Spain risks becoming Europe’s other ‘sick man’

Now it is not only Italy, but it is Spain as well that risks becoming another sick man of Europe.

Not only has Spain been among COVID-19’s biggest victims in Western Europe. Its tourist-dependent economy has proved to be particularly vulnerable to the pandemic’s ravages. Stuck in a euro straitjacket, this all too likely puts Spain well on its way to another round of its sovereign debt and banking sector crises. That bodes ill for the country restoring a semblance of political stability anytime some.

It would be an understatement to say that Spain has been particularly hard hit by the pandemic. Being among the first European countries to be struck by COVID-19, Spain has had more than 358,000 infections, the highest number of infections in Western Europe. Now a second wave of infections centered on Barcelona is threatening to send the country into a second lockdown and do further major damage to its all-important tourist sector.

Spain’s economy is among the European economies that are the most vulnerable to the pandemic. Not only does its tourist sector account for as much as 12 percent of its overall economy. It also has an economy that is dominated by small and medium-size businesses and that has the highest proportion of jobs in the OECD that require physical contact or close proximity to others.

It is little wonder then that in the second quarter of this year Spain suffered an 18.5 percent quarter-over-quarter decline in output. That made it by far the eurozone’s worst performing economy. With the apparent onset of a second wave, it is likely that this year the Spanish economy will contract by at least the 14 percent being forecast by the OECD. It is also very likely that Spanish unemployment will rise to 25 percent by year end.

Spain’s economic slump is bound to do severe damage to the country’s public finances. That in turn will make it difficult for the economy to recover while stuck in the euro. It will also make it difficult for the country to grow its way out of its public debt or banking sector problems.

According to Cristina Herrero, the head of Spain’s fiscal watchdog, the country entered the recession with imbalanced public finances. Now as a result of the deep economic slump, Spain’s budget deficit will balloon to between 11 and 14 percent of GDP in 2020 and to between 7 and 9 percent of GDP in 2021. That is bound to soon raise questions about the country’s debt sustainability, as its public debt-to-GDP ratio is set to skyrocket to 120 percent by year end and to remain on a rising path thereafter.

Spain’s longer run prospects for revitalizing its economy and growing its way out of its debt problem are clouded by its being stuck in the euro. Being in the euro denies Spain the use of exchange rate depreciation as an offset to budget tightening. This means that if Spain were to try to address its public finance problem by resorting to budget austerity, it would risk deepening its economic slump. Yet if Spain does not reduce its budget deficit, it risks inviting a debt crisis by leaving its public debt on an ever-increasing path.

Further clouding Spain’s economic outlook is the risk that the very depth of the economic slump might trigger another round of the Spanish banking crisis. It might do so by causing both households and companies to become ever more delinquent on their bank loans. Heightening this possibility is the prospect that Spain’s current economic recession will prove to be three times as deep as that which the country experienced during the 2008-2009 Great Recession. It also will not help matters that important sectors of the Spanish economy such as tourism will be particularly hard hit by the slump or that the Spanish banks currently have the lowest level of tier-one capital in Europe.

An unfortunate fallout of the 2008-2009 Great Recession was to fragment Spanish politics and to exacerbate regional tensions. One would think that there is now the real risk that the even deeper economic recession that will come in the wake of the pandemic will only worsen an already difficult political situation.

All of this heightens the urgency for Europe to help Spain if that country is to avoid drifting towards another round of its sovereign debt and banking system crises. The eurozone could do so by moving more swiftly to the formation of a fiscal and a banking union. However, judging by the strong reluctance to date of the eurozone’s northern member countries to move in that direction, I would not recommending holding one’s breath waiting for that to happen.

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.