Spain: The Most Complicated Economic Environment in Decades

"The reality," concedes banker Enrique Casanueva after listing Spain's advantages in the face of a deepening global financial crisis, "is that this economy has grown a lot because we have built lots of houses."

Hundreds of thousands of those houses - in what seemed a virtuous circle, their construction was both a cause and an effect of Spain's rapid growth - now lie empty and unsold along the coast and on the fringes of big cities. The residential property market has crashed, and the worst hit developers are bankrupt. Unemployment has surpassed 11 per cent of the workforce and is rising fast.

Economists say a recession is looming, or already under way. After that, says Mr Casanueva, who heads JP Morgan Chase in Spain and Portugal, "there's no reason for a rebound. So the probable scenario is a stable, low-growth situation for several years."

A few weeks ago, such a gloomy prognosis would have been angrily rejected by the Socialist government of José Luis Rodríguez Zapatero as unduly pessimistic. Today, even ministers admit the gravity of the situation. "This is possibly the most complicated economic environment in decades," said Pedro Solbes, finance minister, when he announced details of an austerity budget for 2009 last month.

That is not to deny the real strengths of the Spanish economy. In the past two decades, Spanish companies, underpinned by a statefinanced programme to build a modern transport infrastructure, have become more diversified, international and entrepreneurial.

Although Spaniards accept that construction and property have dominated their economy for too long, companies in other sectors, from fashion to wind power, have begun to punch above their weight internationally.

"We are much more internationalised than we were 10 years ago and the economy in many ways is stronger," says Alfredo Pastor, economics professor at Iese, the Barcelona business school.

José Miguel Andrés, country managing partner of Ernst & Young, says companies such as Telefónica in telecommunications or Iberdrola in energy have improved dramatically over the past decade.

"There is no comparison in terms of personnel and diversification," he says.

The proof of this is in the statistics. Foreign direct investment into Spain last year hit a record $53.4bn, but outward investment, also a record, was more than double that at $119.6bn, according to the UN Conference on Trade and Development.

Javier Sanz, chief executive of Interes, the Spanish investment promotion agency, is anxious to change perceptions that Spain is largely dependent on construction, arguing that sectors such as information technology and renewable energy have recently been growing at a faster rate than in other European countries.

Inditex, with its Zara brand, has become a global role model for delivering just-in-time, affordable fashion to demanding consumers. Abengoa, among other things, sells technology for solar power systems. Smaller companies, many family owned, have become internationally competitive in sectors such as auto parts. BBVA, the bank, owns Bancomer, Mexico's largest, and makes 44 per cent of its profit in Latin America. And Santander, the biggest bank in Spain, has snapped up no less than three UK banks in the past four years.

The Bank of Spain's conservative approach to bad loan provisioning and its distaste for assets held off the balance sheet have protected Spanish commercial banks from the worst of the crisis over sub-prime loans and toxic securitised products.

Spain, however, has not escaped the credit crunch or the fallout from bank failures in the US, the UK and continental Europe. As this report went to press, Mr Zapatero announced a €30-50bn plan to buy assets of Spanish banks - healthy assets, not toxic ones, he insisted - so that the banks could continue supplying credit to companies and individuals in spite of the dearth of interbank lending.

Spanish banks, meanwhile, are entering a more conventional crisis arising from the domestic property crash and the accumulation of bad loans. Sales of new homes have almost entirely stopped, and some property brokers say a recovery could be three or four years away.

Spaniards are already feeling the effects of this on the broader economy. Consumption is being squeezed. Construction companies and car factories have laid off thousands of workers, pushing the number of unemployed over 2.5m and provoking the first stirrings of racial tension in a society that has until now been tolerant of millions of legal and illegal immigrants from north Africa, Latin America and eastern Europe.

In finance, deal flow has declined sharply. Among the few promising fields is the trade in distressed assets and the almost inevitable mergers and acquisitions involving some of the weaker cajas , the regional savings and loans institutions. According to Ernst & Young, the level of announced M&A transactions involving advisers fell to €53bn in the first half of this year, about a quarter of the €205bn recorded in the same period of 2007.

A more fundamental sign of fragility is the yawning current account deficit, which peaked at over 10 per cent of gross domestic product in 2007 as Spain borrowed at modest interest rates from the rest of the world to finance over-investment in real estate and unsustainable consumption.

Once, Spain would have been forced to devalue the peseta in order to rebalance its economy. Now that it is part of the eurozone, Spaniards will have to tighten their belts. Indeed, the latest statistics suggest that the process is already under way and that the current account deficit is falling as import growth slows.

"We have enjoyed the benefits of the euro for a number of years and now we are suffering the costs of the euro," says Prof Pastor of Iese. "My impression is that we are probably going to have a few years of slow growth."

Economic liberals would argue that this would be an ideal moment to trim Spain's bureaucracy and liberalise the highly regulated formal labour market.

Psychologically, however, this will be a difficult time for politicians and chief executives to take bold steps. The country's population and its companies have become used to seeing their developing post-war economy and their corporate profits grow faster than the European average, and they have tended to regard any criticism of Spain's economic performance as an affront to national pride.

"For the past eight years, we've been used to profits growing at 20 or even 30 per cent," says Mr Andrés of Ernst & Young. Single-digit growth, or even a decline in profits, may not be a grave problem but is nevertheless dispiriting for those accustomed to good times. "The problem is cultural."

The chief executive of one of the country's big infrastructure companies takes a similar view. "The adjustment will be bigger than in the rest of Europe, because we were growing faster and we were taking funds from the rest of Europe," he says.

Spain, by and large, has caught up with its European neighbours. Crisis or no crisis, it will therefore have to learn to live with the more staid performance of a developed economy.

Story from FT.com

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