Bank of Spain predicts deep recession this year

The Bank of Spain on Monday predicted the domestic economy faced a deep recession, as the IMF warned of the risk of a "solvency crisis" for Spain and Italy if Europe fails to beef up its rescue fund.

The central bank estimated the economy declined by 0.3 percent in the last quarter of 2011 on a quarterly basis, foreshadowing a contraction of 1.5 percent of GDP this year, with the new Popular Party government bent on fulfilling its deficit-reduction targets at all cost. The severe setback this year will give way to a "moderate" recovery the following year when GDP is expected to grow by 0.2 percent.

According to a draft version of a report by the IMF due to be released this year, the multilateral agency expects Spain's GDP to shrink 1.7 percent in 2012 and 0.3 percent in 2013.

The main victim of the worsening of the economic crisis will once again be the job market, with unemployment — already the highest in the developed world at 21.5 percent — set to rise to over 23 percent this year and the next.

Urging the European Union to increase the scope of its European Financial Stability Facility (EFSF) and its planned successor, the European Stability Mechanism (ESM),the IMF's managing director, Christine Lagarde, warned that the risk of higher funding costs for Italy and Spain could lead to a "solvency crisis" that "would have disastrous consequences for systemic stability."

"The longer we wait, the worse it will get," Lagarde said in a draft version of a speech to be delivered on Monday and provided by the IMF. "The only solution is to move forward together."

Lagarde suggested the EFSF could be folded into the ESM, the size of which should be increased. She also urged the EU to consider other risk-sharing measures, such as issuing eurobonds.

In its report, the Bank of Spain also identified the worsening of the euro-zone sovereign debt crisis as one of the reasons behind the renewed fall in output in the fourth quarter after stagnating the previous three months.

Nonetheless, GDP for full-year 2011 was positive at 0.7 percent after contracting the previous two years.

A buoyant export market and sluggish imports led to net trade adding two percentage points to GDP growth last year, offsetting a contraction in domestic demand of 1.3 points due to the austerity drive, which saw government spending decline by 1.2 percent and private spending stagnate.

The bank said its forecasts for this year and the next were drawn up against a "particularly uncertain background" because of ongoing doubts about the future of the euro zone and the impact of the austerity drive on output.

Nonetheless, it backed the need to reduce the public deficit further in order to enhance Spain's creditworthiness and reduce borrowing costs.

"In light of the current extreme tensions on financial markets because of the European sovereign debt crisis, perseverance with the fiscal adjustment process is unavoidable, given the costs of not doing so would be very high," the report said.

The bank said the government would need to introduce further measures on top of the 15 billion euros in tax hikes and spending cuts announced at the end of last year to meet the deficit reduction target for this year of 4.4 percent. The shortfall last year was 8 percent of GDP, two percentage points more than the official target. The administration is aiming to trim the deficit next year to 3 percent of GDP, the European Union's ceiling.

"The adoption and application of [other measures] will be necessary to meet the targets set," the report said. The bank said it expects the fiscal adjustment will focus mainly on spending cuts rather than attempts to boost revenues this year, and exclusively on belt-tightening next year.

The secretary general of the PP, María Dolores de Cospedal, on Monday attributed the failure to reach the 6-percent deficit figure last year to the regions, which almost doubled their target of 1.3 percent of GDP. The central government missed its target by only 0.3 percentage points, while the Social Security system had a deficit of 600 million euros when its goal was for a surplus of 4.4 billion euros.

As a result of the austerity drive, government spending is expected to contract by 6.3 percent this year, while private consumption will fall by 1.2 percent as the public sector wage freeze remains in place. The uncertain environment will also cause companies to cut back on investment, with spending in capital goods predicted to fall by 7.0 percent. In all, domestic demand is expected to shave 4 percentage points off GDP this year.

This will be partly offset by the export sector. The Bank of Spain expects shipments to overseas markets to rise 3.5 percent, while imports are seen down 4.8 percent. As a result, net trade will contribute 2.5 percentage points to GDP growth.

The central bank expects the contraction in output to peter out toward the end of this year, with growth turning positive at the start of 2013 when the budget adjustment burden will be smaller.

But in the absence of radical labor reforms the prospects for the job market will remain grim next year. The jobless rate is forecast to rise to 23.4 percent this year from 21.5 percent in 2011, with only a minimal improvement to 23.3 percent in 2013.

However, "the approval of a comprehensive reform of wage bargaining mechanisms, non-wage conditions and hiring arrangements would contribute to kick-starting medium-term growth," the report concluded.