Spain: A mild recovery arrived, along with international investors

As in Q2, the number of unemployed finding a job in Q3 was higher than those employed losing a job. The external sector continued to perform strongly as the increasing current account surplus through August demonstrates. Also foreign direct investment in the first eight months of the year nearly doubled relative to the same period of 2012. On the fiscal front, the data through August signal that the 2013 deficit target of 6.5% of GDP appears (almost) within reach. The crisis evidently is not over, and there is the danger that the government may relax with these encouraging signals. The reform agenda is incomplete, and the debt dynamics appear to be as challenging as ever, not only because the primary deficit is still far from the debt-stabilising one, but also because the much-needed price moderation has the downside of working against the public debt-to-GDP ratio.

Growth finally arrived, but expect low growth for long

INE released preliminary Q3 13 GDP data that showed the Spanish economy grew at +0.1% q/q, as we expected and in line with the Bank of Spain’s recent estimate. It is the first positive print after nine consecutive quarters of contracting activity. INE’s preliminary release did not provide any details on the growth composition. Nonetheless, we expect export performance to remain essentially the only growth driver: by our estimates, external demand contributed to growth by +0.4pp; in contrast, we expect domestic demand to have contracted by 0.3pp, as fiscal consolidation continues (more on this below); private investment remains negative, even if capital goods investment is already contributing positively (since Q1); and private consumption is likely to have been nearly flat. Also on economic activity, September retail trade data released by INE show that Q3 13 grew by 1.5 q/q (-2.5% m/m in September but +3.1% in August). However, ongoing bank credit constraints, intense fiscal consolidation and the private sector deleveraging will all continue to weigh down domestic demand, which we expect to remain in the red for another three quarters.

Ongoing structural and cyclical adjustment in the balance of payments

The current account balance through August registered a surplus of EUR2.6bn, in sharp contrast to a deficit of EUR15.3bn a year ago. This was due to a strong performance of the trade balance, which delivered a surplus of EUR4.1bn, as exports continue to grow and imports to contract. The financial account, excluding Bank of Spain, registered inflows of EUR36.8bn in the first eight months of the year. During the same period in 2012, in the midst of the crisis, there were outflows of EUR267.4bn. The sharp improvement is closely related to the repayment of the LTROs by Spanish banks, as the Spanish financial markets gradually becomes less stressed thanks in part to the bank restructuring process under the troika programme. Indeed, net assets of Bank of Spain versus the Eurosystem increased by EUR55.8bn in the first eight months of 2013.

Perhaps even more relevant, foreign direct investment inflows have reached EUR18.8bn through August, equivalent to a growth of nearly 50% y/y. It will be critical to continue to monitor the performance of FDI, which has the potential to make private sector deleveraging less painful, thereby speeding up the recovery. Structural reforms and the internal devaluation process would be critical factors that may (or may not, if reforms stall) continue to attract international investors ready to take a long-term view on the country.

Labour market is finally turning, but has a long way to go

On the labour market, INE also released Q3 13 unemployment data that showed the unemployment rate fell to slightly below 26%. While the seasonally-adjusted data are somewhat less flattering, this generally confirms a mild recovery from the labour market side. The reduction in the unemployment rate continues to be driven mainly by a fall in active labour force (migration outflows), even if employment also improved slightly in Q3 13, mainly driven by the strong tourism sector performance. Specifically, the number of unemployed that found a job in Q3 (1.23mn) was higher than those that lost their job (1.09mn). Of the new jobs created, the tourism sector was the main employer with nearly 60%. On the negative side, the majority of the new contracts (nearly 80%) were temporary; therefore, the excessive use of these type of contracts continue to reinforce a dual labour market. Moreover, long-term unemployment remains painfully high, with approximately one-third of those unemployed not having had a job for more than two years. All in all, we continue to expect a drop in the unemployment rate due to a falling active labour force.

We do not expect significant fiscal slippage in 2013

On the fiscal front, the overall deficit of the public sector through August stood at 4.8% of GDP. The reported deficit includes the central government, social security, and the regions, but excludes local entities and municipalities. For the latter, the government expects a surplus of about 0.2% of GDP (it targets a balanced budget). The breakdown of the fiscal data shows that the central government balance reached -3.82% of GDP, social security -0.18% of GDP and the regions -0.79% of GDP. The Ministry of Budget also released the fiscal balance of the central government through September, which improved to -3.58% of GDP.

The year-end target is -6.5% of GDP for the entire public sector: -3.8% of GDP for the central government, -1.3% for the regions, -1.4% for the social security, and a balanced budget for the local entities. We think the composition of the actual deficit is likely to be different from these targets. We expect slippages in social security and the regions, but we expect overperformance by the central government to be driven partly by lower financing costs (year-to-date, the treasury has funded itself at an average rate of 2.5%), and (according to the government) there should be some over-performance by the municipalities and local entities. All in all, these fiscal data remain broadly consistent with the government’s 2013 fiscal target (seeEuropean Economics Quarterly, October 2013, for further details).

The medium-term still looks very challenging for Spain. Public debt-to-GDP is projected to increase to 99% in 2014, and probably peak at nearly 105% by 2016. Spain still needs to achieve a swing in the primary balance of nearly 5% of GDP before it reaches a level consistent with solvency, even if the cyclical recovery will help. Moreover, with the internal devaluation process exercising downward pressure on wages and prices, reducing the debt-to-GDP ratio will become increasingly challenging – a problem shared by several euro area economies, both in the core and the periphery. This is another fundamental reason growth-enhancing structural reforms are a sine qua non for sovereign solvency, given the limited fiscal space, as well as the limited scope for inflation and devaluation.