The Spanish bull: how strong is it really?

Economics Department

David Rooney

Spain's economic performance has been remarkable. Even so, the country still has some difficult problems to tackle. 

¡España va bien! (“Spain is doing well”) has been the constant refrain of José María Aznar, who remains head of the Spanish government after his centre-right party's clear victory in the March general elections. Since the mid-1990s, Spain’s economy has indeed been robust, even though the country must still tackle some difficult problems. It still has the OECD’s highest unemployment rate, at nearly 16%, and inflation drifted up during 1999. Moreover, there are structural pressures on the government’s finances which need resolving, such as on pensions.

Nevertheless, the pace of growth has quickened, rising to 3.7% in 1999—significantly outstripping Spain’s partners in the EU (2.1%) and the OECD (2.8%). The result has been a significant rise in employment, since nearly 1.4 million jobs were created between 1996 and 1999, accounting for nearly a quarter of aggregate EU employment growth. Spain has also appreciably strengthened its foreign trade position, making substantial gains in market shares. And according to official estimates, the budget deficit was trimmed to 1.1% of GDP in 1999, down from to 6.9% in 1995.

A number of factors have contributed to these good results. First were the budgetary and monetary efforts expended to satisfy the Maastricht criteria, thus allowing Spain to join the euro area from the outset in January 1999. This membership bolstered the confidence of consumers and investors, both foreign and domestic. At the same time, interest rates dipped sharply, having a direct impact on the financing costs of businesses and households, which also responded to major tax reform and deregulation in labour and product markets.

The labour market reform of 1997 was the fruit of a rare display of unity between trade unions and management. With joblessness hitting 22% in 1996 and severance costs so high that more than 33% of employment contracts were fixed-term, Spain was setting records of dubious distinction. The situation impeded the formation of human capital and sapped the confidence of households, making it necessary to formulate a new pact, lowering severance costs and sharply reducing social security contributions. This facilitated the return to the job market of large groups of people most affected by unemployment, such as young people, women and the long-term unemployed. As a result, after hitting more than 42% in 1996, the youth jobless rate slipped back under the 30% mark in 1999. Moreover, the incentive to work was enhanced by the income tax reform of 1998, since the highest marginal tax rate was lowered from 56% to 48%, and the bottom rate from 20% to 18%.

Businesses have enjoyed a more favourable climate. They have improved earnings and strengthened their position in domestic and foreign markets. Furthermore, the 1995 reform of the corporate income tax eliminated double taxation of profits, thereby encouraging Spanish companies to expand internationally. Outward foreign direct investment increased more than tenfold between 1995 and 1999. Companies like Telefónica, Repsol (oil), Endesa (electricity), Iberia, and Banco Santander Central Hispano have become dominant players in South America, where Spain was the leading foreign investor in 1999. Moreover, a large number of clothing chains, such as Zara, one of the largest groups in the world, Mango and Springfield, have racked up remarkable export performances. They have succeeded by going for quality rather than low production costs alone. Meanwhile, in some key sectors like telecommunications, competition has driven prices down substantially and enhanced the quality and diversity of services on offer.

Another sign of this new dynamism is Spain’s modernised infrastructure: high-speed rail links (Madrid-Seville and soon Madrid-Barcelona and then onward to the French border); and expansion of the motorway system and of airport capacities. This is good news for the tourist industry. After all, Spain is the number two visitor destination in the world, after France and ahead of the United States. And tourists are not coming merely for the sunny, though saturated, beaches. A vast campaign to promote cultural tourism has boosted the number of visitors outside of peak summer periods and away from coastal areas. It has paid off. For the past few years, it has been in spring and autumn that the number of tourists has risen fastest, with more trips to cities like Seville, Barcelona and Bilbao, site of the new Guggenheim museum.

Spain has also become more attractive for foreign investors. This is reflected in the vitality of foreign investment flows—nearly 2% of GDP in 1998 and 1999, up from 1.2% in 1995. Moreover, many of the sectors concerned, such as in automotive components (Renault, Daimler Benz, Daewoo), are highly competitive ones in which quality and value-added are essential.

Hold the fiesta

But as with all economic success stories, every silver lining has a cloud. Price stability is one of them. After dipping to a record low in 1997, inflation averaged 2.3% in 1999, as opposed to only 1% in Germany and France—Spain’s leading trade partners. In addition, Spanish wages are indexed to inflation more often than in most of Spain’s European partners. A large proportion of pay agreements include a catch-up clause that is triggered if inflation exceeds government targets. Yet any slippage in prices would impair the economy’s competitiveness and have repercussions on employment. Also, participation in the euro area precludes any cushioning adjustment via the exchange rate. In the short term, a tighter budgetary policy could keep the lid on inflation, but in the longer term a reassessment of the conditions for salary indexation will be needed. At the same time, competition should be bolstered in certain product markets. Electricity prices, for example, remain among the highest in the OECD area, in part, because competition between producers is limited.

Unemployment is another area where Spain has serious problems. The jobless rate, which in 1999 stood at 15.9%, remains the highest in the OECD area, whose average is 6.7%. Furthermore, Spanish joblessness varies considerably from one region to another, exceeding 26% in Andalusia but at around 10% in Catalonia. And yet, wage levels in these two regions are very similar. Moreover, unemployment benefits are relatively generous, so it is not surprising that migratory movements between regions are rare. In fact, fewer than one in four workers say they would accept a job if it meant having to move. One way of reducing such rigidities is to allow the wage bargaining process to reflect local conditions more closely. Another idea would be to review measures that impose heavy penalties for breaking housing leases, to make labour more geographically mobile.

Another reason why Spain should keep its feet on the ground despite its successes is the budget and the structural tensions that weigh upon it. The transfer of powers from the central government to the regions and communes has been accompanied by an increase of public sector employment. And this, despite the rather drastic rule that only one in four retiring civil servants can be replaced. Given the problem of low mobility, instances of overstaffing have arisen in some areas while others have suffered shortages. The government has responded by taking on temporary workers. But if decentralisation is not to exert additional pressures on the budget, the civil service status will have to be redefined soon—with particular attention to the terms of mobility, training during employment and compensation criteria.

Spain’s finances could also come under strain from demographic pressures, which are more unfavourable than for most of the other OECD countries. Today, there are four working-age persons to pay for the needs of one elderly person. Twenty years from now, the ratio will be three to one, and it is expected to grow very rapidly. Insofar as the retirement scheme has constituted little or no reserves to cover these future commitments, the potential cost to future budgets is considerable (several percentage points of GDP). Moreover, the ageing population will also have an impact on the labour market, and some economists are already projecting a shortage. All of this needs to be taken into account during the talks on pension reform that will be held this year. In particular, it will be imperative to reconsider the terms of early retirement and the level of benefits—which are currently far more generous than in most of the other OECD countries. After all, it would be economically dangerous if the retirement plan recently offered to those over 52 by Telefónica became widespread.

If these risks were not enough, policymakers will have to prevent the current system of fiscal decentralisation from putting an additional strain on public finances too. Since 1997, the regions themselves have been setting tax rates on a portion of personal income in order to provide greater funding for their spending. Since these resources are particularly volatile, a revenue guarantee system was set in place. Under the system, the State alone assumes the risks and potential costs. In order to avoid such a scenario while still giving the regions more power to tax, the revenue collected by the regions will have to be stabilised. One solution might be to levy more fees—for wastewater treatment, for example—but also to decentralise consumption taxes. Nevertheless, in moving towards greater decentralisation of revenue, the Spaniards will have to review the issue of solidarity between regions. Extending the model in force in the Basque Country and Navarre, which enjoy exceptional independence in tax matters, would seem unwise (see box).

All these are warning signs for Spain. Yes, the economy is “doing well”. But there is work to be done if Spain's impressive growth performance is to be sustained.

NOTE: This article is based on the OECD’s recent Economic Survey of Spain. Aristomène Varoudakis and Miguel Jimenez also contributed to the draft of the Economic Survey.

©OECD Observer No 220, April 2000




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