Morgan Stanley Research, The New Spain

The New Spain
The Spanish economy looks set to grow again. But
whether a subpar recovery turns into a more
sustained upswing hangs on where Spain is in the
process of deleveraging, rebalancing and
reforming. There’s more to do, but we’re more
constructive than market expectations on Spain’s
ability to set itself apart from the rest of the
periphery in the medium term.
Exiting recession: GDP should have troughed. We
expect above-consensus growth of close to 1% on
average in 2014-15. That’s good news, but it’s also only
one quarter the pre-crisis pace of growth.
Continuing to reform: The momentum remains strong,
with measures being announced and implemented in
many areas. This should lift potential GDP and, in time,
help boost job creation.
An export-led recovery: Exports are structurally
strong. They’re growing, also as a share of GDP, as
competitiveness is improving courtesy of wage
moderation – in part due to labour market reforms.
Job market stress: Domestic demand is likely to stay
weak. Our worry is not that unemployment will go much
higher. It’s that it will not come down quickly.
Housing market vs. construction investment: House
prices will likely fall further, but the bubble in (residential)
construction investment has almost fully corrected.
Thus, it should cut less into GDP growth.
Deleveraging across the board: The current account
is now in surplus, but external debt remains elevated.
The public finances are not yet stabilised. Balance-sheet
repair is more advanced for corporates than consumers.
Banks’ health: Banks have provisioned c. €250 billion
(14% of their loan books) and raised €130 billion of
capital since 2008. The increased coverage levels in
real estate, together with the 2012 stress tests, lead us
to believe the sector is now more reasonably capitalised.

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The New Spain
Summary & Conclusions
Troughing – then what?
Spain’s economic path is at a turning point – with GDP growth
likely to have stabilised or even become (fractionally) positive
in 3Q after eight outright contractions in a row. But the strength
and sustainability of the recovery in the ‘new Spain’ depends
crucially on where we are in the process of:
 Deleveraging in the private and public sectors at large,
along with fixing the banking system and dealing with the
housing downturn.
 Rebalancing the economic model away from domestic
demand and into exports, with a particular focus on
recouping previous competiveness losses.
 Reforming the labour, product and services markets to
facilitate price and quantity adjustments, with a view to
strengthening Spain’s economic fabric.
This report argues that dealing with balance-sheet repair is
necessary. But a quick economic turnaround, and a
resumption of job creation, appears unlikely as long as
this process continues. So, the outlook is vulnerable to
setbacks, and very high unemployment rates for a protracted
period of time, a larger than expected adjustment of the
housing market, and more unfavourable financial conditions
are all key risks.
Yet Spain’s export engine continues to strengthen, external
and fiscal imbalances are being gradually corrected, and
structural measures keep coming on many fronts. All this is
likely to bring, slowly but surely, a more sustained pace of GDP
expansion, characterised by less boom-bust dynamics than in
the pre-crisis years. This makes us fundamentally more
constructive on Spain’s ability to set itself apart from the
rest of the eurozone periphery in the medium term.
On the macro outlook
Our more positive view than the consensus is based on:
1. The economic cycle has stabilised. We expect zero-ish
GDP growth in 3Q, and a very gradual pick-up thereafter to
an above-consensus 0.8% for the whole of 2014.
2. Structural reforms have progressed more than anywhere
else in the periphery. While there’s more to do, decisive
action might exert a positive impact further down the line.
3. Firms’ competitiveness is improving, courtesy of wage
moderation and reforms; the current account surplus
should increase further, exports are likely to outperform.
4. We doubt that the jobless rate will go much higher, but
we’re worried that it will not come down quickly.
5. House prices will likely fall further, but the bubble in
residential construction investment has almost fully
corrected; thus, it should cut less into GDP growth.
6. Belt-tightening is still not very advanced for the household
sector. But there is evidence of good progress on the
corporate side.
7. Government debt is high and rising. But the budget
deficit is narrowing and important reforms are happening in
this area too