Otherwise, it may be in Spain's best interests to depart the euro zone, even if the short-term costs of quitting the currency may seem prohibitively large.
“Thanks to its large fiscal stimulus, Spain appears to have avoided an economic meltdown,” said Capital Economics Ltd. (CE) In London
“But with the Government now embarking on a long and punishing bout of austerity, Spain may soon re-enter recession... If the economy is to return to a more even keel then it will have to go through a prolonged period of stagnation at best. ”
Indeed, they add, since Spanish companies and households are still sitting on mountains of debt and given a need for a long bout of deflation to restore external balance, Spain may yet suffer its own “lost decade”.
“Against this backdrop, the Government will struggle to reduce its budget deficit over the coming years,” CE stated.
“If it is also forced to implement an expensive bailout of the banking sector, public debt might eventually peak at around 120% of GDP – on a par with the current level in Greece.”
Despite all this, CE believes Spain can still get its public debt down to a more sustainable level in the medium term without defaulting.
“But it is questionable whether it will be willing to accept a decade of deflation in order to restore full competitiveness,” CE cautioned.
“For now, there remains a strong political will to remain in the euro-zone and the Government is optimistic about the prospects for growth, meaning that Spain is unlikely to abandon the euro any
time soon. But if Spain is still mired in recession a few years down the line, with no end in sight, support for the euro could begin to disintegrate.”
If, say, Spanish government debt reached a level of 100% of GDP or more, it would simply be too costly to leave the single currency and continue to service its euro-denominated debt.
“Accordingly, the Government would almost certainly be forced to restructure its debts by converting them from euros to Spain’s new currency,” CE posited.
“While this would certainly lead to frictions in financial markets, the likely losses would probably not be big enough to prompt a financial market meltdown, unless it prompted other economies, such as Italy, to abandon the single currency too.”
While it is doubtful that Spain would be the first euro-zone economy to exit the euro-zone, B&L think the benefits of leaving may outweigh the costs.
“If another peripheral economy abandoned the single currency and thrived, we think that Spain would probably follow suit,” CE concluded.
Between 1999, when Spain initially joined the euro zone and the beginning of the global economic crisis in 2007, Spain's economy grew annually by 3.7 percent, just behind Greece and Ireland in the currency bloc. Even if one includes the credit crunch, Spain's GDP still grew by an average of 2.7% annually, much better than the euro zone average of 1.5%.
However, GDP numbers don't tell the full story, CE noted.
“The economy became distinctly lopsided. Domestic spending accelerated and residential construction investment as a share of
GDP doubled,” CE said. “But export growth plunged, resulting in the external sector becoming a larger drag on the economy.
Moreover, cheap and easily available credit largely drove the surge in household spending and residential property construction – which in turn led to a bubble in real estate prices that eventually popped.
After nearly a decade of blessings under the euro, the picture has clearly soured.
Spain is now racked by huge debt, still-falling house prices, unemployment at 20-plus percent, slowing wage growth – in addition to the government's draconian austerity program.
“A period of deflation could prolong the much-needed bout of belt tightening,” CE said. “After all, falling prices, wages and profits will increase the real value of firms’ and households’ debt, making the cost of servicing and paying down debt more expensive.”
Essentially, with Spain facing a huge fiscal squeeze, the private sector saddled with huge debts, banks in no position to lend and the external sector hampered by a lack of competitiveness, a sustained and strong recovery remains far away, CE noted.
“On the face of it, Spain’s low level of government debt may mean that the public finances can withstand a long period of stagnation even if the potential future costs of supporting its banking sector are factored in,” CE said.
“But it is more questionable whether voters and politicians will be willing to go through more than a decade of internal devaluation to restore external balance, particularly if another peripheral economy were to leave and do well.”
Moreover, in the event that an economy of Spain’s size chose to leave, it would inevitably cause increased speculation that other members could follow suit.
“Indeed, if it prompted markets to become significantly more concerned about the full break-up of the single currency, the impact of a Spanish exit on the financial markets could be huge,” CE concluded.
Source: International Business Times