Plain sailing no longer

FOR a decade or more, the Spanish economic galleon has been blessed with a following wind and full sails. It has outrun the OECD average in nine of the past ten years and the euro-area standard for all of the past dozen. A country that in 1994 had an unemployment rate of almost one in five has provided work for lots of immigrants as well as many more of its natives. Almost two-fifths of net new jobs in the euro zone since the creation of the single currency have been Spanish ones. Only a few years ago, the thought of Spanish fashion chains, banks and construction companies swashbuckling their way around the globe in search of booty would have seemed preposterous. Now, as our special report describes, they are doing precisely that. Yet in home waters at least, more difficult conditions are ahead—and Spain's weaknesses are about to be exposed.

For some time two hazards have been visible. One is a giddying rise in house prices, which have climbed by 180% in the past decade, more than doubling in real terms. The market has so far been steadying—property-price inflation fell to 7.2% in the year to the first quarter—but the recent collapse of a property company's share price shows that the stockmarket, at least, is worried. No wonder, when the market is overvalued and oversupplied and housebuilding accounts for 7-10% of GDP, depending on your measure.

The second is the country's current-account deficit, which in absolute terms trails only that of the United States. At more than 9% of GDP, it mainly reflects Spanish business's thirst for borrowing. Lending to companies has risen by 30% in the past year. The euro zone's central bankers are fond of repeating that its members' current accounts are no more meaningful than those of Tennessee or Texas, but Spain's deficit does tell you something: how tilted towards domestic demand—including construction—the country's economy has become.

The booms in building and borrowing have been helped along by Spain's membership of the euro zone, which has made credit much cheaper for people and businesses. In the run-up to the creation of the single currency, Spain benefited as its interest rates tumbled towards German levels. Since the euro came into being, monetary conditions have remained pretty loose. Spain's inflation rate has consistently exceeded the euro-area average by a percentage point or more, making its real interest rates correspondingly lower and giving an extra puff to an economy already going at a rate of knots.

Granted, there is more to the Spanish story than the cheapness of borrowing in euros rather than pesetas. Like Ireland, which has also had a vertiginous housing boom, Spain has a high proportion of people of the age to buy a first home and start a family. The rise in female employment has increased families' incomes and what they are willing to pay for a home. Many foreigners as well as Spaniards have had both appetite and wherewithal for a second home in the sun and by the sea. Still, cheap money has played an important part.

The other side of the coin

Now, though, Spain may be about to see the other side of life in the euro zone: interest rates are rising and the currency is climbing, just as the economy is set to slow down. Even though economists think growth stayed strong in the first quarter (perhaps 4% in the past year), it is likely to lose strength—maybe abruptly, if the housing market is unkind.

In some ways, Spain is well placed for this test. The government has run a budget surplus for the past two years (even allowing for the economic cycle) and gross debt is only around 40% of GDP, so fiscal policy can help out should the economy slow sharply. In other ways, though, it is poorly prepared. One obvious means of rebalancing the economy, devaluing the currency, is ruled out, so Spain must find another method of bringing down its real exchange rate. It will have to look hard. Wages have been hitched to the country's higher-than-average inflation rate. Productivity growth has been woeful (even though, admittedly, to some extent this reflects high employment growth). The result has been a 12% increase in unit labour costs, relative to the euro-area average, since 2000.

Spain's “dual” labour market is no model, despite its remarkable job-creation record. That as many as a third of workers are on temporary contracts suggests some flexibility. But there are so many such contracts precisely because employers find permanent workers expensive to fire—and thus to hire. Recent reforms have done too little to close the gap in costs between the two types of contract. In product markets, too, Spain should do more to loosen its economy and let in more competition. In the past few years, Germans have found that it is possible to win competitiveness in a currency union. But they have also found that it can hurt. So might the Spanish.