Will the Spanish Economy Crash?

Usually when discussing Euro-zone economies with economic problems, it is Italy or Germany, and sometimes Portugal, which is mentioned. Which is natural since these three economies has had the weakest growth in recent years. Yet many observers, like here Matthew Lynn and Charles Duma, now believe that the biggest problem in the future will be Spain. This may strike some people as odd, as Spain have in recent years had the fourth highest growth rate among the old 15 EU countries, after Ireland, Luxembourg and Greece. But looking beyond headline GDP numbers and you see great imbalances in the Spanish economy. As late as in 1998, Spain actually had a small current account surplus, but now they have largest deficit relative to GDP of all mayor economies, including America. Unit labour costs have increased by as much as in Italy and household debt has increased from 50% of disposable income in 1996 to 100% today. And Spain’s economy is dangerously dependent on the construction sector, with residential investments making up an incredible 17% of GDP, more than double the level in America.

These facts are of course related to each other the current account deficit being the result of massive borrowings by households to buy these newly constructed homes. The overheated construction sector have helped bid up unit labour costs, something which have further increased the trade deficit. The housing boom is driven by two factors: low interest rates and massive immigration.

The low interest rates are of course a result of Spain’s entry into the Euro-zone, where interest rates are set at very low levels reflecting the weak economies of Germany and Italy. But clearly, the current low levels are certainly not sustainable. A 8.9% money supply growth rate and 11.4% private sector credit growth is simply not sustainable for an economic area whose structural growth rate is as weak as that of the Euro-zone. Because the current Spanish boom is so dependent on the interest rate sensitive construction sector and because Spanish households have accumulated such a high debt burden (although it is still lower than in the U.S. or the U.K.), rate increases are likely to hit Spain a lot harder than other Euro-zone economies. Indeed, if a significant pick-up in growth and inflation in the rest of the Euro-zone forces the ECB to a more dramatic tightening of monetary policy than the timid moves so far, Spain’s construction sector, and by extension the entire Spanish economy could be hit hard.

However, there are reasons to believe that any housing bust will be limited, even if the ECB significantly raises interest rates. The other main driving force behind the boom, the large scale immigration of both low skilled workers from Africa and Latin America and old age retirees from Northern Europe looks set to continue. While the economies of Africa and Latin America have picked up pace recently, the existing income differential is far too big for that to significantly reduce the willingness to emigrate. And despite some grumblings from the conservative opposition, anti-immigrant sentiment has so far remained limited. So the flow of immigrants from Africa and Latin America looks set to continue for the next few years.

Meanwhile, the continued ageing of Northern Europe means that the number of old age retirees wishing to settle in Spain’s warmer climate will in fact likely increase, not decrease. All of which implies that demand for housing will remain strong in Spain even if ECB tightens its monetary policy.

Further likely to cushion the Spanish economy in case of rising interest rates are the fact that these rising interest rates presuppose economic strength in the rest of Europe, which would mean stronger demand for Spanish exports, counteracting any downturn in the housing sector.

For all these reasons, Spain will not "collapse" as Matthew Lynn or Charles Dumas think, although growth will likely slow significantly in particularly relative and probably also absolute terms as interest rates rise.