Spain

Highlights and Key Issues

* The outlook for 2007 remains bright with above-trend GDP growth of 3.7%. helped by the continued strength in consumer demand. However, a cyclical slowdown in the Eurozone and more modest domestic demand is likely to cut growth to around trend at 3% in 2008.

* Downside risks to our outlook primarily stem from the possibility of a severe correction in the housing market, which would hit consumer demand, and mounting concerns that further losses in competitiveness could dilute the positive effect on the export sector of relatively robust foreign demand from the rest of the EU.

* Although higher ECB interest rates are likely to act as a drag on private consumption growth, positive wealth effects from further rises in house prices – albeit at a much slower pace than last year – and robust real income growth due to a buoyant labour market are likely to offset this. As a result, consumer spending is expected to grow at a healthy 3.3% this year.

* A high energy intensity of production, nominal wage rigidities and insufficient competition in certain sectors have meant that inflation has continued to run above the Eurozone average. The steady loss of competitiveness may push the 2007 current account deficit, in US$ terms, to a new high.

Overview

Economy to motor ahead in 2007…

* The outlook for 2007 is remains bright with above-trend GDP growth of 3.7% expected. However, a cyclical slowdown in the Eurozone and more modest domestic demand is likely to cut growth to around trend at 3% in 2008. The strength of domestic demand is no surprise this year, but reasonable export growth is a welcome development and this should persist as the cyclical recovery in Europe extends into 2007H1 . A modest rebalancing of growth, with moderating domestic demand and a much smaller drag from net exports, is expected to continue over the coming years.

* Nonetheless, downside risks to our outlook primarily stem from the possibility of a severe correction in the housing market, which would hit consumer demand, and mounting concerns that further losses in competitiveness could dilute the positive effect of relatively robust foreign demand from the rest of the EU on the export sector. The latter would result in a further deterioration in the current account deficit.

…as consumers continue to spend…

* For now. the consumer spending binge shows no sign of abating in Q 1 Retail trade volumes grew by a robust 4% in the year to January and February, with demand in the non-food sector up around 5.5% over the same period. Indeed, latest survey data indicate that consumer confidence remains fairly steady at around 2006 levels, with households unperturbed by the potential downside risks to their wealth over the next 12 months. This suggests robust spending growth in the months ahead.

* Although higher ECB interest rates are likely to act as a drag on private consumption growth, positive wealth effects from further rises in house prices – albeit at a much slower pace than last year – and robust real income growth due to a buoyant labour market are likely to offset this. Consumer spending is expected to grow at a healthy 3.3% this year.

…helped by a tighter labour market

* The unemployment rate looks likely to fall below 8% in 2007. helped by the ongoing strength in employment growth. The latter reflects both the construction boom and a buoyant services sector. However, over the coming months, a moderation in house price growth is likely to push down residential investment, hitting the construction sector. Moreover. the downward trend in service sector employment growth that began in 2006Q1 should continue into this year as firms become less optimistic about prospects for the domestic economy next year. As a result, employment growth is likely to moderate to 2.7% in 2007 from 4.1 % last year – although this will be still well above the Eurozone average

Upward drift in underlying inflation…

* The strength in wage growth should drive underlying price pressures to above 3% by the year-end from an average of 2.8% in 2006Q4. Despite this, headline inflation is likely to remain around 2.5% over the coming months – on the assumption that oil prices hover around US$60p b this year – before rising towards 3% in Q4. We forecast headline CPI inflation will average 2.6% this year, rising to 3.2% in 2008. compared with Eurozone inflation of 1 .8% and 2%.

* Part of the explanation for such a large inflation differential with the rest of the Eurozone stems from a far higher energy intensity of production. Moreover. nominal wage rigidities and a lack of competition in certain product markets, particularly in the services and utilities sector, add to the problem. Further structural reforms will need to be pushed through if the country is to remain near the top of the Eurozone growth table over the medium term.

…and external deficit tops US$100bn

* The current account deficit reached a record 8.8% of GDP in 2006: at US$1 07bn. it was the second largest deficit in absolute terms behind the US. And the deficit is projected to hit a new high this year at US$1 14bn. Some of this can be attributed to cyclical and transitory factors, such as surging domestic demand driving up import growth relative to export growth and the sizeable oil import bill. But the structural component of the deficit remains a real worry, as a loss in competitiveness is preventing exporters from benefiting more fully from the recent upswing in EU demand. Looking further ahead, if exports do not grow at a reasonable pace at the same time as the expected slowdown in the domestic economy comes through, then there is a risk that medium-term growth could slow to well below 3%. Reforms that tackle low productivity growth should be a priority for the government, especially those that encourage more R&D and business investment.

Background

* Spain joined the European Union together with Portugal in 1986. in what was the culmination of a process that began after the death of General Franco in 1975 and which helped the country consolidate its increasing economic prosperity as well as cement the roots of democracy. Since then, but especially in the last decade, economic performance has been characterised by robust growth and real convergence with core European economies at a fairly rapid pace. Relative to the Eurozone, the income per capita differential has narrowed from 20% in 1995 to around 1 0% in 2005.

* Economic growth in recent years has been fuelled by strong employment growth accompanied by declines in productivity growth. Interest rates have been low in real terms since the start of the decade and immigration has boosted aggregate consumption while also curbing pressures on real wage growth. This has fuelled strong consumer spending and domestic demand growth on the back of rising asset prices, in particular large rises in property prices, which surged by more than 120% between 1997 and 2005. A strong credit-driven consumer boom ensued, and household indebtedness has reached unprecedented levels (around 1 15% of disposable income in 2005) with an associated decline in the savings ratio.

* Together with the increased pace of economic activity, an inflation differential relative to the Eurozone has persisted for some time. This differential was 1% in 2004. 1 .2% in 2005 and 1 .4% in 2006. continuing to erode competitiveness while stimulating domestic demand by acting to reduce real interest rates. Lately, the strongest increases in CPI inflation have been registered in energy-related goods (specifically in energy and transport sector prices) and this has an added negative effect given the economy’s relatively high-energy intensity of production. Nonetheless, core inflation remains above the Eurozone average and has trended upwards recently following developments in non-core inflation.

* Recent empirical evidence suggests that this inflation differential can be explained by positive domestic demand shocks interacting with wage and price rigidities in the non-tradable sector rather than through a sustained effect of a catch-up’ process. This means that firms are able to pass increases in their input prices relatively rapidly into consumer prices. Furthermore, widespread wage indexation clauses covering around 8m workers (just under half of the workforce) have led to a rapid rise in unit labour costs. Given the structure of the labour market. the inflation differential with the Eurozone is likely to persist over the medium term.

* The surging current account deficit is another concern. As a proportion of GDP. the deficit reached 7.4% in 2005 and rose to 8.8% in 2006 – at US$1 07bn in 2006. the deficit was the second largest among OECD countries in absolute terms, behind the US. and the largest relative to GDP The recent robust pace of economic activity has spilled over into rapid import growth, while exports have failed to catch up mainly due to high unit labour costs (both in manufacturing and the overall economy) associated with slow productivity growth.

* The current account deficits have been financed by financial and capital account inflows, mainly in the form of large portfolio inflows. These reached EURl36bn in 2005. rising dramatically from EUR31bn in 2001 Portfolio outflows, on the other hand, have risen much more gently since 2001 . reaching EUR79bn in 2005 from EUR50bn in 2001 . It is likely that the large portfolio inflows seen in recent years will moderate over the medium term, making the current account deficit increasingly hard to finance.

* Fiscal policy has been sound in recent years, helping to take some steam out of an overheating economy. Indeed, one of the success stories of the past few years has been the dramatic improvement in the fiscal position. Fiscal consolidation has been a pillar of economic strategy in recent years and has allowed for reductions in the overall income tax burden and an increase in investment expenditure. The Budgetary Stability Law approved by the conservative administration in 2003 stipulated budgetary balance at all levels of government (central, regional, municipal and local) with so-called fiscal co-responsibility’ in order to stimulate a culture of fiscal discipline. This proved an important development given the high degree of autonomy enjoyed by the various regions and municipalities and so far it has delivered an overall public sector budget surplus of 1.1% of GDP in 2005 (the first since the 1970s), with a similar surplus expected for 2006

Copyright Oxford Economic Forecasting Apr 3, 2007

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