The Spanish economy has been a driving force for economic activity in the euro area for more than a decade, with year-on-year GDP growth exceeding the average rate of expansion in the euro area in every quarter since 1995. The good times are now over. Turmoil in the world's financial markets has coincided with the bursting of Spain's decade-long housing bubble, raising fears of a deeper and more abrupt economic slowdown than previously thought.

Gloom time

The weakness began last year in the housing market—the major driver of the Spanish economy over the last ten years—with a decline in residential building permits of 11% in 2007 (in the fourth quarter alone the number of permits slumped by a disturbing 29% year on year). And the danger signs are now spreading to other sectors of the economy. Price-adjusted retail sales contracted by around 2% year on year in each of the three months to February 2008, while consumer confidence fell back to its lowest level for more than a decade in the first quarter. The manufacturing sector is also taking a hit. According to Eurostat data, year-on-year growth in manufacturing orders has slowed down markedly since the start of 2008, with the European Commission's business confidence survey revealing that sentiment in the services industry in March had fallen to its weakest level since the inception of the survey in 1996 (admittedly a good period for the Spanish economy).

The Economist Intelligence Unit has cut its forecast for Spanish GDP growth to just 1% in both 2008 and in 2009 (previously 1.9% in both years), compared with an annual average rate of expansion of 3.8% in 1998-2007. The Economist magazine poll of major forecasters from April 19th still showed average forecasts of 2.4% for 2008 and 2.1% for 2009. Despite being well below consensus, we still see the risks primarily on the downside, particularly for 2009. The main reason for our pessimism stems from our view that construction and housing booms rarely peter out smoothly.

Unstable foundations

Spain has clearly gone through such a boom over the past ten years. One of the clearest indicators of this has been the rising share of residential investment to GDP, which increased to 9.3% in 2006 and 2007, compared with an average for Spain since the early 1970s of 5.5% and a current average of around 6.5% for industrialised economies. Rising employment in the construction sector has accounted for a substantial share of overall employment growth in recent years, while house prices are estimated to have increased by 190% between 1997 and 2007—only Ireland and the UK have experienced a similar hike in prices among major industrialised countries. At the same time, household liabilities surged from 47% of disposable income at the end of 1997 to 135% at the end of 2007. Although this was backed in part by easier access to borrowing resulting from lower interest rates (a consequence of euro area accession), it has also reflected increased leverage among consumers. That said, further rises are now unlikely given the tightening in credit conditions in response to continued financial market uncertainty.

A return to a more normal level of housing investment would take off some 3 percentage points of GDP, and in order to absorb earlier excess construction, a temporary fall to below the normal level would probably be necessary. The experience of Sweden, where housing investment declined by 71% between the peak in 1990 and the first (not final) trough in 1995, suggests that such adjustments can be dramatic. Apart from the direct effect of weaker construction investment, private consumption would also be affected by a decline in consumer confidence and negative wealth effects. Most estimates suggest that these wealth effects would be weaker than in the UK or the US, not least because conditions for home equity withdrawal in Spain are more stringent. However, the high level of household indebtedness and the extraordinarily high current-account deficit (a measure of savings of the economy as a whole)—which widened to an estimated 9.1% of GDP in 2007—suggests substantial potential for an increase in household savings, which automatically would depress private consumption.

Financial fears

All these strains will be tough on the Spanish economy. The global financial sector crisis has started to contribute to the pain by tightening access to credit, a serious concern for an economy showing signs of excessive leverage. However, the domestic financial sector seems unlikely to be a major source of trouble itself; it is more likely to be the victim of problems created elsewhere in the Spanish economy and internationally. Spanish covered bonds (the principal instrument for banks to finance housing loans) are backed by mortgages, but the banks retain ultimate responsibility for the repayment of the bonds. This means that unlike banks and housing lenders in the US, Spanish institutions had no incentive to sell mortgages to borrowers who could not afford to repay them. Consequently, there is no equivalent to the sub-prime mortgage lending sector in Spain. Spanish banks also have full recourse to all the assets of a defaulting borrower. In the US, banks only have access to the house for which the mortgage was issued, so that borrowers with negative equity have a strong incentive to default.

This firmer incentive structure suggests that the impact on the Spanish financial system will be less dramatic. However, the size of the housing overhang means it will still be a massive hit. Miguel Ángel Fernández Ordóñez, the governor of the Bank of Spain (the Spanish central bank), which has key responsibilities for banking supervision, said in a speech on April 16th that banks have built provisions and buffers "that would enable shocks of an order of magnitude comparable to those experienced at the height of the crisis in the 1990s to be absorbed". Although data suggest that the economy is in a better position to cope with a crisis than was the case in the early 1990s, when growth slowed to 0.9% in 1992 and contracted by 1% in 1993—at that time the public finances were in deficit, unemployment had risen to over 20% and inflation was higher than it is currently—the continued uncertainty in the international financial markets means that the downturn could be just as bad and take much longer to absorb.

Limited manoeuvre

Apart from the scale of the recent housing boom, policy constraints are an important factor that could have a detrimental effect. Although there are downside risks to growth prospects for many euro area countries, the Spanish economy is likely to perform much worse than the euro area as a whole. Monetary policy for the euro area is generally conducted with a view to the euro area in aggregate, and with Spain's economy accounting for just under 12% of euro area GDP, the European Central Bank will not take much action aimed specifically at stimulating the Spanish economy. With Spain being a member of the euro area (and a departure from the club out of the question), a devaluation of the currency to improve competitiveness and boost export demand is also not an option (although the high, and rising, current-account deficit would suggest a serious overvaluation).

The fiscal situation may be brighter, but support would still be limited. The general government budget balance showed a solid surplus of 2.2% of GDP in 2007. However, the surplus has been boosted in recent years by strong economic activity, and a period of slower growth would lead to a much weaker outcome (the downturn in 1992 led to a deterioration in the fiscal balance of 3.3 percentage points in just one year). The government is in the process of approving a fiscal stimulus package worth €10bn (US$16bn), which includes a €400 annual rebate to every taxpayer, and can be expected to boost public infrastructure investment in an effort to sustain activity and employment in the construction sector. With social spending set to rise as the slowdown deepens, the government's budget surplus is likely to evaporate quickly. Although Spain's low level of government debt—an estimated 35.2% of GDP in 2007—suggests ample room for stimulus measures, the restrictions of the EU's Stability and Growth Pact, which requires the budget deficit to be kept below 3% of GDP, will put a rein on fiscal expansion.