Danske-Spains unrealistic expectations

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Investment ResearchGeneral Market Conditions

The Spanish government expects the recession to come to an end by mid-2013. In an

environment of fiscal tightening and sliding house prices, that appears to be wishful

thinking.

Even if Spain manages to deliver the anticipated -0.5% growth in 2013, this does not

justify the governments expectations that the unemployment rate should decline

slightly in 2013. It is simply at odds with the empirical evidence.

We expect that the Spanish economy will contract 1.5% or more in 2013, that Spain

will miss its fiscal target and that the unemployment rate will rise to at least 26.5%.

Export-driven growth

The Spanish government expects an export-driven recovery that will bring Spanish

growth back into positive territory by mid-2013. The assumption is that Spanish exports

can grow 6-7% annually in 2013-15. This may materialise if global growth picks up

notably or Spain manages to win global market shares, e.g. in services and green energy.

We find that it is an ambitious target that may prove difficult to reach, though not

impossible. A driver for winning market shares is to become more competitive. The new

government has undertaken a lot of reforms during the last 10-11 months. But it is no

time for complacency. Looking at the business climate and unit labour costs, we believe

that Spain is really only halfway through the needed reform agenda.

However, our real concern is that even if exports grow as much as anticipated, the

contraction in domestic demand will be much bigger than the government anticipates.

Austerity and fiscal multipliers

The Spanish government needs to reduce the fiscal deficit by at least 1.8% of GDP next

year to reach its target. This will have a substantial negative impact on growth. In an

economy operating close to its capacity constraint the fiscal multiplier is probably close

to zero, as the private sector will replace public sector cuts. However, when demand is

lacking, as is the case in Spain, there is little reason why cuts in the public sector should

cause an increase in private sector production. Until recently, IMF consensus was a fiscal

multiplier around 0.5, but in October IMF chief economist Olivier Blanchard and Daniel

Leigh emphasised that during recessions the multiplier is probably in the range of 0.9 to

1.7. In the absence of a central bank response, the multiplier is probably at the high end of

this range. Assuming a fiscal multiplier of 1.5 means that a 1.8% cut in the budget deficit

should pull GDP growth down by as much as 2.7%.

31 October 2012

Important disclosures and certifications are contained from page 3 of this report.

Senior Economist

Frank land Hansen

+45 45 12 85 26

[email protected]

Chief Strategist

Bernt Christian Brun

+47 23 13 91 90

[email protected]

Spanish government budget

00 02 04 06 08 10 12 14-10

-8

-6

-4

-2

0

2

4

-10

-8

-6

-4

-2

0

2

4% of GDP % of GDP

Budget Balance

Source: Reuters EcoWin, Spanish government

ResearchSpains unrealistic expectations

Spanish export growth

00 01 02 03 04 05 06 07 08 09 10 11 12

-20

-15

-10

-5

0

5

10

15

20

25

-20

-15

-10

-5

0

5

10

15

20

25% y/y % y/yExport growth

Mean

Source: Reuters EcoWin

GDP and fiscal consolidation

Real GDP Growth, % y/y

-4 -3 -2 -1 0 1 2 3 4 5Increaseingovernmentsurplus

-7.5

-5.0

-2.5

0.0

2.5

5.0

7.5

+ 2 standarddeviations

Expected GDP growth andfiscal consolidation in 2013

%-point

2012

Source: Reuters EcoWin, Danske Bank


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Research

Housing market downturn

At the same time, we expect house prices to continue to slide in Spain, which will

dampen domestic demand further. Declining house prices are a drag on private

consumption not only because it reduces wealth, but also because uncertainty about the

extent of future house price declines causes substantial precautionary savings. Spain hasseen a housing bubble comparable with that of Ireland, but for now the decline in official

house prices has been much more modest. We would not be surprised to see another 20%

decline in Spanish house prices over a 3-4 year period. This may amount to an additional

drag of about 1% in annual GDP growth (assuming that the elasticity of GDP to house

prices is 0.2). All in all, we expect these two headwinds to drag growth down by around

3.7%.

On top of this, the Spanish banks are expected to continue to deleverage. Spanish banks

have a lot of bad assets on their books and we expect credit conditions to remain tight. An

ongoing credit contraction is an important headwind too, although difficult to quantify.

With all these headwinds we really have a hard time seeing how Spain can return to

positive growth by mid next year. It is pretty much the same as saying that Spain would

be able to grow at least 4-5% next year in the absence of headwinds. We do not think so.

Unemployment likely to continue to rise

Even if the Spanish government manages to deliver the -0.5% growth anticipated for next

year, it is unlikely that it will succeed in reducing the unemployment rate by 0.3%-points

as foreseen. The historical relationship between GDP and unemployment suggests that

with a 0.5% contraction in GDP the unemployment rate should rise 2.6 %-points. The

governments expectation is four standard deviations away from this. On top of this, we

would argue that growth is much more likely to be -1.5% or less, which suggests an

increase in the unemployment rate of 4.0% or more. We agree that the impact on the

unemployment rate is probably lower at the end of a recession than at the beginning.

Taking this into account we would still expect the unemployment rate to increase at least

1.5%-point next year. The governments expectations of a 0.3%-point decline in the

unemployment rate are just wishful thinking.

Complacency is a risk

It is of course worrying that economic growth might be worse than one could wish for.

But it is even more worrying, in our view, that large parts of official Spain appear

complacent. The new government has delivered important reforms during the past 11months, but we think it is too early to believe that the work done is sufficient. If the

Spanish government does not continue its reform efforts constantly, its problems could

grow much bigger.

We expect that Spain will eventually have to ask the ESM for a precautionary credit line,

which will pave the way for the ECB to start buying Spanish government bonds. The

Spanish government would be well advised to adjust its fiscal targets for 2013 before

asking for help. The ECB will, in our view, not refrain from buying Spanish government

bonds when it becomes clear that Spain is likely to miss its 2013 targets, but fiscal targets

and consolidation efforts will then have to be renegotiated. In such a negotiation process

the European partners might demand additional reforms.

Spanish house price bubble

00 01 02 03 04 05 06 07 08 09 10 11

75

100

125

150

175

200

225

250

75

100

125

150

175

200

225

250

Spain

Index, 2000=100

Eurozone Ireland

Ireland,discontinued

Index, 2000=100


Wishful thinking

Real GDP Growth, % y/y

-5 -4 -3 -2 -1 0 1 2 3 4 5 6unemploymen

t,%-pointchange,y

/y

-7.5

-5.0

-2.5

0.0

2.5

5.0

7.5

10.0

+ 2 standarddeviations

Expected GDP growthand unemployment

Source: Reuters EcoWin, Danske Bank

ECB has helped

Jan

12

Mar May Jul Sep

1

2

3

4

5

6

7

1

2

3

4

5

6

7%, 2-year government bond yields

Spain

Italy



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Disclosure

This research report has been prepared by Danske Research, a division of Danske Bank A/S (Danske Bank).

The author of this research report is Frank land Hansen, Senior Economist.

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Danske-Spains unrealistic expectations