Weaknesses pose tough challenges

Only three months ago, José Luis Rodríguez Zapatero, Spain’s prime minister, was reassuring the country that his Socialist government had no plans to raise taxes to help bring the country’s crisis-stricken finances under control.

Mr Zapatero – now under fire not only from business and the conservative opposition but also from some members of his own party for his haphazard handling of the economic crisis – has changed his tune since.

With the 2009 budget deficit expected to exceed 10 per cent of gross domestic product, he has been obliged to backtrack and approve a series of unpopular tax increases.

Last weekend, the cabinet approved a 2010 “austerity” budget marked by rises in value added tax, higher tax on interest income and capital gains, and more personal income tax. The government also promised to cut its own spending, but few independent economists believe the measures will be enough to bring the public finances under control.

The government, in a view shared by many prominent Spanish bankers and business leaders, nevertheless believes Spain has been unfairly portrayed abroad during the crisis as “the sick man of Europe”, when its economy has actually shrunk less than those of most of its European neighbours: latest GDP statistics show Spain contracting 4.2 per cent over the past year, compared with 4.7 per cent for the eurozone.

Mr Zapatero, furthermore, has insisted that he intends to bring the budget deficit down to the widely ignored European Union limit of 3 per cent of GDP by 2012.

“We believe in increasing the effort to modernise our productive model, both to improve its competitiveness and to give it greater stability in the face of the changing economic cycle,” he told parliament last month.

Unfortunately for Spain, other data puts the economy in a less favourable light. Although the Spanish recession has so far been relatively shallow in terms of GDP because of the economy’s heavy dependence on imports, domestic demand has declined steeply and even GDP growth is unlikely to be restored before next year – leaving Spain as one of the last European countries to emerge from recession.

Unemployment, furthermore, has topped 4m or 18.5 per cent of the workforce – the worst in the eurozone – and is predicted to rise further to more than 20 per cent. Traffic at Spanish ports tells the story of a construction-dependent economy badly affected by the crisis: in the seven months to July, the tonnage handled fell nearly 17 per cent from the same period in 2008, according to the state ports authority.

Few in Spain would argue with Mr Zapatero’s call for improved competitiveness and investment in innovation, or with the thrust of his slogan “menos ladrillo, más ordenadores” (“less bricks and mortar, more computers”).

But there is heated debate about how to achieve these aims. Employers have complained about the relentless rise of the wages and numbers of civil servants, both in the central government and in the 17 autonomous regions. Miguel Angel Fernández Ordoñez, governor of the Bank of Spain, has expressed concern about the deficit and joined the campaign for a more flexible labour market.

An increasingly embattled Mr Zapatero and Elena Salgado, his finance minister, have responded with acerbic populism, criticising chief executives as overpaid and undertaxed and saying it is corporate life, not the labour market, that is in urgent need of reform. Mr Zapatero was quoted as telling a Socialist party meeting that the central bank governor had taken to “pontificating”.

Spain entered the crisis in a strong fiscal position after years of growth fuelled by what turned out to be an unsustainable boom in construction. Accumulated public debt amounted to less than 40 per cent of GDP and although the debt is likely to double within a few years as a result of the crisis, Spain still compares favourably with its European peers.

The country’s biggest companies and a few of its smaller ones – Iberdrola and Acciona in renewable energy, Inditex in clothing and the upstart Panda in internet security, for example – have diversified their risks by expanding abroad and are highly regarded by their competitors.

“Spanish businesses have become so international,” says John Scott, chairman of KPMG in Spain. “The quality of Spanish management has improved radically over the past 15 years.”

Reflecting its long record of growth and “convergence” with its European neighbours since the impoverished 1950s and 1960s, Spain continues to be one of the world’s biggest players in both outward and inward foreign direct investment.

And in spite of the property bust that has weighed down the banking system with bad debts, larger and more internationalised banks are emerging from the crisis relatively strong, having escaped the crippling damage inflicted on international rivals by US subprime mortgage lending and off-balance-sheet assets.

Yet the Spanish economy also suffers from severe structural weaknesses. The labour-intensive real estate and tourism sectors, which flourished in the past few years, have been badly affected by the crisis, while high-tech sectors such as biopharmaceuticals still make up only a tiny proportion of output and exports. Education has improved, but its quality still trails that of Spain’s main rivals.

Recent surveys show Spain slipping down the rankings in competitiveness and ease of doing business, in part because of its impenetrable bureaucracy. In the World Bank’s latest Doing Business Survey, Spain overall sank 11 places in a year to 62nd out of 183, and for opening a new business it ranked a dismal 146th, the worst in the EU.

Spain was also down – by four places to 33rd out of 133 – in the World Economic Forum’s 2009-10 Global Competitiveness Index.

Some foreign investors and foreign tourists say a long period of almost effortless growth has made Spanish companies dangerously complacent about the quality and prices of the services they sell. It came as a surprise to many Spaniards – but not to outsiders – when in an August report the Organisation for Economic Cooperation and Development calculated that Spain was the most expensive developed economy for mobile telephony, except the US.

As Mr Zapatero has suggested, Spain – which as a member of the eurozone cannot devalue its way out of trouble as it used to do – needs to promote high-tech industries and reduce its reliance on homebuilding. But it also needs to modernise a labour market divided between privileged permanent employees too expensive to fire and an underclass of temporary workers, boost the supply of credit to smaller companies and encourage risk-taking in the real economy.

“We don’t actually structure things to help entrepreneurs. We structure things to help people take advantage of an opportunity and make a quick sale,” says KPMG’s Mr Scott.

Antonio Garrigues, veteran chairman of the Garrigues law firm, is calling for a truce between left and right in Spanish politics to help haul the country out of the crisis. He says Spain risks becoming “a second-class” economy without fundamental reforms.

“The problem with Spain has been that growth was so easy that the serious things were abandoned and forgotten – like technical education, competition and labour reform,” he says.

Achieving the necessary reforms is likely to take years. Until then, Spain faces months of economic winter as harsh as the approaching frost on the sierra north of Madrid.

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