer will continue to bolster the wider recovery of the Spanish economy, as we progress through 2015. Over and above this, subdued inflation dynamics – which have not been helped by the recent fall in oil prices – and further reduction in the pace of fiscal tightening this year are likely to imply some uptick in real disposable income going forward, further supporting the recovery in private consumption. Pickup in investment & signs of stabilisation in the construction sector On the corporate front, rising business confidence appears to be supporting a recovery in fixed investment spending (see Chart 12). We expect this positive development to continue further through this year, as the corporate sector takes heart from the broadening of the economic recovery. Additionally, with recent signs that the Spanish housing market may have bottomed, not least evidenced by the recovery in house prices, this appears to be creating the conditions for a tentative rebound in construction/housing related investment (see chart 13). We expect this virtuous cycle to continue going forward and are of the view that house prices will continue to show positive, albeit small, y/y growth in coming quarters.


Chart 13:...While the investment in the construction sector is also on the mend on

the back of rising house prices

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Chart 12: Thanks to the improvement in business confidence overall investment in Spain has moved into positive territory...

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Reforms & clean-up of the banking system After enduring a difficult period through the course of the global financial crisis – which ultimately exposed the weakness and overexposure of Spanish banks to the country’s housing market – the Spanish banking system is starting to emerge from the crisis in much healthier shape, in large part owing to the €100bn lifeline that was made available to the Spanish authorities under the EU’s ESM programme, with the express aim of recapitalising and cleaning-up the country’s banking system. Reflecting such measures, there has been a fairly noticeable improvement in the financial health of the Spanish banking system (see Table 4), such that the immediate sense of crisis that was facing the Spanish banks is now clearly over. Indeed, of the 15 Spanish banks that were subject to the Asset Quality Review/stress tests that were undertaken by the EU authorities last year, only one – Liberbank – failed to pass these tests under the adverse scenario. But despite the positives, it will be a while longer before the Spanish banking system returns to “business as usual” and lending returns to its pre-crises norms.

Table 4: Selected financial soundness indicators (%, unless otherwise indicated)

2006 2012 2013 2014 (latest)

Core tier 1 capital ratio 7.5 10.0 11.8 -Return on average assets 1.0 -1.4 0.4 -Return on average equity 19.5 -21.0 5.3 -Non-performing to total loans 0.7 10.4 13.6 13.4Non-performing to construction loans 0.3 28.2 37.1 37.1Non-performing to house purchase loans 0.4 4.0 6.0 6.0Coverage ratio (provisions to NPLs) 43.6 42.6 46.9 47.4Use of ECB refinancing (€bn) 21.2 357.3 206.8 185.0Loan-to-deposit ratio 165.0 137.3 123.0 124.3

Source: IMF Spain country report, July 2014


Key challenges & what next? Although Spain has come a long way since the outbreak of the financial crisis – and has won praise for the manner in which it has executed its adjustment process – it is too soon to sound the all-clear on the country. In our mind, vigilance over Spain still needs to be exercised across both economic and political spheres. i) Economic challenges High levels of indebtedness & dangers of deflation Spain’s headline budget deficit was reduced from a peak of 11.1% of GDP in 2009, under the Socialist government, to 7.1% in 2013 in the second year of the Popular Party government (See Table 5). While this – coupled with the structural reforms the country has adopted – has helped it to regain the confidence of the investor community, the point to note is that this is not the end of the road as far as the austerity programme is concerned. Indeed, there are still plans to more than halve the aforementioned budgetary figure to the EU’s threshold of 3% of GDP by 2016 – a commitment made by Madrid to Brussels after receiving a two-year extension in 2013. However, we think meeting this objective is going to be very difficult, particularly since a general election will be held by the end of 2015, making further spending cuts politically unpopular.

Table 5: Spain’s budgetary performance vs its major peers (% of GDP)

France Germany Italy Spain

2009 -7.5 -3.1 -5.5 -11.12013 -4.3 0.0 -3.0 -7.1

Source: Eurostat, BTMU

Meanwhile, gross public debt is approaching 100% of GDP, a figure which is broadly comparable to the average for its three larger Eurozone peers. That said, more disconcerting perhaps is the fact that Spain has since 2009 presided over a much sharper deterioration in its public finances than its aforementioned peers (see Chart 14). Adding to these woes is the fact that the Spanish economy has recently fallen into deflationary territory (currently -1.04%) which, if it becomes entrenched, could make the task of repairing its public finances much more difficult4, especially if past experience from countries such as Japan is anything to go by.

4 Not only does deflation have a negative effect on nominal GDP, thereby boosting the ratio of public debt to GDP, but it could also hit tax revenues by reducing nominal income growth.


Chart 14: Spain has seen a sharper run-up in its public debt than its rivals

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A final point worth making here relates to private indebtedness – which in the run-up to the global financial crisis was experiencing explosive growth – peaking at an unsustainable level approaching 200% of GDP, a figure well above that for the rest of the Eurozone countries and not to mention Germany (see Chart 15). Although the size of this debt burden has been trending down more recently – at over 160% of GDP – it is still higher than the equivalent figure for the single currency bloc as a whole (<130% of GDP). As such, we expect the deleveraging process among the private sector to continue to play out – albeit at a more tempered pace – suggesting that while its negative influence on economic activity going forward may start to wane somewhat it will still likely continue to act as a headwind to growth.

Chart 15: Spain's non-financial private sector has been in de-leveraging mode but this process needs to run further to return it to more sustainable

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Labour market woes Persistently high unemployment – while nothing new for Spain – represents a key challenge for the country’s authorities. Although the jobless rate appears to be coming down – albeit slowly – on the back of the recent structural reforms and the revival of the economy, as we alluded to above, at over 20%, it is still very high and certainly well above that of its Eurozone peers (see Chart 16). If this situation persists, the risk remains that this could cause the recent recovery in private consumption – the mainstay of the economy – to fizzle out.

Chart 16: High jobless was & remains a key problem for Spain

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A gap of >10% has opened upbetween Spain & its Eurozone peers


Restricted availability of credit Although the recent reforms introduced to the Spanish banking system have clearly been a step in the right direction – and beyond the recapitalisation and restructuring of the banking system, have also entailed the state setting up a “bad bank” scheme to help the country’s financial institutions to dispose of some of their toxic assets and bring a welcome level of transparency to the sector as a whole – this is not the end of story. Most notably, it is worth pointing out that the NPL ratios of Spanish banks as a whole still remain at elevated levels (see Chart 17) and, as such, their willingness to lend to the “real economy” will remain rather restrictive (see Chart 18).


Chart 17: High NPLs among Spanish banks...

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Chart 18: Will make them reluctant to lend to the real economy

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24%


Another factor worth highlighting here is that aside from general risk averseness of banks in the current environment, there is also ongoing regulatory pressure on banks to boost their underlying capital position. This in our mind will further add to the pressure on banks to be cautious about lending to the “real economy”. ii) Political challenges Spain’s general election, due in Q4 2015, will be one of the most closely watched events in the European political calendar. Currently polls suggest a dramatic decline for the two main political parties, the ruling Partido Popular (PP) and opposition Socialist Workers Party (PSOE) on the back of a rise for new far-left party Podemos. The joint share of support for Spain’s two mainstream parties has now dropped below 50% from roughly 75% gathered at the 2011general election. In our view, ongoing corruption scandals involving senior members of both parties (at least three since the end of the summer 2014) coupled with public discontent amid continued depressed economic conditions and lingering high unemployment are key factors contributing to sharp decline in support for Spanish mainstream parties. Against this backdrop, the support for the fledgling left-wing party Podemos has risen dramatically, from 1% in April 2014 to well over 20% in the latest polls. From its sudden emergence, Podemos is, according to some opinion polls, now running ahead of the ruling party PP. The party garnered 8% of the vote in this year’s European Parliamentary election in May, only four months after it was founded. Among the measures included in its policy platform, the party is calling for public control over “strategic” sectors of the economy, the introduction of a state funded basic income for all citizens, reversal of some key structural reforms approved since the outbreak of the crisis, a 35-hour working week, as well as proposals to stop companies from firing workers. While it is difficult to envisage how the support base of Podemos will evolve in the run-up to this years election, we remain sceptical about the ability of Podemos to achieve many of the measures currently envisaged in its programme – in the unlikely scenario that the party wins the election and is successfully able to form the government – especially in a context where many of the domestic economic decisions are already constrained by rules under EMU. Yet, it is safe to say that political uncertainties are likely to remain highly elevated in the run-up to


national elections, leaving room for potential market vitality, and posing some downside risks to current prediction of fairly benign economic recovery this year. Going forward, the next signpost in Spain’s pre-election political trajectory will be the upcoming regional and local elections in May 24. In our view, while the general election is some months away and polls have limited predictive power at such an early stage, the degree of popularity of new political parties, such as Podemos, suggests that the next Spanish government is unlikely to enjoy the same broad popular mandate as the current one, with reasonable probability of a multi-party coalition or minority government. The lack of large and/or stable majority for the next government will likely increase the risk of political inaction both in terms of structural reform progress and fiscal consolidation efforts, further capping potential economic growth in Spain in the medium-term. Aside from the forthcoming parliamentary election, another factor worthy of note here is the issue of regional – and more specifically – Catalonia independence. While we are of the view that this push for independence will not ultimately succeed – as it proved to be the case with Scotland – “political noise” related to this issue will continue to remain at elevated levels in the run-up to the general election and likely beyond, such that it may start to potentially undermine foreign investors intention of investing in the country. Concluding thoughts Spain has come a long way since the outbreak of the financial crisis. Key to this progress has been the willingness of the country to “take its medicine” in a timely manner, particularly in terms of structural reforms, a factor which has been crucial in allowing the country to rekindle its competitive zeal and to place it on a rather better footing than in the pre-crises period. Notwithstanding this, the fact remains that Spain is still not fully “out of the woods” yet, especially given that the current government’s economic and structural reform drive needs to be consolidated further. However, the risk is that with a forthcoming general election on the way, this is not assured. In particular, there is a danger that – as in the case of Greece – the Spanish electorate who, thanks to protracted “reform fatigue” may not be willing to give the existing political parties the benefit of doubt at the forthcoming polls and, in so doing, allow an untested political party (Podemos) to come to power. Such an outcome, in our mind, could well help to undo some of the hard work that the country has recently undertaken with respect to economic and structural reforms and, in the process, this could potentially make the country vulnerable to the vagrancies of the government bond market once again.


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Special Report - Espania