Ernst & Young

Eurozone Forecast
Spain
Spring edition, April 2011
Outlook for Spain
Ernst & Young Eurozone Forecast Spring 2011

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Highlights

Fiscal consolidation on track, but growth is still missing

• In the final three months of 2010, Spanish GDP increased by just 0.2%, only a marginal
improvement from the stagnation seen in Q3 2010. In 2010 as a whole, Spanish GDP shrank
by 0.1%: fiscal consolidation and private sector deleveraging severely constrained domestic
demand and the pull from foreign trade, which was instrumental in lifting growth in the
other large Eurozone countries, proved too weak an offset. Fiscal consolidation has
proceeded on schedule. Downside risks remain to the fore, related to a bleak outlook for
domestic demand and ongoing uncertainty about the future health of the banking sector.

• Spanish GDP is expected to grow by just 0.6% in 2011, markedly underperforming the
Eurozone average. In 2012, growth is unlikely to exceed 1.1%. Private consumption is
expected to remain depressed, as household income should remain under pressure from
stubbornly high unemployment, which is not expected to decline significantly from its
current levels, and from the adverse effect of the cut in public sector wages and
government transfers that are part of the fiscal consolidation process. Moreover,
deleveraging and uncertainty about employment are likely to keep the savings rate high.

• Investment should continue its fall this year, dropping by 2.8%. Non-residential investment is
expected to slide marginally, thanks to the improvement in foreign demand, but residential
capital expenditure should fall by another 12%, as the construction industry has to grapple
with a difficult financial situation and lack of demand.

• Export growth is expected to remain moderate, as unwinding the huge competitiveness gap
with the main trade partners, accumulated since the adoption of the euro, needs far-
reaching structural reforms to boost productivity that are only implemented gradually and
take time to bear fruit. However, weak import growth should lead net trade to provide a
significant contribution to growth.

• Since the beginning of 2011, the Government has taken new and important measures to
restructure the banking system and, in particular, to strengthen capitalization in the ailing
regional savings banking sector. A key concern is the amount of public money needed to
recapitalize the system, which could escalate to €100 billion, far above the resources made
available by the Government (€20 billion planned so far). In the meantime, banks are
regaining access to the interbank market but non-performing loans (NPLs) are increasing
and the large exposure to Portuguese debt could lead to a significant worsening in asset
quality in the event of a debt restructure there. Credit conditions remain tight and this is
going to affect domestic demand negatively going forward.

• Preliminary data for 2010 shows that the ambitious fiscal consolidation plan proceeds
according to schedule. The budget deficit for 2010 has been contained to an estimated 9.2%
of GDP. If fiscal discipline continues (especially at the regional level), the deficit is forecast
to shrink to 6.5% of GDP in 2011, not too far from the Government’s 6% target. However,
bond markets remain nervous as the Government has to roll over nearly 25% of total debt in
2011. At over 200 basis points (bp) by the end of February, spreads over German Bunds
have fallen by less than 50bp from the peak observed in the final months of 2010.

Ernst & Young Eurozone Forecast Spring 2011 Spain 1

Fiscal consolidation on track,
but growth is still missing

Muted growth at the end of 2010 …
In the final three months of 2010, Spanish GDP increased by just
0.2%, only a marginal improvement from the stagnation seen in
Q3 2010. The dynamic of the economy changed little through
2010, with domestic demand dragging down growth and net trade
providing only a small contribution. In 2010 as a whole, Spanish
GDP shrank by 0.1%, as the pull from foreign trade, which was
instrumental in lifting growth in other Eurozone countries, proved
too weak to counter the plunge in domestic demand.
The first indications for 2011 do not point to a major turnaround.
The Purchasing Managers’ Index (PMI) for March suggested that
output only increased on account of foreign orders, while spare
capacity remained large. Meanwhile, the services PMI pointed to
only a tiny increase in activity. Both sectors reported a contraction
in labor force. As a result, the unemployment rate has continued to
increase this year, to 20.4% in January (on the International Labor
Organization measure).
… and GDP to increase by just 0.6% in 2011
Spanish GDP is forecast to grow by just 0.6%, markedly lower than
the Eurozone average. In 2012, growth is unlikely to exceed 1.1%.
Subdued domestic demand and a positive contribution from net
trade should continue.
the cuts in public sector wages and government transfers that are
part of the fiscal consolidation process. Growth in private sector
wages are going to be limited by unemployment and the cap
agreed in 2010. In addition, savings are expected to remain high at
around 13% of disposable income, as uncertainty about
employment should encourage precautionary savings. In addition,
deleveraging of the Spanish household sector has barely started.
Household debt has fallen only marginally from the pre-crisis peak
and remains at 90% of GDP, around 20 percentage points (ppt)
above the Eurozone average. As a consequence, private
consumption is expected to increase by just 0.4% this year.
Investment to continue its slide as the construction
sector remains weak
Investment is expected continue its fall and, in 2011, being 2.8%
lower than the year before. The recovery in exports seen in 2010
has restored profitability in the manufacturing sector somewhat;
together with relatively better prospects for demand, this should
help limit the slide in non-residential investment.
By contrast, residential investment is expected decrease by more
than 12% this year. And we do not expect it to start rising before
2013. Saddled with strained balance sheets, the construction
industry faces quite bleak prospects.

Household income is expected remain under pressure from The fall in house prices is likely to continue, as price-to-rent ratios
stubbornly high unemployment, which is not likely to decline suggest that housing is still overvalued. Tax incentives for house
significantly from its current levels, and from the adverse effects of purchases in place until the end of 2010 and low interest rates are

Table 1
Spain (annual percentage changes unless specified) Source: Oxford Economics

2010 2011 2012 2013 2014 2015

GDP -0.1 0.6 1.1 1.8 1.9 1.9

Private consumption 1.2 0.4 0.7 0.8 1.1 1.4
Fixed investment -7.6 -2.8 1.5 3.4 4.4 5.2
Stockbuilding (% of GDP) 0.4 0.5 0.4 0.8 1.1 0.8
Government consumption -0.7 -1.1 -0.9 0.1 1.3 2.3
Exports of goods and services 10.3 6.1 7.0 8.0 6.6 6.7
Imports of goods and services 5.4 1.9 4.7 7.0 7.0 7.0
Consumer prices 2.0 2.9 1.6 1.4 1.5 1.5
Unemployment rate (level) 20.1 20.6 20.0 19.2 18.6 17.7
Current account balance (% of GDP) -4.5 -3.7 -3.1 -2.8 -2.6 -2.1
Government budget (% of GDP) -9.2 -6.5 -4.7 -3.3 -2.8 -2.5
Government debt (% of GDP) 62.0 67.5 70.8 71.8 72.1 72.1
ECB main refinancing rate (%) 1.0 1.3 2.3 3.1 3.5 3.9
Euro effective exchange rate (1995 = 100) 120.8 119.4 117.0 116.0 114.9 114.1
Exchange rate ($ per €) 1.33 1.36 1.28 1.25 1.24 1.23

2 Ernst & Young Eurozone Forecast Spring 2011 Spain

Figure 1
GDP and industrial production
% year
10
GDP
0
Industrial
-5 production
-10
-15
-20
-25
1980 1984 1988 1992 1996 2000 2004 2008
Source: Oxford Economics
likely to have prevented a steeper fall in prices so far. As these
factors no longer support the housing markets, very large declines
in prices seem likely. Moreover, despite the pickup in sales seen in
Q3 2010 (due to the anticipation of the end of tax incentives), the
backlog of unsold homes remains large. According to Bank of
Spain’s estimates, there are between 700,000 and over a million
unsold homes, corresponding to over three years’ worth of sales.
Moreover, credit conditions remain tight. According to the latest
Bank of Spain’s Bank Lending Survey for Q1 2011, the significant
tightening seen in the first part of 2010 has not been relaxed, and
the majority of banks continue to report an increase in interest
margins. Tighter and more costly credit is expected to act as an
additional drag on domestic demand and, in turn, threaten the
relative stability of the banking sector.
Investment is forecast to increase by only 1.5% in 2012 and may
accelerate to 3.4% the following year.
Only net exports to provide a positive contribution
to growth
Given bleak prospects for domestic demand, only exports could
provide some pull to the economy, but Spanish exporters have to
grapple with structural competitiveness problems. Between 1999
and 2010, Spain’s real exchange rate has appreciated by 22%, as
opposed to the 2% appreciation of the Eurozone average and the
over 10% depreciation experienced in Germany. Wage moderation
is expected to bring about some small competitiveness gains going
forward, but undoing the losses accumulated in the past decade
requires substantial improvements in productivity resulting from
structural reforms, which take time to implement and bear fruit
only slowly.
Figure 2
Unemployment rate
%
Forecast 25 Forecast
20
15
10
5
2012 1980 1984 1988 1992 1996 2000 2004 2008 2012
Source: Oxford Economics
All in all, in the medium term, the Spanish economy is expected see
growth rates much lower than those enjoyed in the boom years,
and we forecast GDP growth below 2% per year until 2015.
Inflation expected to come back down
Subdued domestic demand should put a lid on inflation in the
medium term. The rise in inflation since the end of 2010, which
has seen consumer prices increase by 3% year on year in January
(harmonized measure), has been mostly accounted for by the spike
in energy prices and last July’s increase in VAT. Inflation should
remain above 3% during H1, but it is expected to come back down
later this year in line with the forecast moderation in energy prices
and as the impact of the VAT increase drops out of the
calculations, averaging 2.9% for the year as a whole. In the medium
term, inflation is projected to remain below the Eurozone average,
at around 1.5%, as Spain tries to regain competitiveness.
Health of the banking sector key uncertainty
Our baseline forecast assumes a gradual but effective resolution of
the problems affecting the banking sector. Some important policy
measures have been taken and, on the whole, the situation has
improved since the final months of 2010, but the possibility of a
marked deterioration, leading possibly to a state bailout, cannot be
ruled out. The health of the banking sector constitutes a key risk to
our forecast.
The most important policy initiatives taken are aimed at
overhauling the regional savings banking sector (cajas), in order to
tackle its low capitalization and large dependence on wholesale
funding. At the beginning of 2010, the Government implemented a
series of reforms aimed at strengthening the sector, by merging
the cajas and improving their governance. The number of banks
has dropped from 45 to 17, and average total assets per institution
have more than doubled, which should improve efficiency.
Ernst & Young Eurozone Forecast Spring 2011 Spain 3
Fiscal consolidation on track, but growth is still missing

Figure 3 Figure 4
Contributions to GDP growth Government balance and debt
% year % of GDP % of GDP
8 Forecast 4 Forecast 80
Domestic
demand
6 2 70
GDP
4 0 60

2 -2 50

0 -4 Government debt 40
(right-hand side)

-2 -6 30

-4 Net exports -8 Government budget balance 20

(left-hand side)

-6 -10 10

-8 -12 0
1985 1988 1991 1994 1997 2000 2003 2006 2009 2012 2015 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014

Source: Oxford Economics Source: Oxford Economics

Moreover, in February 2011, new measures were put in place to
strengthen capitalization. Banks will have to raise the capital needed
on the market, sell assets or tap temporarily into a government-
sponsored fund that would amount to a partial nationalization.
According to central bank estimates, the capital shortfall to be filled
by public money will not exceed a manageable €20 billion, but
other analyses put the amount of resources needed as high as
€100 billion, given the uncertainty surrounding the quality of assets
linked to the construction sector. Such a sum would far exceed the
amount of resources set aside by the Government to restructure
the banking sector and would jeopardize fiscal restructuring.
Meanwhile, Spanish banks have succeeded in regaining access to
the interbank market and have greatly reduced their dependence
on the European Central Bank (ECB). In January 2011, loans from
the ECB have dropped to €53 billion, less than half the amount
borrowed at the peak last June. However, the weak economic
situation is continuing to erode the quality of banks’ assets. In
December 2010, the ratio of NPLs to total credit climbed to a
15-year high of 5.8%. Bad loans may continue to increase as they
normally lag economic activity.
An additional source of risk stems from the large exposure of the
Spanish banking sector to Portugal. According to analysts’
estimates, Spanish banks own roughly a third of Portugal’s foreign
debt (which is 60% of total debt). Any loss triggered by a
Portuguese debt restructuring would inevitably have a sharp
adverse impact on Spanish banks’ balance sheets.
Fiscal consolidation appears on track
Better news is coming from public finances. Preliminary data for
2010 shows that the ambitious fiscal consolidation plan is
proceeding according to schedule. The budget deficit for 2010 has
been contained to an estimated 9.2% of GDP. If fiscal discipline
continues to be enforced, budget deficit will shrink to 6.5% of GDP
in 2011, not too far from the Government’s 6% target.
However, most of the improvement has come so far from the
better-than-expected performance of the central government.
According to the Ministry of Finance, more than half of the regions
(including the biggest one, Catalunya) have missed their deficit
reduction targets and will be obliged to step up the fiscal
retrenchment measures in 2011.
Yet, the improvement in fiscal balances has so far failed to impress
bond markets, which remain nervous, as the Government has to
roll over nearly 25% of total debt this year. At over 200bp by the
beginning of March, spreads over German Bunds have fallen by
less than 50bp from the peak observed in the final months of last
year. While they remain low in comparison to those on Portuguese
and Irish bonds, the burden of interest payments on government
finances remains substantial. These latent tensions in the Spanish
government bond markets imply that any slippage in fiscal
consolidation, for instance from regional governments, could have
a significant impact on the cost of borrowing and the sustainability
of public finances.

4 Ernst & Young Eurozone Forecast Spring 2011 Spain

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