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Spain’s political risk

7 Apr 2014 By Hugo Dixon

Spain’s recovery is clouded by politics. Mariano Rajoy has achieved a lot in the two years that he has been prime minister. Growth has finally returned; even unemployment is falling. But as Spain enters a new electoral cycle, the appetite for reform is waning. What’s more, there is a big question mark about what will happen after the next election, which has to be held by March 2016.

Rajoy cannot claim the lion’s share of the credit for Spain’s economic turnaround. That belongs to Mario Draghi, president of the European Central Bank, whose “do whatever it takes” speech in mid-2012 marked the beginning of the end of the euro crisis.

However, Rajoy’s centre-right government has doggedly pursued reform. Most important, it has liberalised the labour market and cleaned up the banks. As a result, competitiveness has been restored and exports are booming.

Meanwhile, conditions in global financial markets have been benign. Investors no longer fear a breakup of the euro zone, but are scared of blowups in emerging markets. As a result, they have returned to peripheral euro zone markets such as Spain. Madrid’s 10-year bond yield is now only 3.2 percent – down from 4.2 percent at the start of the year and a far cry from the 7.6 percent in July 2012.

In the same way that Spain suffered from a vicious spiral during the downturn, it is now enjoying something of a virtuous cycle. Speculative capital is back. The government, for example, was able in February to offload a chunk of stock in Bankia, a bank which until recently was a byword for everything wrong with Spanish finance.

Investors are also hunting for bargains in a property market where values have collapsed in recent years. There is still an overhang of unsold properties, built at a dizzying rate during the bubble. But in some parts of Madrid, prices seem to have bottomed out.

Although banks overall are still deleveraging, credit is beginning to flow to healthy businesses and new channels of non-bank finance are being opened up. The government has also passed a reform that makes it easier to restructure corporate debt by, for example, converting it into equity. As a result, some of the zombie companies, which are haunting the Spanish economy, could be revived.

The official unemployment rate is still an eye-popping 25.6 percent. But unemployment is falling extremely early in this cycle. It dipped late last year after GDP grew only 0.1 percent in the third quarter and 0.2 percent in the final quarter. The changed behaviour of unemployment is almost certainly the result of the labour reform.

With consumer confidence returning, domestic demand is also creeping back. As a result of all these factors, economists have been pushing up their growth forecasts to 1-1.5 percent for this year and 1.5-2 percent for next.

Such numbers are fantastic compared to where Spain stood two years ago. But, unless the recovery is long and strong – which is unlikely given that deleveraging economies rarely grow fast – unemployment could still get stuck at unacceptably high levels.

It is, therefore, vital that wages stay under control as the economy recovers and Madrid continues to encourage employment. One government policy that should help is that of making it harder for people to get access to benefits if they don’t take jobs.

Another plan, the details of which are being thrashed out, is to cut the tax on employment and recoup the revenue by putting up consumption taxes. An ambitious reform on these lines, a so-called “fiscal devaluation,” would give a further incentive for companies to hire workers.

There are two worries. One is that the government will use the tax reform as a way to increase revenue. It certainly needs to do more to cut its fiscal deficit, which was 6.6 percent last year before counting the cost of bailing out banks. But it would be better to close the gap by cutting spending rather than raising revenue through taxes.

This leads into the second worry. Elections are only two years away. As a result, Rajoy’s desire to push through more unpopular reforms may be waning. When I visited Madrid recently, one common concern among business and finance leaders was that the current tax reform may be the last in this electoral cycle. It would be a huge shame if it was watered down.

Strong government is one explanation why the country has picked itself up faster than Italy, which has been bedevilled by fractious coalitions, despite Spain starting in a worse place. But, looking forward, political conditions in Madrid could be about to get almost as murky as those in Rome.

Consider the momentum building in Catalonia for independence. The central government is dead set against this, arguing that the Catalan government’s plan for a referendum as soon as this year is unconstitutional. In the circumstances, it is hard to see any of the Catalan independence parties supporting either Rajoy’s conservatives or the socialists in a national coalition.

This wouldn’t matter if either of the two traditional governing parties was likely to win an overall majority at the next election. But both have been doing poorly in the opinion polls, something that will probably be confirmed in next month’s European Parliament elections.

As a result, there is a risk that Spain could struggle to put together a stable government from 2016. That makes it all the more important to be ambitious with reforms now.


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