Spain Loses Competitiveness

Rafael Pampillón. Professor. Instituto de Empresa

4 May 2006

If Spain fails to curb inflation, it stands to lose competitiveness on the European and world markets. And if imports continue to grow faster than exports, the country’s trade deficit will widen to alarming levels. What can be done to stave off a crisis?

In January, the Spanish National Statistics Institute or INI predicted a year-on-year inflation rate of 4.2%-- the highest rate since January 1997. This sharp rise should concern both private citizens and the government: Not only does this increase mean a loss of purchasing power for consumers; it also translates into a loss of competitiveness because the price of our goods and services is increasing faster than those of our trading partners and rivals. In other words, Spanish products are losing market share, both in Europe and in other parts of the world.

What happened between February 2005 and January 2006 for this to occur? The causes behind our loss of competitiveness aren´t new, but it´s worth taking a closer look at them. Let´s start with January 2006. The year started with sharp price increases in sectors such as energy, where home electricity rates jumped 4.5% and natural gas prices surged 4.24%. The price of a bottle of liquefied petroleum gas shot up a full 10.3%, while the prices of motorway tolls, stamps, Iberia air tickets and inter-city transportation all kicked off the year with large increases. What´s more, bad weather has boosted the cost of raw foodstuffs over the past year. A heavy drought hit the sector particularly hard, driving up the price of some products by as much as 20%.

Tax hikes throughout the year also pushed up the prices of some goods and services, most notably that of tobacco and alcohol. Lastly--and probably most importantly--has been the steep and steady climb in oil prices totalling almost 60% over the last 12 months. This hefty jump has not only fuelled the increase in the consumer price index, it also contributed heavily to the 40% rise in Spain’s trade deficit last year.

Spain no longer controls exchange-rate policy, which means that local companies are only able to compete in foreign markets if they improve supply-side production and hone their competitive edge. This can be achieved through the introduction of structural reforms aimed at improving the way markets work, increasing labour flexibility and promoting the creation of new businesses. This, in turn, will help stimulate foreign and domestic investment in Spain and retard the process of ¨globalisation”.

The government would do well to post an even larger budget surplus. The question, though, is how? One way is to slash public spending, thus paving the way for lower inflation. Despite the quarter percentage-point increase in its key interest rate in December, the European Central Bank has adopted an overly expansive monetary stance for Spain—which as a result requires a far tighter fiscal policy. The Spanish economy is expanding at a rate of 3.4% -twice the European Union average. Fast economic growth generates greater tax income, enabling the government to not only balance its books, but to show a surplus. Now the government’s goal should be to achieve a budget surplus of 3% of gross domestic product. If it fails, the imbalances—mainly, inflation and a trade deficit--will continue to grow, threatening to jeopardize economic growth in 2007.

If proper measures aren’t taken in 2006, inflation will remain high, fuelled by strong demand and rising energy prices. But even if oil prices were to remain stable, the inflation rate for 2006 would likely exceed 3% for the seventh year running.

If the government fails to stem inflation, the foreign trade deficit is likely to widen further. A crisis could be averted, however, if the economy cools off in 2006-- thus curbing imports—while the EU economy shows signs of recovering-- thus sparking a boom in Spanish exports. Even in this best-case scenario, it won’t be easy for the government to slash the deficit on the current account of the balance of payments. And although the European Commission is predicting the current account deficit will drop to 8.3% of gdp this year, from 8.5% of gdp in 2005, the figures continue to be alarming.

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