Spain: Recession averted, crisis ongoing

Last year, the Spanish economy performed particularly well (see Figure 1), despite the major erosion of purchasing power and steep increase in interest rates. The economy expanded 5.5%, compared to 3.5% for the eurozone, bringing gross domestic product close(r) to its pre-pandemic level (see Figure 2). Yet Spain still lags its peers in terms of pandemic recovery (see Box below). Moreover, growth slowed significantly in the second half of 2022 and the underlying dynamics were weak. With the reopening boost having largely faded, both investment and private consumption contracted substantially in the final quarter of the year. Partly as a result, private domestic demand still has a quite a bit more ground to recover than GDP as a whole.

Looking ahead, the major drop in energy prices has improved the outlook considerably. The extension of government support measures to the end of this year, favorable job perspectives, and the billions to spend from the European pandemic recovery fund will also support domestic demand in the coming quarters. That said, the economy continues to face headwinds. Inflation is not yet a story of the past, and we expect the ECB to further increase its policy rate. Higher interest rates tend to hurt investment with a lag. Indeed, since past experience shows that it can take multiple quarters before their full impact is felt, we think past rate increases are still working their way through the economy. Higher rates also hit the discretionary spending of households with variable rate mortgages.

All in all, a better-than-expected second half of 2022 and an improved outlook for domestic and foreign demand in the first half of this year have led us to lift this year’s growth forecast for Spain from 0% to 0.9% – compared to 0.3% for the eurozone (see Box, below). We have penciled in a contraction for Q1, after which growth will resume moderately before gaining traction in 2024. We have slightly downgraded our forecast for 2024 from 2.2% to 1.9% (0.9% for the eurozone), mainly due to our upward revision for the ECB’s target policy rate and 2024 inflation. We still forecast inflation to fall, however, from 8.3% in 2022 to just below 4% this year and 2.8% next year. Our growth forecast is slightly below the consensus of 1.3% in 2023 and above the consensus forecast of 1.4% in 2024.

Pandemic Savings

An ongoing matter of debate is how much households will use high pandemic savings to cushion the blow to real incomes. Data suggests that households were already eating into savings in the second half of last year. The amount kept in household bank deposits has decreased since the summer. Some households have transferred money from low-yielding deposits to higher-yielding treasury bills and fixed-income funds. But another reason is that households needed those savings to soften the impact of the cost-of-living crisis.

The amount of household deposits is still relatively high compared to GDP, however, even when adjusted for inflation. Yet excess savings are mostly in the hands of high-income households with the lowest marginal propensity to consume and surveys from Banco de España suggest people have little intention to use them in the coming 12 months.

The upshot is that we don’t expect a large influx of pandemic savings to boost consumption, but they may help to limit the contraction in domestic demand. In any case, the sharp decline in the household saving rate from its pandemic peak (see Figure 3) shows that households have opted to limit the fall in consumption amid rising prices and the reopening of the economy by lowering the amount of income they save.

Note: The Netherlands leads the pack in 2023, an explanation can be found in this publication.

The strong labor market and decent outlook supports household income and should limit the number of people that resort to precautionary saving. This is not to say that inflation hasn’t eroded purchasing power (see Figure 4), but massive layoffs, as seen during previous crises, would have made the hit to households’ real disposable income a lot worse.

Another important feature with respect to job security is the fact that last year’s labor market reform has significantly increased the prevalence of indefinite contracts and decreased the possibility of offering fixed-term contracts (see Figure 11).

The share of temporary employment has decreased from 25% to 18%. While this is still high compared to Spain’s peers, it is certainly an improvement from the workers’ perspective. Critics argue that in some cases it is merely the name of the contract that has changed, while in essence the type of work is still discontinuous – the so-called “discontinuous fixed contract.” Seasonal workers, for example, may now sign a permanent contract but may still actually only work and receive salary “in season.” Yet proponents argue that it still improves circumstances for these workers. For example, they have the certainty of a job when activity resumes, which is generally when the season arrives, but could also be in between seasons. It also raises their entitlement to pensions and unemployment benefits.

All that being said, the total number of hours worked is still below pre-pandemic levels. So people are working fewer hours than before. Plus, employment growth has slowed recently (see Figure 11), while the unemployment rate has increased a bit from its trough of 12.6% last July. The share of businesses indicating that a lack of labor hurts their business has also come down from its peak in the third quarter of 2022, although it remains high in historical context (see Figure 12). Looking ahead, there still is some room for growth in hours worked, but employment growth will likely be modest – both because of modest economic growth and the expected contraction of the working age population. We do not expect a major uptick in unemployment either, however. The tight labor market will probably induce labor hoarding. The vacancy rate – owing to the services sector – still stands at a decade high, and a deep recession will be avoided. We expect unemployment to hover around its current rate of 13.1% for the rest of the year and to trend downward over the course of 2024 (see Figure 10).

All in all, weaker employment growth lowers the potential for consumption growth, but decent job security does put a floor under the expected demand contraction.

Wage Growth

The rather tight labor market has boosted wage growth to a decade high (see Figure 13). So far it has been unable to keep up with the increase in the cost of living, although the gap between inflation and wage growth is narrowing because inflation is coming down. Negotiated wages increased by 2.7% in 2022, compared to inflation of 8.3%. Contracts signed toward the end of the year saw somewhat higher wage growth, but in January it dropped again to 2.7%. On the bright side, both wages offered in new job postings on Indeed and the increase in compensation per employee suggest actual wage/compensation growth has been higher than the negotiated wage increase in business agreements. At the end of December, both topped 4% – that still means a drop in real income out of work, however. Meanwhile, the prevalence of certain wage indexation clauses has increased, giving rise to further upward potential down the line.

The upshot is that inflation seems likely to continue to outpace wage growth this year, but the gap will likely be substantially smaller than in 2022. We forecast inflation to fall from 8.3% last year to 4% this year and 2.8% next year.

Energy and Food

A major drop in energy prices since mid-2022 has significantly slowed growth in both consumer and producer prices (see Figures 13, 14, and 15). Consumer energy inflation has in fact turned negative (see Figure 16). That said, energy prices are still higher than prior to the energy crisis and a substantial share of households are likely to see their energy bills rise in the coming months.

Spain’s energy market is divided into a regulated and a free market. About one-third of households have a regulated tariff and about two-thirds have a free market contract. The retail tariff in the regulated market is strongly linked to wholesale spot prices – reform is on its way to weaken the link to make prices less volatile. The free market rate differs per energy supplier and contract, but is more sticky and generally follows the trend in the regulated market rate with about a one-year lag. Accordingly, households in the regulated energy market have already seen a sharp drop in their energy bill on the back of the drop in wholesale energy prices, while at least part of the households in the free market will still see their energy bills rise instead of fall in the coming months.[1]

Still, energy inflation is expected to remain negative for the better part of the year. Meanwhile, we project food inflation to continue to be high – it currently is the main driver of inflation, despite the recent fall in commodity prices. We think the past years’ increases in energy and food commodity prices still need to be partially passed on going forward.

[1] For the inflation figure compiled by Spain’s statistics agency, it is worth noting that the methodology to calculate inflation has changed. From this year, energy prices in the free market are included, while up until last year only the regulated rate was. The implication is that inflation will come down less quickly than with the former method, while it would have increased less fast over the past two years if the new method had been used. The exact size of this implication is unknown due to a lack of data, which contributes to the uncertainty surrounding our inflation outlook.

Core

Moving on to core inflation. We believe core inflation will remain higher in the coming years than what we have gotten used to for so long. For one, because it will take time before the higher costs of inputs, mainly energy, will have been passed on to other goods and services. Moreover, the large influx of recovery fund money and intentions to speed up the energy transition will likely put upward pressure on the prices of certain types of investment goods. And while wage growth is still quite moderate when compared to the increased cost of living, it is higher than in the past decade. The prevalence of wage indexation clauses has also increased, giving rise to further upward potential, although the risk of a true wage-price spiral is deemed to be limited so far.

Government Support

A final important factor for the inflation outlook is the broad set of temporary government measures targeting prices. Apart from the Iberian mechanism mentioned above, measures include lower taxes on energy and certain food products, an energy bill subsidy for low-income households, a cap on the increases of the regulated gas price and rents, and large subsidies for a variety of train tickets. The Iberian mechanism and VAT reduction on food are planned to be lifted at the end of May[2], while the other measures have been extended until the end of 2023. These measures limit inflation for this year, but will likely push up prices next year once they are withdrawn.[3]

[2] The VAT reduction on certain food products will end on May 1 if underlying inflation has fallen below 5.5% in March, according to the method of Spain’s statistics agency – which differs from Eurostat’s core inflation.

[3] As a reference, INE has estimated that inflation was 2 percentage points lower in November 2022 than would have been the case without the measures in place at that time. Measures in place in November are comparable to today, apart from the VAT reduction on food that was implemented in January 2023, and the subsidy on gasoline for households that ended in January 2023 – only transportation professionals still receive gasoline subsidies. The end of the subsidy on gasoline for households is estimated to have raised inflation by around 6 decimal points, while the VAT rate cut on food is estimated to have lowered inflation in January by around 3 decimal points.

Besides high inflation, the rapid increase in interest rates and tightened credit standards will increasingly act as a headwind. Over the past year, the cost of borrowing has more than doubled for households wishing to purchase a home and almost tripled for businesses. Rates have reached levels not seen since 2014 for business and 2012 for households (see Figure 17). And the cost of borrowing is set to increase further. First, because we believe the European Central Bank is not yet done with hiking rates. And second, because the 12-month Euribor, which is used as a reference rate for mortgages – especially variable rate mortgages – has increased by much more than the average mortgage rate so far. It has reached levels not seen since the aftermath of the global financial crisis. A significant number of banks are also reporting they have tightened credit standards, making it more difficult for households and businesses to get a loan (see Figure 18). Both developments are expected to hit investment growth, although we currently believe it will take multiple quarters before the full negative impact will materialize.

Looking at recent data, we already see that both housing and business investments contracted during the second half of last year, which was only partly compensated by public investment. The drop in new orders and uncertainty regarding the outlook have almost certainly played their part. Yet higher interest rates and tightened credit standards might well have started to affect investment decisions as well.

The development of loan supply could provide some insight into investment demand going forward, although the data seems to be a bit inconclusive at this point. According to ECB data, no trend break is visible yet in private sector loan transactions on the balance sheets of monetary financial institutions. At the same time, however, data clearly shows a reduction in new mortgage lending since October (see Figure 19), not boding well for housing investment. The drop in new mortgages also matches the fall in demand for loans since the final quarter of last year, according to the ECB’s bank lending survey. Yet at the same time, building permits for residential buildings increased again toward the end of last year (see Figure 20), which could actually provide a boost to the ailing construction sector.

Looking at business survey data, we find that overall demand for loans by businesses only contracted a little in the second half of last year and in fact increased in the first quarter of this year. Yet the driver behind the demand was reported to be the building of working capital rather than investment. So that’s not really fueling optimism.

All in all, then, rising interest rates might have had an impact on investments already, but we expect it will take longer before the full impact on investments materializes. The link between higher rates and investment growth will likely be smaller than in the past, though, given Spain still has tens of billions to spend from the European pandemic recovery fund – which is about 15% of the total amount of investment in 2022. Even if not all money will be put to use, as we expect, this will support investment in the coming years.

The Curse of Variable Rate Mortgages

On top of the impact of higher rates on future demand for loans and hence investment, variable rate mortgage loans also have an impact on household mortgage spending and, in turn, consumption.

In Spain, about 65% of mortgages face an interest rate reset within the next 12 months. As the change in rate in many cases depends on the development of the 12-month Euribor, these resets will potentially have a very large impact on households’ financial situation and discretionary consumption. Indeed, newspapers have been publishing articles with horrifying calculations of households possibly needing to pay hundreds of euros more per month on interest. While possible in some cases, this likely overstates the average increase. Indeed, the average impact is softened by the fact that most variable rate loans stem from before 2012, with a large share of interest rate payments already amortized. In the low interest rate environment after the eurozone debt crisis, fixed-rate contracts had become the preferred option (see Figure 21).

Meanwhile, at a macro level, the impact of higher interest rates on consumption is also softened by the fact that private debt has come down significantly in recent years. This mitigates the increase in the aggregate interest burden from an increase in interest rates. Moreover, since total interest payments as a percentage of income are currently really low (see Figure 22), on average, households should be able to bear some increase in interest payments before they run into payment difficulties.

Finally, to soften the blow for distressed households, the government got banks to agree on several support measures for low-income households. Depending on the eligibility criteria met, measures include the option to introduce a grace period, lengthen maturities, lower the interest rate somewhat, or swap from a variable to a fixed rate.