Spain: The Economy Could Hit the Brakes in 2008

Slower growth in 2008 with risks to the downside: We see the Spanish economy growing at 2.5% in 2008, down from 3.8% this year. In this scenario, which we see as most likely, we assume a correction in construction, accompanied by fiscal stimulus. Nevertheless, we see other possibilities: First, a bearish outcome, in which there is no or very little fiscal stimulus and a sharper slowdown in construction, cutting GDP growth to 2.0%. On the upside, a strong fiscal stimulus and a mild correction in the construction sector would leave growth at around 2.8%. Yet we believe that risks are skewed to the downside, and that a recession in 2009 is a possibility.

The construction sector is already cooling: Construction has been one of the main drivers of the Spanish economic growth in the last few years (construction investment amounts to around 17% of GDP in Spain). But it is already slowing: The year-on-year growth rate has been continuously deteriorating during the last 6 quarters, and we expect this trend to continue in the next few quarters.

House price inflation is decelerating: House prices in Spain are still increasing; however, we expect this pattern soon to be reversed. Following current trends, house prices are likely to start falling in 2008. This is likely to affect the construction sector even further. Yet the asymmetries in house prices amongst the different regions in Spain are likely to widen, and thus the effects of any house price movements are likely to be quite heterogeneous.

Tighter credit conditions bring new risks to the economy:
Both corporate and household debt in Spain are high relative to other euro area countries. Household debt levels are approximately 80% of GDP, whilst corporate debt is even higher at around 105% of GDP. Such high levels of debt represent an important risk to the Spanish economy, notably in the face of tighter credit conditions. Companies have managed to cope relatively well with the recent increase in credit spreads. However, we believe that the corporate sector could suffer greatly if current spreads were to widen by an extra 50bp. Fortunately for Spain, we believe that the downward risks to the euro area economy have virtually eliminated the possibility of the ECB raising the refi rate above 4.5% in the coming year.

Investment likely to take a major hit: We believe that a major correction in investment will be observed in 2008. According to our central case scenario, capital expenditure growth is likely to fall from 11.3% in 2007 to 4.2% next year. Similarly, we see construction investment growth falling from 3.9% this year to a mere 0.8% in 2008, and reaching a complete stand-still by year-end. Also, we believe the euro is likely to remain strong in 2008, squeezing profits and putting more pressure on companies to cut capital expenditures.

The government is likely to exercise its fiscal muscle: The current fiscal position of Spain is sound. The general government balance has recorded a surplus in the last few years. Consequently, the Spanish government has room to maneuver, and we believe it is ready to adopt a relatively expansionary fiscal policy to mitigate the effects of the slowdown. This will be particularly true if data from the construction sector show a bigger-than-expected deterioration in 2008. We note, however, that a general election will take place in 2008. Hence, the continuation of the fiscal stimulus after that will depend on which party wins the election.

Inflation: does one size really fit all? Despite the deflationary effects of the deceleration of GDP growth, we see consumer price inflation in Spain reaching 3.2% in 2008, significantly above the euro area average. This inflation gap will most likely persist in the next couple of years. This is an indication that the ECB’s monetary policy will remain expansionary ― with relatively low real interest rates ― from the Spanish economy point of view.

Huge current account deficit poised to continue in the next couple of years: We estimate the Spanish current account deficit at 8.9% of GDP in 2007 and 8.6% for both 2008 and 2009. But why does this external deficit matters, given that Spain is part of the European monetary union ― and thus a depreciation risk is virtually non-existent? This is a usual pattern in countries that are catching up: The rate of investment exceeds the rate of national savings as these countries build their capital. This is not a worrisome issue as long as this extra-investment enhances the country’s future competitiveness, so that the adjustment of the current account could take place in an orderly fashion. In the case of Spain, however, productivity growth has been relatively low ― even after taking into account issues surrounding the measurement of the labor force. Growth in Spain is concentrated in the non-tradable sector (construction and consumer services), which has exhibited low productivity growth in the past. Hence, we would welcome a rebalancing of production in favor of sectors where productivity is growing faster (manufacturing and business services), as well as a reduction in the current account gap, which should result from slower fixed investment growth.

Employment growth to decelerate, but likely to remain robust: The Spanish economy has recently experienced a significant period of employment growth, accounting for roughly half of all job creation in the euro area. However, we believe that employment creation will decelerate to around 2.5% in 2008, down from 3.3% in 2007, because of construction downsizing. The total unemployment rate might nevertheless fall further, but this depends on migration inflows, which may or may not react to the cooling signals from the overall economy. More than 800,000 people moved into Spain in 2006, and we estimate that this number has increased by some 26% in 2007. Going forward, all bets are open, but we tend to think that immigration flows are likely to be rather sticky.

In conclusion, we believe that the Spanish economy is facing powerful headwinds, and the risks remain skewed to the downside. The construction sector, main driver of the robust Spanish growth in recent years, remains fragile. However, the Spanish economy could prove to be more resilient than previously thought, thanks notably to a very sound fiscal position.

By Carlos Caceres and Eric Chaney London
Morgan Stanley
December 17, 2007