The economy in Spain (A-/Negative) experienced the largest recession among major euro-area economies in 2020. GDP contracted by 11%, slightly better than Scope’s estimate of a 12% contraction, but significantly worse than the 8.9% GDP decline in Italy (BBB+/Negative), 8.3% in France (AA/Stable) and 5% in Germany (AAA/Stable).
“Significant monetary policy support has helped the financing of sizeable countercyclical fiscal measures to protect the economy,” says Alvise Lennkh, lead our analyst on Spain. Spain is set to have recorded a double-digit fiscal deficit estimated at 11% of GDP last year, despite better-than-expected tax revenues, resulting in debt rising to nearly 120% of GDP from 96% in 2019.
Despite the deterioration in public finances, the government’s financing costs remain low, with the yield on the 10-year Bono close to 0%. The Bank of Spain holds now more than 25% of Spain’s government debt.
“Any fundamental improvement in Spain’s public finances depends on a sustained economic recovery, government efforts to address inefficiencies in the labour market and raise productivity, together with a credible medium-term fiscal consolidation strategy,” says Lennkh.
The uncertainty on the recovery this year is visible in diverging forecasts, ranging from 9.8% growth by the government, which expects a 2.6pp uplift from EU funds, to the Bank of Spain’s baseline forecast of 6.8% assuming a 1.3pp positive impact from EU funds. Scope’s forecast, in line with the IMF, is for a more modest rebound of 6%.
The government is prioritising growth over budgetary discipline, which for the moment is appropriate given the large output gap. Spain will run a wide budget deficit for some time. For 2021, the authorities forecast a deficit of 7.7% of GDP, which is based on a rather optimistic economic scenario. Thus, should growth be weaker than expected in the coming years, Spain’s public finances would deteriorate further – a risk captured with Scope’s Negative Outlook.
“Sustainable growth over the coming years will depend, among other factors, on the effective spending of at least the 78 billion euros in grants Spain is set to receive as part of the Next Generation EU recovery fund as well as labour and product market reforms that raise the country’s growth potential,” says Giulia Branz, associate analyst at Scope. Spain has the highest structural unemployment rate in the euro area (14%) and almost 25% of employment is on temporary contracts, which has adverse effects on job security as well as on companies’ willingness to invest in human capital.
In addition, reforming the pension system would also contribute to the sustainability of Spain’s public finances as the social security fund has run a deficit for the past 10 years and given the country’s ageing population.
“The dire state of the economy and the European Commission’s conditions for access to the funds might spur the minority government’s reform efforts despite Spain’s fragmented politics,” says Branz. Indeed, the government has obtained parliamentary approval for the first full-year budget since 2016.
Given these politically-costly reforms, tensions are likely to persist, challenging the minority government’s ability to facilitate Spain’s economic recovery and strengthen the country’s public finances. This uncertainty is captured in Scope’s A-/Negative rating.