Spain trying to get its casa in order: Country's debt may shoot past IMF estimates

Spain is still in recession, but could be turning the corner and returning to growth. The country still needs a strong recovery to reduce unemployment and avoid higher public sector debt according to a new note from Capital Economics.

Roger Bootle, Capital Economics:

Thanks to the ECB’s OMT programme, government bond yields are back to more manageable levels. What’s more, the worst of the fiscal squeeze has now passed, the labour market downturn has eased, exports are expanding strongly and progress has been made to reform the economy and support the banks.

But Spain still faces major challenges. First, the labour market improvement may be a bit misleading as it probably partly reflects firms taking advantage of new labour laws and cutting hours and pay rather than headcounts. With wages also likely to fall in response to the past increases in unemployment, labour incomes look set to continue to decline for some time yet.

Second, the high level of household debt, the very low household saving rate and the prospect of further falls in house prices also point to further falls in household spending. Third, tight credit conditions and the need for further deleveraging suggest that firms will remain reluctant to invest. And a further prolonged period of weakness in the construction sector also appears likely.

Fourth, the Spanish economy is relatively closed by European standards and growth in the eurozone, Spain’s biggest export market, looks set to be fairly subdued. Accordingly, export growth is unlikely to be strong enough to drag the economy out of recession single-handedly.

Given all this, we think that the Government’s outlook for growth is too optimistic – we see GDP falling by about 0.5% next year and stagnating in 2015.

We think that the peak in the debt to GDP ratio will be far higher than the 105% or so that the IMF assumes. It is conceivable that the ratio could rise to about 140% by 2020.