Inflation adds to Spain's economic woes

October 30, 2012

What's worse than the type of austerity that plunges an economy deep into recession? Try one that triggers inflation at the same time.

Just ask Spain, the euro zone's fourth-largest economy. Data released Tuesday show that it is the victim of a double whammy dose of economic contraction and rising prices. In the quarter through September, gross domestic product fell 0.3 per cent, according to the National Statistics Institute, compared to a 0.4 per cent fall in the previous quarter. Consumer prices were 3.5 per cent higher than a year ago, well above the European Central Bank's target of 2 per cent for the 17-country euro zone as a whole.

The combo of a shrinking economy – GDP is down for the fifth quarter running – and inflation does not bode well for Spain's ability to meet its budget deficit targets or stem social unrest, as buying power diminishes. Madrid, Barcelona and other cities have been hit with massive anti-austerity protests in recent weeks and Catalonia, traditionally the country's wealthiest region, is on the verge of a regional election that may open the door to sovereignty.

Spain's lone bit of good news was that the third-quarter contraction was marginally less than the Bank of Spain's forecast for a 0.4 per cent GDP fall. There is little evidence that the Spanish economy has bottomed out, raising the chances of a sovereign bailout on top of the banking bailout negotiated by Madrid in recent months. The centre-right government of Mariano Rajoy, however, has given no indication that it is on the verge of negotiating a bailout from the European Stability Mechanism, the new €500-billion rescue fund, and the ECB (the two would work in tandem on bond purchases).

Imperial Tobacco's results for the year to Sept. 30, released Tuesday, provided ample evidence that Spain's economy is in dire shape. The FTSE-100 company wrote down the value of its Spanish business by £1.2-billion, resulting in a fall in pre-tax profits to £1-billion from £2.2-billion in the previous fiscal year.

In a statement, Imperial said "Economic conditions remain difficult in Spain; high unemployment and increasing government austerity measures are placing further pressures on consumers..."

Spain's high inflation is a direct result of the austerity measures, dominated by spending reductions and tax hikes valued at more than €60-billion to the end of 2014. A boost to the value-added tax (VAT) came into effect at the start of September and lifted prices for all consumer products, depressing sales. The retail market in September fell a record 11 per cent, year on year.

The pace of economic contraction in Spain means the country will find it virtually impossible to meet its budget deficit goal. In the first eight months, the deficit was 4.77 per cent of GDP, which was bigger than its full-year target. Madrid has forecast a mere 0.5 per cent GDP contraction in 2013, which most economists dismiss as dreaming. A contraction of 1 per cent to 1.5 per cent is far more likey, economists say, as unemployment – currently 25 per cent, the highest in the Western world – refuses to stop rising.

As Spain and the rest of the euro zone stuggle to find growth, Germany, the region's economic engine, is getting caught up in the mess. Data released Tuesday show that Germany's jobless rate rose in October for the seventh month, to 2.94 million, up 20,000 from the previous month.

The figure meant the jobless rate did not budge – it remained steady at 6.9 per cent, close to its lowest level since German reunification more than two decades ago. But it does show that European weakness is hurting the German job-creation machine.

It is also hurting German growth. The economy grew by 3 per cent last year. Since then, growth has slowed significantly. The second quarter figure was a mere 0.3 per cent. The government, led by chancellor Angela Merkel, who goes up for re-election in 2013, expects GDP growth of 0.8 per cent this year, rising to a decidedly subdued 1 per cent in 2013.

"In the coming months, labour market data will probably be rather weak," said Christian Schulz of Berenberg Bank, in a Reuters report. "Things can only improve once the relative calm currently experienced by financial markets is transferred to the real economy."

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