Spain: Strong recovery does not justify complacency

In 18Q3, Spain’s economy grew by 0.6% QoQ, again outperforming Eurozone peers. The story of (relatively) strong growth in Spain is not new. In the past few years Spain’s economy grew by over 3% a year, on the back of structural reforms implemented in the crisis years, temporary tailwinds with a strong multiplier via improved sentiment, and crisis related pent-up demand.

In line with this trend, employment has also substantially recovered from the large dip during the crisis (see The crisis and recovery of Spain’s labour market). Yet, today still fewer people are at work than prior to the crisis. As much as 15% of the entire labour force is registered as unemployed and more than one third of the youth is without a job (figure 1 and 2). Although the recovery has not yet run its course, measures are required to speed up unemployment reduction and to deal with remaining inefficiencies in Spain’s labour market, to support growth over the medium term.

In October 2018, the unemployment rate had fallen to 14.8% from 26.3% at the crisis-peak, driven by strong employment growth. The unemployment rate has fallen below the country’s long-term average of 16.9%, but is still high in international perspective. Moreover, early 2018, almost half of all part-time workers wanted to work more hours, masking additional labour market slack (figure 3). Looking forward, the labour market is expected to recover further, even though employment growth is set to slow a touch from the 3.5% growth last year, in line with somewhat moderating but still robust economic growth. We expect the unemployment rate to fall from 17.2% in 2017 to around 13.5% on average next year.

The ongoing decline in unemployment supports the increase in nominal wage growth (1.7% in September, figure 4). The Employment and Collective Bargaining Agreement (ECBA) for 2018 until 2020 has incorporated the recent improvements in the labour market and supports our view of accelerating wage growth going forward. In short, the agreement between the country’s most important employers’ and workers’ unions signed foresees an annual wage increase of between 2 and 3%. This compares to 0.5% in 2012 and 1.5% in 2016 for example. We note that while firms are allowed to opt-out of collective agreements, the ECBA serves as a guideline for wage growth for most businesses. Given that we forecast inflation of around 1.8% next year, we expect real wage growth to turn positive over the course of next year.

Since the outbreak of the crisis, Spain has implemented a wide range of reforms. The labour market reforms seem to have limited ‘unnecessary’ layoffs, supported hiring and improved the international competitiveness of Spanish firms. But significant challenges remain.

Reforms have supported (qualitative) employment growth

Important reforms include more firm-level flexibility to alter existing contracts to accommodate the deteriorating economic environment. They have also provided more flexibility to negotiate wage agreements on a firm level instead of a sectoral and regional level, to better match wage growth with performance and productivity growth. According to a study by the Spanish bank BBVA, greater wage flexibility is estimated to have created/ prevented the destruction of almost 1 million jobs between 2013 and 2015. Other measures to support (qualitative) employment growth include(d) incentives to hire people on permanent contracts by lowering employers’ social security contributions for permanent hires, a new permanent contract for small firms (< 50 employees) with an extended probation period of 12 months, introduction of training programs for long-term unemployed to match their skills to those asked at the jobs market, and the introduction of (fixed-term) training and apprenticeship contracts to incentivize firms to attract and train uneducated youth, by allowing them to deduct (part of) the cost of training from social security contributions.

Tackling labour market duality

Different governments have also implemented measures to tackle the country’s large gap between the rights of workers on temporary and permanent contracts. This gap was visualised during the crisis by the relatively massive layoffs of people on a temporary contract compared to people on a permanent contract (figure 6). To reduce the gap, dismissal costs for unfair dismissals of people at permanent contracts have been reduced and the scope of criteria for fair dismissals has been broadened, made more objective and more clear. At the same time, severance payments have been introduced for certain types of temporary contracts if these contracts are terminated instead of turned into a permanent contract. Furthermore, limits on the maximum duration of temporary contracts (between six months and three years, depending on the kind of contract) have been installed and employers are obliged to rollover a temporary contract into a permanent contract if an employee has been employed in the same function in the same company on two or more temporary contracts for more than two years within 30 months’ time.

Despite all the reforms, major challenges remain. The unemployment rate is still high and labour market efficiency low when compared to European peers (figure 7).

Active labour market policy and skill mismatch

Crucially, active labour market policies should be further improved. More specifically, retraining unemployed, on the job training and adjusting Spain’s education system is necessary to better match the skills of the workforce with the skills required in Spain’s labour market. Unemployment is still very high and with over a third of the youth unemployed the risk persists that a generation will be lost. Moreover, employer and employee surveys underscore that there is a substantial mismatch between the skills required and the skills offered. According to OECD data, for example, over one fifth of all workers has a higher degree than required for the job and over one third of all workers has a job in a different field of expertise than their own. There are several reasons for this.

First, there is a mismatch between the field of study students choose in high school and universities and the field of expertise the Spanish labour market is asking for. Second, Spain’s universities deliver more graduates than Spain’s labour market requires. Compared to European peers the share of high-skilled labour in Spain is rather low. At the same time, though, the quality of education in Spain is rather weak, with especially weak vocational training. As a result, skills related to a certain qualification in Spain are lower than in most other European countries and literacy skills for example are lowest of all OECD countries. This makes it more difficult for Spanish employers, especially for those offering high-skilled labour, to find adequately skilled workers, despite the high unemployment rate.

According to business surveys, a lack of adequately skilled labour supply has not been as much of an issue for business operations in Spain since the start of the survey in 1986 as it is now (figure 8). To be fair, labour shortage is much less of an issue in Spain than in most Eurozone countries, but the surveys suggest that not all vacancies will be filled and not all currently unemployed should expect to find a job without retraining. Hence active labour market policies need to improve.

Wage bargaining and labour market duality

Meanwhile, firm level wage bargaining is still very much the exception rather than the rule, as legal uncertainties and costs prevent firms from diverting from sectoral and regional wage agreements. The substantial use of such agreements is one of the factors behind rather large mismatches between wage payments and performance/ productivity. Spain is among the weakest performers among EU countries in this respect (World Bank – Global Competitiveness Index). Finally, large dualities in the labour market persist. Even though, for example, severance payments on permanent contracts have been reduced, they are still high in an international perspective, while temporary contracts are allegedly still being abused.

As the recovery strengthened, the reform drive of Spain’s government substantially slowed, in spite of the fact that the government cannot actually afford to be complacent. Higher employment rates and higher productivity growth are needed to maintain economic growth at a pace compatible with the provision of social services and the ability to service the high government debt also in the medium term, especially in the light of an ageing population.

Elections making a difference?

The current minority government led by socialist Pedro Sanchez is unlikely to sufficiently deal with the remaining labour market challenges, though. Whether the next government is willing and able to do so remains to be seen. Elections are officially scheduled for mid-2020, but they will likely be brought forward to spring or autumn 2019. Based on current polling and upcoming events it is difficult to predict the outcome. Another fragmented parliament is likely, complicating the next government’s task. That said, the next government will enjoy more support than the current one. At this point, a (minority) coalition between the centre-left PSOE and the liberal centre-right Ciudadanos or a coalition between PSOE and the far-left Podemos seem most likely.

In our view the economy could benefit from the former, due to the reform-minded Ciudadanos, but be hurt by the latter, given Podemos’ wish to rollback several recent (labour market) reforms, which have proven to support the economic recovery. We feel that, particularly in the short-term, the economy in general would also benefit more from a PSOE-Ciudadanos coalition and their growth-friendly policies as it could further unlock the slack that remains in the labour market. Moreover, their approach to budgetary policy is likely to be more prudent and so this should also be the better outcome from a financial markets perspective.