Against the tide: Spain is a gauge for Europe

Estelades (Catalan separatist flag) flags fly high

The victory of the pro-independence parties in the regional Catalan parliament has raised the stakes in the Spanish general election due on December 20. At the national level the main centre-right and centre-left parties may be forced into coalition with either populist left or new centrist forces. This renews the risk of further fragmentation in the EU in 2016; a year in which the UK could hold a referendum on leaving the EU altogether. Spain has become a key indicator in gauging which way Europe will go.

In Spain political fragmentation could mean even more fiscal failure. It has been a model of post-crisis European economic recovery in the eyes of investors. The Spanish authorities did a good job of cleaning up the banks and liberalising the labour markets. However, Spain remains a low value-added, low-productivity economy with an unreformed fiscal platform that limits growth and casts doubt on sovereign debt sustainability.

There is still a long way to go from winning a regional election on an independence ticket to achieving a divorce of Catalonia from Spain. A referendum would need to be held and then won. This would take months to organise and would be vulnerable to legal challenge. Even if the referendum obstacle is overcome there would still be lengthy legal objections barring the way to a final split. It is also likely that the central government would use economic sanctions to further undermine the Catalan separatists.

In many ways the call for independence is more important as a bargaining chip than as a reachable goal. The Catalan government can demand greater autonomy and fiscal powers. But that would place further stress on the central government’s books. The Spanish government is struggling to reduce borrowing despite an increasingly robust economic recovery. The budget deficit was 5.9% of GDP in the year to March 2015, higher than any other eurozone member state, and the gross public debt to GDP ratio is not expected to peak until 2017 at over 100%.

Spain is also struggling to meet the fiscal targets set by the European Commission. The Commission has criticised the proposals for the 2016 Spanish budget because it did not include up-to-date figures on several issues. These included the debt of the country’s 17 autonomous communities, putting in doubt Spain’s ability to reach the deficit targets of 4.2% of GDP for this year and 2.8% for 2016. The Commission wants new budget measures to deliver these targets.

Although Spain has been enjoying the fastest growth in southern Europe, the recovery is more the result of low interest rates on a highly leveraged economy than any structural transformation. Productivity continues to lag the core economies, both in Europe and globally. Its efforts to move up the value chain have been limited, with Spain steadily losing high- and medium-tech manufacturing jobs since 2008. High-tech exports make up just 8% of Spain’s total manufacturing exports (matching Greece) compared with 16% in Germany and 22% in Ireland.

Not only is Spain highly indebted at the sovereign level, it is also a highly leveraged private sector economy with a high dependence on foreign funding. This helps explain the strong recovery. The debts cost less thanks to the ECB doing “whatever it takes” to preserve the single currency. But that also implies high economic vulnerability when interest rates start to rise.

Spain’s political problems also serve as a reminder of a broader European malaise. The failure of the European project to deliver either growth or jobs and its success at delivering austerity, is driving voters away from the traditional parties of government to those that promise change. In the Spanish general election, the populist leftist Podemos and the centrist Ciudadanos party could hold the balance of power between the incumbent People’s Party and the Socialists.

The price of coalition could be further relaxation of fiscal targets.

If the Spanish general election produces instability then it will start a new chapter in the story of the struggling euro project. It will see the return of the political fragmentation of EU seemingly averted by the resolution of the Greek crisis at the end of the summer.