Spain’s economy rages on, despite policy inertia

Spain’s economy started the year on a good footing. The economy grew by 0.7% QOQ, continuing a streak of quite impressive growth figures, despite a high-interest rate environment (see figure 1). Growth was driven by both domestic demand and net foreign demand, on the back of strong export of services, even as export of goods contracted. Spain has been consistently exceeding expectations since the end of 2021, outperforming its peers. This achievement is remarkable considering that among the largest EU member states, Spanish consumers have so far been the hardest hit by the ECB’s rate-hiking cycle. As a significant portion of household debt in Spain carries a variable interest rate, resulting in much higher household interest payments over the past two years compared to interest income. In contrast, German and French households have experienced the opposite trend (see figure 2).

There are several drivers behind Spain’s recent outperformance of its peers, some more structural than others. For example, for years, the Spanish export sector has been benefiting from increased competitiveness due to lower wage growth compared to its northern peers. The real effective exchange rate, based on relative unit labor costs, has steadily declined since the global financial crisis of 2007-2009. Spain is also less dependent on China than most other member states, with Germany being a notable example. More favorable demographics, including immigration, also contribute to Spain’s success, especially when compared to Germany and Italy. Both factors are expected to continue supporting Spanish outperformance in the coming years.

A more temporary factor is that Spain has been playing catch-up lately. Its hospitality and tourism-driven economy took longer to recover from the pandemic slump. Arguably, this driver has now largely run its course. Another factor relates to its relatively small manufacturing sector. As a consequence, Spain’s economy benefited less from the industrial boom during the pandemic years, but the current slowdown is acting as a smaller drag.

Finally, significant support from the EU Recovery and Resilience Facility (RRF) has been bolstering Spanish growth and is projected to continue to do so until the facility ends by 2027. Spain is entitled to as much as EUR 80bn in EU grants (equivalent to 5.5% of 2023 GDP), and has so far received slightly less than half of that amount. However, not all the funds received have been fully utilized yet. While we don’t expect all available funds will ultimately reach Spain (as discussed below), and/or to be spent without cannibalizing other projects, it is still expected to contribute positively to GDP growth by several decimal points annually until 2027.

Going forward, we project annual GDP growth to remain rather strong, although it may slow somewhat compared to last year. Apart from the factors already mentioned above, growth will be supported by lower long-term yields, which should boost net interest income for households and investment. The historically still high saving rate also provides upside for consumption growth (see figure 3). At the same time, however, the external environment is not particularly robust. Additionally, growth in household real disposable income is projected to slow, partly due to lower employment growth (measured in hours worked). Meanwhile, hourly wage growth is past its peak, and the future trajectory for inflation is one of gradual decline following last year’s major drop. Our forecast indicates that the Spanish economy will grow by 2.2% this year and 2% next year, compared to 0.8% and 1.4% for the eurozone. Hence, Spain is expected to continue outperforming.

Prime Minister Pedro Sánchez recently suspended public duties in response to corruption claims against his wife. He denied the allegations, attributing them to a witch hunt orchestrated by the (far) right. This situation led him to question whether it was still worthwhile to remain in office. However, as expected, within day he announced he would continue in office and he expressed gratitude to everyone who had offered support. While emotions undoubtedly played a role, this decision was also widely perceived as a political maneuver.

Since Sánchez leads a minority administration with the (far) left Sumar coalition, he requires the support of all regional parties in parliament or the right-wing opposition to advance legislation. Given the right’s consistent opposition against any proposal, Sánchez practically depends on Catalan separatist parties to implement policy. However, these parties have their own distinct agenda.

After the government and separatist parties had reached a deal on the amnesty bill for those involved in Catalonia’s unilateral effort to secede from Spain – the Senate is still delaying but cannot prevent final adoption [1] – Puigdemont’s hardline Junts party has moved on to the next demand on their list: a legally binding independence referendum. However, Sánchez’ PSOE opposes this move.

Moreover, Catalan parties have been in election mode since mid-March when Catalan President Aragonès called for early elections on May 12. This has limited their willingness to lend Sánchez any support on the national level. And as if that weren’t bad enough, the PSOE’s junior coalition party, Sumar, has started quibbling with Sánchez’ PSOE. Sumar accuses the PSOE of showing off with the left-wing policy measures that Sumar brought to the table.

In summary, developments over the past few months confirm our earlier predictions: Spain’s current minority government faces challenges in effective policymaking. These challenges arise from both opposition pushback and instability from within its own ranks. By threatening to resign and highlighting the flaws in Spanish right-wing politics, Sánchez might have garnered support across centrist and left-wing parties, as well as among the electorate. However, we maintain the view that policymaking will continue to be arduous and slow going forward. Importantly, even with the Catalan elections out of the way, Sánchez will need to persistently seek the support of Catalan separatist parties – despite and perhaps even because the PSOE won, and pro-independence parties have lost the Catalan elections.

The amnesty bill has been approved by the lower house, despite fierce objection from the right-wing opposition. While the right-wing holds a majority in the Senate and has managed to delay the final adoption, objections across the judicial spectrum could well delay the actual implementation. Nevertheless, the bill is set to take effect.

Paradoxically, the government’s weak ability to act improves the short-term fiscal outlook. The government couldn’t secure parliament’s approval for the 2024 budget, which means that the 2023 budget has been rolled over and that certain expansionary measures envisioned in 2024 bill have not been adopted, yet. Still, beyond the short term, decisive action is needed to adhere to the reinstated and reformed budget rules, as we recently showed. Moreover, a lame duck government can hinder progress on the investment and reforms required to access and use funds from the EU RRF and EU cohesion funds.