Growing through domestic demand: a double-edged sword

The summer has helped to strengthen the Spanish economy. Although the main European economies have posted worse figures than expected, and in some cases even worrying figures, the Spanish recovery seems to be gaining traction little by little, something that is finally being noticed in the labour market. There are therefore reasons to be optimistic. We must be as cautious as possible, however, due to at least three reasons. Firstly, part of this upswing
in activity is being supported by temporary factors such as decisions to consume or invest being taken that had been proposed during the years of crisis. Secondly, the recovery depends almost entirely on domestic demand, undoing
the external rebalancing achieved over the last few years. Thirdly, although the Spanish economy has managed to remain relatively insulated from Europe's weak performance so far, its resilience is limited. We will now analyse these issues in more detail.

Domestic demand has taken over from the foreign sector as the driver of GDP growth in 2014 Q2. As expected, both household consumption and investment have posted considerable growth rates. Specifically, household consumption advanced by 0.7% quarter-on-quarter and has grown by an average of 0.6% for the last four quarters. This has pushed the year-on-year rate of change above 2%, at 2.4% specifically. Investment is also recovering strongly, in this case thanks particularly to investment in capital goods (+2.1% quarter-on-quarter) which, given its good performance, is likely to end the year with an almost double digit growth rate. Investment in construction also made notable progress in 2014 Q2 (+0.9% quarter-on-quarter). On the other hand, public expenditure remained the same after a surprising increase in Q1 and is likely to post negative figures for the next few quarters to ensure the government meets the deficit reduction targets agreed with Brussels.

The other side of the coin for Spain's economic growth: a deteriorating external balance. Both exports of goods and services picked up again in Q2 with quarterly growth of 1.4% and 1.2% respectively but this was not enough to offset the sharp rise in imports. These rose by 1.9%, a figure that may not seem much higher than exports but, given that this gap has occurred over the last few quarters, in year-on-year terms the difference is greater: 3.9% for imports compared with 1.7% for exports. This key support for the Spanish economy during the years of recession has disappeared quickly once domestic demand started to recover. For the moment, the result is that, in June, the current account balance once again fell into negative figures. Specifically, in cumulative terms over the last 12 months, the current account balance decreased by just over 1 billion euros (compared with a rise of almost 8 billion euros in December 2013).

The recovery in domestic demand looks like continuing, as suggested by the main leading indicators. Consumer confidence, for example, is still following an upward trend in spite of the ups and downs of the last few months and is consolidating at levels that have not been seen for several years. Other good indicators for demand, such as the sales
of large companies or automobile sales, with 2.0% and 17.2% growth year-on-year respectively, point in the same direction. However, it is important to note that the household savings rate is at an all-time low; this fell to 9.4% of the gross disposable income of households in 2014 Q1, a figure that, according to all indications, will continue to fall in the short term until the recovery in the labour market builds up steam.

The improvement in the labour market is becoming stronger and broader. The LFS for Q2 suggests that the labour market has finally started to reflect the recovery in economic activity. The number of employed increased by 402,400 people, its largest rise since the start of the crisis. Discounting seasonal effects, employment grew by 1.0% quarter-on-quarter compared with 0.1% in 2014 Q1. It is significant that this revival has not appeared exclusively in the services industry: industry has also reported positive growth. It also seems as if this progress by employment has started to alleviate the discouraging effect as the labour force, which had been shrinking for several quarters, increased by 92,000 people and the unemployment rate therefore fell by 1.45 p.p. down to 24.5%. The data for workers affiliated to Social Security in July continue to point to a recovery in the labour market although the rate of growth slowed down slightly compared with previous months. Although these figures are good in general, a significant proportion of this recovery is being supported by tourism, which continues to break records in 2014. The figures for the coming months will therefore be crucial to determine just how solid this recovery in employment may be.

Business indicators are withstanding Europe's increased weakness, for the moment. Unlike the data coming from the main countries on the Old Continent, the different leading indicators for activity in the Spanish economy are still enjoying an upward trend. The PMI for manufacturing, for example, continued to rise in July. Although this might be interpreted as a sign of a strong economic recovery in Spain, it is important to remain cautious. Part of this upswing in activity is a result of improved confidence in the Spanish economy's growth capacity, leading to decisions to consume or invest being taken that had been postponed during the years of recession. The underlying trend, therefore, is lower than the observed trend. Moreover, although the Spanish economy may have diversified its exports over the last few years, its relative weight of trade with the rest of the European countries is still substantial, so if the European situation becomes entrenched, sooner or later Spain will notice its effects.

Inflation is not responding to the higher growth rates and falls to negative figures. In August it stood at –0.5% (–0.3%
in July), driven by the fall in lubricant and fuel prices compared with the rise seen in 2013. Part of the answer to why, within a context of economic recovery, the inflation rate has a downward trend can be found in the fact that it is the most volatile components, such as those previously mentioned and also food prices, that have been pushing down inflation over the last few months. Core inflation has remained stable for several months at around 0.0% and is not expected to start any downward slide in the near future. However, we must remember that, although activity has enjoyed positive growth rates for the last four quarters, industrial capacity utilisation is still relatively low and wages contained, helping the economy to continue gaining in competitiveness. This explains why inflation is taking longer than usual to recover.

The adjustment of the general government deficit is progressing at a good pace thanks to higher revenue and improved financing terms. In July, the government deficit stood at 3.1% of GDP, 0.5 p.p. less than the balance for 2013. To a large extent, this improvement is thanks to the economy's greater growth, which has helped to increase tax revenue and a decrease in transfers to other public administrations is also playing an important role. Public expenditure has been contained, essentially due to improved financial conditions. For example, the bills issued in August closed with a yield close to 0% and the spread between the yield on ten-year Spanish bonds and their German equivalent was just 130 b.p. in August. However, although the government looks like meeting its deficit target, it must not let its guard down.

Further signs of improving bank activity. In June the decline in the credit balance eased (from –6.9% to –6.3%  year-on-year) and the drop in the NPL ratio speeded up (13.06% compared with 13.62% in December 2013). One particularly positive note was the revival in new loans, especially for household consumption and SMEs. Specifically, in July 12.44% more new loans were granted to SMEs than in the same month in 2013 (and 4.72% more than in July 2012). We expect the results of the stress tests on banks, to be announced in October, to help stabilise the banking sector and consolidate this revival in loans.