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Ernst & Young Eurozone Forecast

Spain
Spring edition, April 2011

Outlook for Spain
Ernst & Young Eurozone Forecast Spring 2011

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Highlights
Fiscal consolidation on track, but growth is still missing
• In the final three months of 2010, Spanish GDP increased by just 0.2%, only a marginal

improvement from the stagnation seen in Q3 2010. In 2010 as a whole, Spanish GDP shrank by 0.1%: fiscal consolidation and private sector deleveraging severely constrained domestic demand and the pull from foreign trade, which was instrumental in lifting growth in the other large Eurozone countries, proved too weak an offset. Fiscal consolidation has proceeded on schedule. Downside risks remain to the fore, related to a bleak outlook for domestic demand and ongoing uncertainty about the future health of the banking sector. Eurozone average. In 2012, growth is unlikely to exceed 1.1%. Private consumption is expected to remain depressed, as household income should remain under pressure from stubbornly high unemployment, which is not expected to decline significantly from its current levels, and from the adverse effect of the cut in public sector wages and government transfers that are part of the fiscal consolidation process. Moreover, deleveraging and uncertainty about employment are likely to keep the savings rate high. expected to slide marginally, thanks to the improvement in foreign demand, but residential capital expenditure should fall by another 12%, as the construction industry has to grapple with a difficult financial situation and lack of demand. with the main trade partners, accumulated since the adoption of the euro, needs farreaching structural reforms to boost productivity that are only implemented gradually and take time to bear fruit. However, weak import growth should lead net trade to provide a significant contribution to growth.

• Spanish GDP is expected to grow by just 0.6% in 2011, markedly underperforming the

• Investment should continue its fall this year, dropping by 2.8%. Non-residential investment is

• Export growth is expected to remain moderate, as unwinding the huge competitiveness gap

• Since the beginning of 2011, the Government has taken new and important measures to

restructure the banking system and, in particular, to strengthen capitalization in the ailing regional savings banking sector. A key concern is the amount of public money needed to recapitalize the system, which could escalate to €100 billion, far above the resources made available by the Government (€20 billion planned so far). In the meantime, banks are regaining access to the interbank market but non-performing loans (NPLs) are increasing and the large exposure to Portuguese debt could lead to a significant worsening in asset quality in the event of a debt restructure there. Credit conditions remain tight and this is going to affect domestic demand negatively going forward. according to schedule. The budget deficit for 2010 has been contained to an estimated 9.2% of GDP. If fiscal discipline continues (especially at the regional level), the deficit is forecast to shrink to 6.5% of GDP in 2011, not too far from the Government’s 6% target. However, bond markets remain nervous as the Government has to roll over nearly 25% of total debt in 2011. At over 200 basis points (bp) by the end of February, spreads over German Bunds have fallen by less than 50bp from the peak observed in the final months of 2010.

• Preliminary data for 2010 shows that the ambitious fiscal consolidation plan proceeds

Ernst & Young Eurozone Forecast Spring 2011 Spain

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Fiscal consolidation on track, but growth is still missing

Muted growth at the end of 2010 …
In the final three months of 2010, Spanish GDP increased by just 0.2%, only a marginal improvement from the stagnation seen in Q3 2010. The dynamic of the economy changed little through 2010, with domestic demand dragging down growth and net trade providing only a small contribution. In 2010 as a whole, Spanish GDP shrank by 0.1%, as the pull from foreign trade, which was instrumental in lifting growth in other Eurozone countries, proved too weak to counter the plunge in domestic demand. The first indications for 2011 do not point to a major turnaround. The Purchasing Managers’ Index (PMI) for March suggested that output only increased on account of foreign orders, while spare capacity remained large. Meanwhile, the services PMI pointed to only a tiny increase in activity. Both sectors reported a contraction in labor force. As a result, the unemployment rate has continued to increase this year, to 20.4% in January (on the International Labor Organization measure).

the cuts in public sector wages and government transfers that are part of the fiscal consolidation process. Growth in private sector wages are going to be limited by unemployment and the cap agreed in 2010. In addition, savings are expected to remain high at around 13% of disposable income, as uncertainty about employment should encourage precautionary savings. In addition, deleveraging of the Spanish household sector has barely started. Household debt has fallen only marginally from the pre-crisis peak and remains at 90% of GDP, around 20 percentage points (ppt) above the Eurozone average. As a consequence, private consumption is expected to increase by just 0.4% this year.

Investment to continue its slide as the construction sector remains weak
Investment is expected continue its fall and, in 2011, being 2.8% lower than the year before. The recovery in exports seen in 2010 has restored profitability in the manufacturing sector somewhat; together with relatively better prospects for demand, this should help limit the slide in non-residential investment. By contrast, residential investment is expected decrease by more than 12% this year. And we do not expect it to start rising before 2013. Saddled with strained balance sheets, the construction industry faces quite bleak prospects. The fall in house prices is likely to continue, as price-to-rent ratios suggest that housing is still overvalued. Tax incentives for house purchases in place until the end of 2010 and low interest rates are

… and GDP to increase by just 0.6% in 2011
Spanish GDP is forecast to grow by just 0.6%, markedly lower than the Eurozone average. In 2012, growth is unlikely to exceed 1.1%. Subdued domestic demand and a positive contribution from net trade should continue. Household income is expected remain under pressure from stubbornly high unemployment, which is not likely to decline significantly from its current levels, and from the adverse effects of

Table 1

Spain (annual percentage changes unless specified)
2010 GDP Private consumption Fixed investment Stockbuilding (% of GDP) Government consumption Exports of goods and services Imports of goods and services Consumer prices Unemployment rate (level) Current account balance (% of GDP) Government budget (% of GDP) Government debt (% of GDP) ECB main refinancing rate (%) Euro effective exchange rate (1995 = 100) Exchange rate ($ per €) -0.1 1.2 -7.6 0.4 -0.7 10.3 5.4 2.0 20.1 -4.5 -9.2 62.0 1.0 120.8 1.33 2011 0.6 0.4 -2.8 0.5 -1.1 6.1 1.9 2.9 20.6 -3.7 -6.5 67.5 1.3 119.4 1.36 2012 1.1 0.7 1.5 0.4 -0.9 7.0 4.7 1.6 20.0 -3.1 -4.7 70.8 2.3 117.0 1.28 2013 1.8 0.8 3.4 0.8 0.1 8.0 7.0 1.4 19.2 -2.8 -3.3 71.8 3.1 116.0 1.25

Source: Oxford Economics 2014 1.9 1.1 4.4 1.1 1.3 6.6 7.0 1.5 18.6 -2.6 -2.8 72.1 3.5 114.9 1.24 2015 1.9 1.4 5.2 0.8 2.3 6.7 7.0 1.5 17.7 -2.1 -2.5 72.1 3.9 114.1 1.23

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Ernst & Young Eurozone Forecast Spring 2011 Spain

Figure 1

Figure 2

GDP and industrial production
% year 10 GDP Forecast

Unemployment rate
% 25 Forecast

5 20 Industrial production 15 -10

0

-5

-15

10

-20 5 1980 1984 1988 1992 1996 2000 2004 2008 2012 1980 1984 1988 1992 1996 2000 2004 2008 2012

-25

Source: Oxford Economics

Source: Oxford Economics

likely to have prevented a steeper fall in prices so far. As these factors no longer support the housing markets, very large declines in prices seem likely. Moreover, despite the pickup in sales seen in Q3 2010 (due to the anticipation of the end of tax incentives), the backlog of unsold homes remains large. According to Bank of Spain’s estimates, there are between 700,000 and over a million unsold homes, corresponding to over three years’ worth of sales. Moreover, credit conditions remain tight. According to the latest Bank of Spain’s Bank Lending Survey for Q1 2011, the significant tightening seen in the first part of 2010 has not been relaxed, and the majority of banks continue to report an increase in interest margins. Tighter and more costly credit is expected to act as an additional drag on domestic demand and, in turn, threaten the relative stability of the banking sector. Investment is forecast to increase by only 1.5% in 2012 and may accelerate to 3.4% the following year.

All in all, in the medium term, the Spanish economy is expected see growth rates much lower than those enjoyed in the boom years, and we forecast GDP growth below 2% per year until 2015.

Inflation expected to come back down
Subdued domestic demand should put a lid on inflation in the medium term. The rise in inflation since the end of 2010, which has seen consumer prices increase by 3% year on year in January (harmonized measure), has been mostly accounted for by the spike in energy prices and last July’s increase in VAT. Inflation should remain above 3% during H1, but it is expected to come back down later this year in line with the forecast moderation in energy prices and as the impact of the VAT increase drops out of the calculations, averaging 2.9% for the year as a whole. In the medium term, inflation is projected to remain below the Eurozone average, at around 1.5%, as Spain tries to regain competitiveness.

Health of the banking sector key uncertainty
Our baseline forecast assumes a gradual but effective resolution of the problems affecting the banking sector. Some important policy measures have been taken and, on the whole, the situation has improved since the final months of 2010, but the possibility of a marked deterioration, leading possibly to a state bailout, cannot be ruled out. The health of the banking sector constitutes a key risk to our forecast. The most important policy initiatives taken are aimed at overhauling the regional savings banking sector (cajas), in order to tackle its low capitalization and large dependence on wholesale funding. At the beginning of 2010, the Government implemented a series of reforms aimed at strengthening the sector, by merging the cajas and improving their governance. The number of banks has dropped from 45 to 17, and average total assets per institution have more than doubled, which should improve efficiency.

Only net exports to provide a positive contribution to growth
Given bleak prospects for domestic demand, only exports could provide some pull to the economy, but Spanish exporters have to grapple with structural competitiveness problems. Between 1999 and 2010, Spain’s real exchange rate has appreciated by 22%, as opposed to the 2% appreciation of the Eurozone average and the over 10% depreciation experienced in Germany. Wage moderation is expected to bring about some small competitiveness gains going forward, but undoing the losses accumulated in the past decade requires substantial improvements in productivity resulting from structural reforms, which take time to implement and bear fruit only slowly.

Ernst & Young Eurozone Forecast Spring 2011 Spain

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Fiscal consolidation on track, but growth is still missing

Figure 3

Figure 4

Contributions to GDP growth
% year 8 6 GDP 4 2 0 -2 -4 -6 -8 1985 1988 1991 1994 1997 2000 2003 2006 2009 2012 2015 Net exports Domestic demand Forecast

Government balance and debt
% of GDP 4 2 0 -2 -4 -6 -8 -10 -12 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 Government budget balance (left-hand side) Government debt (right-hand side) % of GDP Forecast 80 70 60 50 40 30 20 10 0

Source: Oxford Economics

Source: Oxford Economics

Moreover, in February 2011, new measures were put in place to strengthen capitalization. Banks will have to raise the capital needed on the market, sell assets or tap temporarily into a governmentsponsored fund that would amount to a partial nationalization. According to central bank estimates, the capital shortfall to be filled by public money will not exceed a manageable €20 billion, but other analyses put the amount of resources needed as high as €100 billion, given the uncertainty surrounding the quality of assets linked to the construction sector. Such a sum would far exceed the amount of resources set aside by the Government to restructure the banking sector and would jeopardize fiscal restructuring. Meanwhile, Spanish banks have succeeded in regaining access to the interbank market and have greatly reduced their dependence on the European Central Bank (ECB). In January 2011, loans from the ECB have dropped to €53 billion, less than half the amount borrowed at the peak last June. However, the weak economic situation is continuing to erode the quality of banks’ assets. In December 2010, the ratio of NPLs to total credit climbed to a 15-year high of 5.8%. Bad loans may continue to increase as they normally lag economic activity. An additional source of risk stems from the large exposure of the Spanish banking sector to Portugal. According to analysts’ estimates, Spanish banks own roughly a third of Portugal’s foreign debt (which is 60% of total debt). Any loss triggered by a Portuguese debt restructuring would inevitably have a sharp adverse impact on Spanish banks’ balance sheets.

Fiscal consolidation appears on track
Better news is coming from public finances. Preliminary data for 2010 shows that the ambitious fiscal consolidation plan is proceeding according to schedule. The budget deficit for 2010 has been contained to an estimated 9.2% of GDP. If fiscal discipline continues to be enforced, budget deficit will shrink to 6.5% of GDP in 2011, not too far from the Government’s 6% target. However, most of the improvement has come so far from the better-than-expected performance of the central government. According to the Ministry of Finance, more than half of the regions (including the biggest one, Catalunya) have missed their deficit reduction targets and will be obliged to step up the fiscal retrenchment measures in 2011. Yet, the improvement in fiscal balances has so far failed to impress bond markets, which remain nervous, as the Government has to roll over nearly 25% of total debt this year. At over 200bp by the beginning of March, spreads over German Bunds have fallen by less than 50bp from the peak observed in the final months of last year. While they remain low in comparison to those on Portuguese and Irish bonds, the burden of interest payments on government finances remains substantial. These latent tensions in the Spanish government bond markets imply that any slippage in fiscal consolidation, for instance from regional governments, could have a significant impact on the cost of borrowing and the sustainability of public finances.

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Ernst & Young Eurozone Forecast Spring 2011 Spain

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