<B>The Spanish economy in 2004</B>

Juan Carlos Martínez-Lázaro. Professor. Instituto de Empresa

28 June 2005

Two thousand four could be called a transition year for Spain’s economy - not so much for economic changes, but because of the new government that came in after elections on 14 March.

Eight years of the People’s Party (Partido Popular or P.P.) left the economy in probably its best shape ever, despite a few imbalances. The P.P.’s significant achievements included Europe’s highest growth rates, healthy public accounts, strong job creation which trimmed unemployment, and above all, entry into the euro.

The victory of the Socialist Party (Partido Socialista or P.S.) on 14 March implied a reorientation of economic policy rather than drastic change. Most Spaniards were satisfied with the state of the economy, and the program which the P.S. took into the elections differed from their 1980s policies. The need to adapt to new economic realities after changes in the mid-‘90s, and success of the previous government’s policies, induced the Socialists to shift their stance. New views on budgetary stability as a necessary condition for growth, and proposals implying income-tax reform were hard for a large sector of the party to accept. Only strong backing by party leader José Luis Rodríguez Zapatero pushed the program forward.

To execute this new policy, who better than Pedro Solbes, ex-Commissioner for Economic Affairs at the European Commission? Solbes had been Minister for the Economy between 1993 and 1996 during Felipe González’ last Socialist regime. This appointment, well received by the markets, implied a guarantee of seriousness for the economy. As Economics Commissioner, Solbes proved a staunch defender of budgetary stability.

On purely economic aspects, 2004 was a good year for Spain. GDP growth reached 2.7 percent. Though not particularly high, it again outstripped our European Community partners, a feat repeated every year since 1995. Growth was based on two factors: strong domestic consumption (which has remained high due to low interest rates), job creation and tax cuts passed by the previous government; and the booming construction industry, which again was the nation’s most dynamic. A third element was an upturn in capital-goods investment, which reached figures not seen since 2000.

Exports down

However, this rosy picture was clouded by the negative performance, again, of exports. The difference between imports and exports broke the 50,000-million euro barrier and was decisive in doubling the current account deficit, which reached 5 percent of GDP.

This trade-balance deterioration set off alarm bells and forced the government to act. Like rising inflation, it has become the economy’s main problem. In some ways, the two go hand-in-hand. Surging imports can be explained by dynamic consumer spending and capital-goods investment, while sluggish exports are caused by stagnation of Europe’s economies - the destination for over 70 percent of Spanish goods - and by the strength of the euro. However, leaving it at that would be irresponsible. Spain’s economy has been gradually losing competitiveness for reasons independent of the economic situation. Inflation is persistently higher than in neighboring countries. Loss of wage-cost advantages, competition from Eastern Europe and Southeast Asia – which have similar export patterns but lower costs – and concentration of Spain’s exports in five European markets, accounting for 60 percent of exports, need to be considered for a fuller explanation.

Most serious - or favorable, depending on your viewpoint – is the impossibility of correcting the trade deficit by modifying the exchange rate now that the peseta is no longer with us. Devaluation, a device used by governments throughout history to adjust the trade balance, is fortunately a thing of the past. If we assume that convergence of prices and salaries with our European partners is irreversible, it is time to redefine our economy’s position.

This is why the new government is backing investment in R&D as the driver of improved productivity, hence competitiveness. But this change cannot be achieved overnight, despite generous government funding. Examining R&D investment in detail, we find that the small percentage of GDP devoted to it is not the problem. We see instead that a culture of appreciating R&D as a source of competitive advantage has not taken root among small and medium-sized companies, despite their benefiting from one of Europe’s most generous tax-incentive schemes.

The slowing of Europe’s economy, a strong euro and foreign competition have made us less attractive as a destination for investment: volume in 2004 was down one-third over the previous year. On the other hand, last year saw the start of a recovery in foreign investment, which had remained low since 2000. More important, a change is taking place in the destination of Spain’s capital flows. Latin America used to be the main destination. Though it remains important, firms now seem to be directing foreign expansion toward European countries, and are even taking a few timid steps in the United States. Though these markets are more mature, they balance risks taken in Latin America. This is noteworthy, since Spanish companies lacked a tradition of foreign investment until just 10 years ago. The nation has gone from being a net receiver to a strong source of direct investment.

Commercial relations between Spain and the United States felt the impact of the euro’s value against the dollar. This helped Spanish exports grow over 2 percent, while imports of American goods rose almost 10 percent. Nevertheless, the trade volumes of approximately 6,000 and 7,500 million euros, respectively, suggest there may still be room for growth.

Unemployment and immigration

Two additional observations merit attention. The first is the fiscal situation. As mentioned, budgetary stability was a main economic goal of the P.P. during their eight years in power. From a public-sector deficit of 5 percent of GDP in 1996, the economy moved to a small surplus in 2002 and 2003. This was in marked contrast with the euro-zone economies, which since 2001 have had difficulty meeting the 3-percent limit on the deficit set by the Stability and Growth Pact. The Socialists’ decision to maintain budgetary equilibrium seems to guarantee stability for Spain’s economy, giving it room for manoeuvre in fiscal matters not available to other Europeans.

The other variable is the change in the unemployment rate, which in 2004 fell below 10.5 percent, thanks to creation of 600,000 jobs. Though this is still the highest in the EU, it is a long way from levels seen in the early ‘90s economy, when the jobless rate reached nearly 25 percent. A powerful process of job creation since 1996 has led to a nearly 50-percent increase in the number of employed, from 12.5 million in 1996 to almost 18 million today.

Rapid growth and demand for workers has drawn a massive influx of immigrants. There may be as many as 3.5 million of them in Spain, both legal and otherwise - more than 8 percent of our total population. This has been a significant stimulus for the economy. Yet Spain lacks a tradition of immigration, and the speed of the process has left public authorities ill-prepared to adequately respond. Certain sectors of society view the phenomenon with suspicion. Still, it should not be forgotten that immigrants meet needs in the labor market and have played a role in the growth our economy has enjoyed in recent years.

A final point is the increase in housing prices. These have soared due to low interest rates, high employment, more disposable income available to households, tax advantages, immigration, and a shortage of building land. Some commentators have even talked of a property-market bubble. They warn that it could burst if the European Central Bank raises interest rates, since Spanish families have taken on substantial debt at variable rates. This is why the new government announced measures to make houses more affordable. Unfortunately, they do not appear to have had the desired effect, as prices rose over 17 percent last year.

The Spanish economy’s behavior in 2004 was similar to preceding years. On the downside: inflation, trade-balance deterioration, rising housing prices and household debt, and a budget surplus that gave way to a mild deficit – hopefully only temporarily. On the other hand, growth rates were not all bad: there was recovery in capital-goods investment, job creation was brisk, and Spanish firms increased their investments abroad. In short, a year of transition, while waiting for the new government’s measures to bear fruit.

They need to bear fruit, because dangers lurk on the horizon. Not only in competition from new countries and the off-shoring of industry, but from cuts in the generous Community funding which Spain has enjoyed since it joined the EC. In 2004, the nation received over 8,000 million euros, but entry of 10 new countries last May will mean serious cuts to these funds over the period 2007-2013. Our economy’s chances of success in these years depends to a large extent on how able it is to meet these challenges.

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