Will Spain Be the Next Country in Need of a Bailout?

Spain benefited from only a few years of economic health after finally recovering from the 2008 crash. Then came the coronavirus.
July 23, 2020
Featured Image
Spanish Prime Minister Pedro Sanchez poses in front of Picasso's "Guernica" during his visit to the Reina Sofia Museum with his Italian counterpart, in Madrid on July 8, 2020. - Italy and Spain will seek to jointly convince four reticent EU members to back a huge bailout aimed at overcoming the coronavirus crisis, their prime ministers said today in Madrid. European Union leaders are negotiating a plan worth up to 750 billion euros ($850 billion) to help countries absorb the economic impact of the COVID-19 crisis. (Photo by Kiko Huesca / POOL / AFP) (Photo by KIKO HUESCA/POOL/AFP via Getty Images)

One has to pity the Spanish people. No sooner did Spain finally recover from its housing-bust-induced 2008 recession than a once-in-a-century coronavirus pandemic caused a worldwide economic slump.

This does not bode well for Spain’s longer run economic outlook, especially considering that the country remains stuck with the Euro, a currency over which it has no control. Nor does it bode well for Spanish political stability, which was shattered in the aftermath of its Great Economic Recession.

Spain’s economy was painfully slow to recover from its 2008 economic recession, which saw its GDP drop by 4 percent. It was only by 2016 that Spanish income per capita returned to its 2008 level. Similarly, after unemployment rose to a staggering 25 percent of the labor force, it was only in 2016 that it finally dropped below 20 percent.

One of the results of the 2008 recession was the fragmentation of Spanish politics at the national level and the exacerbation of its regional tensions. Following 30 years in which the center-left Spanish Socialist Workers’ Party and the center-right People’s Party alternated in government, the far-right Vox and far-left Unidas Podemos parties have also vied for power in recent elections. That has seriously complicated the formation of a stable government. At the same time, economic dissatisfaction has fueled a strong Catalonian separatist movement.

Over the past decade, a major reason for Spain’s poor economic performance was its need to mend its public finances, which were seriously compromised by the collapse of its housing bubble and it’s limited monetary options. Only after years of budget austerity did Spain’s public debt shrink to a more manageable size. But because Spain no longer has its own currency, it could not use interest rate or exchange rate policy to cushion the blow that budget austerity dealt to its economy.

Spain’s coronavirus-induced recession could now make the 2008 housing market collapse look like a minor speed bump. In a cruel twist of fate, the pandemic has inflicted its miseries on Spain’s tourism- and export-dependent economy more severely than on the broader European economy. According to the IMF’s latest forecasts, whereas the European economy is expected to contract by 8 percent in 2020, Spain’s GDP is projected to contract by almost 13 percent.

As in 2008, Spanish public finances will be sure to suffer, possibly reviving questions about the sustainability of its public debt. (Spain once loaned its initial to the infamous PIGS group of wobbly sovereign debtors.) The fear is not only that the country’s public-debt-to-GDP ratio will by the end of this year jump to 120 percent—a level appreciably above its 2010 peak. It is also that, according to the Bank of Spain, the country’s budget deficit could balloon to 11 percent of GDP.

Spain’s compromised public finances will once again make it difficult for the country to recover from a deep recession. As happened before, the country will be forced to exercise considerable budget discipline in the midst of a recession to prevent its public debt level from rising any further. And once again, the strictures of the Euro will prevent Spain from using interest rate or exchange rate policy to make the belt-tightening more palatable, either economically or politically.

Following the 2008 recession, it took Spain nine years to come back into compliance with the Eurozone’s rule that a country’s budget deficit cannot exceed 3 percent of GDP. This time, the Bank of Spain is suggesting that the country will need to balance its budget by 2030 if it is to put its public debt on an acceptable path. Over the past 25 years, Spain has only managed to balance its budget on three occasions.

But public finances aren’t the only concern about Spain’s current economic crisis. Another disturbing projection is the toll that the recession will take on its banking system, especially considering that the Spanish banking system will now be exposed to a recession more than twice as deep as that experienced in 2010 and more severe than the worst-case scenario of the Spanish banks’ stress test. It does not inspire confidence that Spanish banks entered the present crisis with among the slimmest capital reserves in Europe.

All of this suggests that Spain is likely to remain on a glacial economic growth path for years to come. This would be unwelcome news to any country, but it is especially sobering for one struggling with political instability and regional independence movements.

It also will complicate the European Central Bank’s present challenge of holding the Euro together. Already, the ECB has begun buying large amounts of Italian debt in a bid to keep the Eurozone’s third-largest economy afloat. Whether it will be in a position simultaneously to do the same for Spain, the Eurozone’s fourth-largest economy, remains to be seen.

Desmond Lachman and John Kearns

Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund's Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney. John Kearns is a research assistant at the American Enterprise Institute.