Spain’s Economic Challenges in 4 Charts

Recently, Spain was ranked the healthiest country in Bloomberg’s 2019 Healthiest Country Index. And what’s not to like? Mouth-watering cuisine, splendid hospitality, a rich history of culture, and the highest life-expectancy at birth among European countries make for an excellent country to live in. Not only that, Spain’s economy continues to grow relatively strongly, compared to some of its peers (see: Italy). Improved macroeconomic fundamentals reflect the arduous structural reforms that Spain undertook in response to the 2008 Global Financial Crisis.

Yet, Spain also faces numerous domestic and external economic challenges that are simply unavoidable. According to a recent IMF blog post, the Spanish economy has maintained a strong momentum but has passed its peak. Real GDP growth is projected to moderate to 2.5 percent in 2018 and 2.2 percent in 2019 — still above the euro area average, but on a cyclical slowdown. These IMF projections reflect both a less supportive external environment and weakening domestic demand. External downside risks are especially troubling, such as sudden changes in investors’ global risk appetite. Within the Euro Zone, the risk of Italy’s so-called “doom loop” continues. Geopolitical risks include trade protectionism, and weakening conditions in emerging market economies.

For Spain to successfully weather increasing external downside risks in the medium term, it needs to focus on domestic reform. The following charts highlight 4 areas in the Spanish economy that are especially important.

1. Spain’s Sluggish Productivity Growth

The 2008 crisis and the subsequent 2013 Euro Debt Crisis placed Spain under unprecedented financial and stress. Yet, despite improved productivity growth sine the crisis, Spain’s productivity is still considerably below that of advanced European peers. For example, the IMF estimates suggest that Spain’s productivity gap relative to Germany is above 10 percent.

In Figure 1. we examine the OECD’s Multifactor Productivity (“MFP”) index for five European Union countries. The MFP reflects the overall efficiency with which labour and capital inputs are used together in the production process. Growth in MFP is measured as a residual, i.e. that part of GDP growth that cannot be explained by changes in labour and capital inputs. Changes in MFP reflect the effects of changes in management practices, brand names, organizational change, general knowledge, network effects, spillovers from production factors, adjustment costs, economies of scale, the effects of imperfect competition and measurement errors.

The evolution of Spain’s MFP before and after the 2008 Global Financial Crisis illustrate Spain’s difference in experience compared to other Euro economies. Most advanced economies recorded strong productivity growth pre-crisis, which then slowed down considerably during the crisis. In the case of Spain, average productivity growth already was negative in the years prior to the crisis and afterwards, has remained sluggish.

2. Tackling Spain’s Unemployment Crisis

Few countries have experienced the scourge of high youth unemployment like Spain has. The OECD’s definition of youth unemployment rate is the number of unemployed 15–24 year-olds expressed as a percentage of the youth labour force. As shown in Figure 2, Spain’s youth unemployment in 2017 was at 38.7%, with only Greece and South Africa having higher rates among OECD economies. Spain’s total unemployment rate is also high at 14.6 percent.

Studies have pointed out that one of the main determinants of both high worker turnover and volatility of youth unemployment is the high incidence of temporary employment in Spain. As the IMF has noted, widespread short-term contracts and temporary employment is a problem in the labor market as it lowers investment in the training of employees under short-term contrats and weakens their productivity. The high incidence of temporary employment may also lead to increases in inequality especially among low-skilled labor.

According to the IMF, the main reason for the wide-spread use of short-term fixed contracts is that there is still a large difference in the cost of hiring workers on fixed-term contracts compared to employees on open-ended contracts. Labor market reforms in Spain should be focused on reducing this large difference to make the hiring of worker on open-ended contracts ore attractive for employers. However, labor market reforms are often politically difficult; just look at Macron’s efforts in France.

Overall, Spain should pursue more coordinated and better-designed active labor market polices in helping low-skilled youth and long-term unemployed return to work.

3. Spain’s Onerous Debt Burden

Despite strong economic growth and a low interest rate environment, Spain’s government debt remains a hefty weight on the shoulders of Spanish citizens. From it’s peak in 2014 at the height of the Euro crisis, government debt remains close to 100 percent of gdp — more than double of what it was before the crisis. This means Spain will have most likely limited fiscal space to alleviate future economic downturns or shocks.

A stronger government balance sheet means Spain would be in a better position to stabilise the economy and shield the population from large swings in unemployment. Considering ECB Central Bank Governor Draghi’s recent remarks on the Euro zone economy, Spain would benefit from reducing public debt while economic activity is still relatively robust. As Managing Director Lagarde always says, “fix your roof while the sun is still shining.”

4. Spain’s Demographic Challenges & The Need for Pension Reform

The aging population in Spain and among many of the advanced economies is a growing concern. As Spain’s population ages (see Figure 4), the working age population will have to support a growing fiscal burden and pressures on the pension system will only increase. Important pension reforms in 2011 and 2013 have addressed some of the financial pressures on the pension system, and other economies may look to Spain for inspiration.

However, the pension reforms have been increasingly questioned by the Spanish public. Further adjustments to the pension system will be needed, and it will be difficult to entirely avoid a reduction in real pension benefits in the future. The challenge that Spain faces now is how to balance transparency and fairness, with the need for fundamental changes to the pension system.