November 2023

Spain and its territorial entities in 3Q 2023: recent dynamics, outlook and medium-term fiscal challenges

Executive Summary

The global macro backdrop

Global economic activity has moderated in recent months. In the second quarter, the slowdown was particularly pronounced in China, in a context of notable weakness in its real estate sector, while in the eurozone the slowdown is already evident in the preliminary data for the third quarter of the year. On the contrary, other economies showed greater dynamism. In particular, we would highlight the United States, where the dynamism of its labor market made it possible to maintain the strength of domestic demand. Regarding the third quarter, the available evidence suggests an additional slowdown in global activity, with a divergent pattern, again, by geographic areas.

The return of geopolitical risk to the international scene with the open confrontation between Israel and Hamas adds an additional element of uncertainty to the outlook for the coming months, with the possibility that the conflict will spread and new actors will be involved. It is obvious that if tensions spread to other countries, the situation would become much more complicated. Then we could see a more forceful rise in the price of oil, something that would have immediate negative effects on
global growth and inflation, aggravating the outlook we now have. The situation could be even worse if inflation rises so high that it forces central banks to keep interest rates at high levels for longer than expected. The latter would jeopardize the prediction that central bankers will be able to cool the economy without causing a recession.

There is a recent deterioration in the growth prospects of the euro area, where GDP is expected to increase by just 0.4% in 2023 and 1.0% in 2024. The industry suffers from a lag in recovery that it is probably more structural than conjunctural. The decline seems widespread and also affects the services sector. Investment spending is negatively affected by increased costs and uncertainty about the future evolution of manufacturing. For its part, household consumption is limited by the loss of purchasing power, the increase in the financial burden and the exhaustion of the effect of deconfinement.

By sector, manufacturing continues to show considerable weakness, especially in comparison with services, although the greater dynamism of the latter has tended to attenuate in the summer months, with a further slowdown throughout the third quarter, as weakness in the manufacturing sector appears to have spread to services, against a backdrop of tightening financial conditions.

Among advanced economies, in their last monetary policy meetings in both September and November, both the US Federal Reserve and the Bank of England decided to maintain official rates at current levels (5.25-5.50% for the Fed and 5.25 % for the Bank of England), while the European Central Bank (ECB) last rise by 25 basis points (bp) took place in September, although the latter has given clear signals that it could have reached the terminal rate in the interest rates, with the end of rates-hikes scenariosupported by the October meeting, where after ten consecutive increases the ECB decided to keep rates on hold since from an economic point of view, the confidence indicators, the conditions for granting credits and the dynamics of declining loans point to a significant weakening of domestic demand. We can therefore say that central banks have reached their terminal rate and that we have therefore entered the phase of “high rates for a prolonged period of time”.

The euro area economy has continued to experience some sluggishness. The eurozone GDPcontracted by 0.1 % in Q3 2023. PMI indicators, available until October, suggest an intensification of the weakness of activity, especially in those sectors and components of demand, such as manufacturing and investment, that show greater sensitivity to a tightening of financial conditions.

On the other hand, the moderation in core inflation is not as firm and generalized as that of headline inflation. Among the components of underlying inflation, the persistence of services inflation stands out, which has even increased in some countries since April. This unfavorable evolution would respond to a combination of factors, such as the strength of demand for services in the first half of the year, the increase in salaries, which have a relatively high weight in the cost structure of the services sector, and the behavior of business margins in the latter.

The Spanish economy will continue to do better than the EZ average in 2023-2024

The global economic context continues to be marked by slowdown and uncertainty, but it must be highlighted that Spain is resisting more than other EU countries thanks, among other factors, to its productive structure, more linked to the services sector. In our opinion, the foreign sector and the resistance of the labor market are being key to the evolution of the Spanish economy, but there are already signs of loss of dynamism in both areas.

Therefore, the GDP is showing comparatively greater dynamism in Spain than in other countries in the euro area (Figure 1). This more favorable behavior is explained, above all, by the differences in the sectoral composition of the economy. Specifically, the greater recent strength of activity in Spain would be related, in part, to the greater weight in our country of services linked to hospitality and tourism, which have continued to experience very high demand during the summer. The improvement in consumer confidence would also have contributed to the expansion of consumption in the third quarter, in light of the information provided by the European Commission’s economic sentiment indicator until September.


FIGURE 1 Quarterly GDP growth since 4Q22: Spain vs Eurozone

In summary, there are three main reasons why the Spanish economy has recently shown
better performance than that of the EMU.

• Greater weight of the services sector compared to manufacturing.
• Better evolution of the energy-intensive industry.
• Less commercial exposure to China.


The activity of the Spanish economy has also shown signs of weakening since the summer.
PMI indicators
in particular point in this direction, which have deepened the downward path that began in spring, both in the case of services and manufacturing, the latter reaching contractionary territory, so the services activities continue to show a comparatively higher dynamism than that of manufacturing, especially with regard to activities linked to leisure and tourism and the results of the latest Bank of Spain Survey on Business Activity (EBAE), which point to a weakening of companies’ turnover in the third quarter.

According to the first estimate from the INE published at the end of October, Spain grew by 0.3% q/q in the third quarter of the year. It is less than the figure in the first quarter (0.6%) and in the second (0.4%), but enough to confirm, once again, the resilience of the Spanish economy in a scenario of international turbulence and the relative outperformance from the contractionary trend that the eurozone is facing. Given the weakness of its main trading partners, domestic demand has taken over from the foreign sector as the engine of growth. This data would be in line with the fulfilment of our forecasts for 2023, which stand at 2.3%.

In year-on-year terms, Spain slows down its growth rate slightly, going from 2% in the second quarter to 1.8%yoy and it is now 2.1 percentage points (pp) above the pre-crisis maximum reached in 4Q19. In this period, the contribution of national demand was 1.7 points, while external demand only contributed two tenths. It is precisely this broader photograph that allows us to appreciate more clearly the change in the main drivers of the economic expansion that our country is experiencing.


FIGURE 2 Macroeconomic projections for the Spanish economy, annual rate of change (%)

Therefore, in the short term, the economic context is marked by the slowdown in economic activity due to the transfer of monetary policy tightening, the weakness of the external backdrop, the withdrawal at the end of 2023 of the measures in response to the crisis energy and the loss of dynamism in the labor market. In this way, we estimate economic growth for 2023 at 2.3% (estimating a GDP deflator of 4.8% in 2023 would imply a nominal growth of the Spanish economy of 7.1%), where internal demand will remain, in the remainder of the year, as the main driver of growth, although in the year as a whole the contributions of the foreign sector and national demand to the GDP growth will be similar and a moderate deceleration to 1.8% by 2024 and a slight rebound to 2% by 2025 (Figure 3), supported by the gradual decline in inflationary pressures, the gradual recovery of confidence, the resilience of the labor market and the planned intensification of the deployment of NGEU funds.


FIGURE 3 Macroeconomic projections for the Spanish economy, annual rate of change (%)

In the labor market, employment will maintain high dynamism this year (with a growth of 2.6% in terms of the number of people employed), only to slow down in the following two years, in line with our GCP estimates, although on a positive note, the apparent productivity of work will experience a certain recovery. The continuation of the job creation process explains the projected decrease in the unemployment rate, which would be around 11% on average in 2025, in a context of sustained growth in the active population, which benefits from the population increaseassociated with migratory flows.

Economic slowdown in the second half of 2023 and the beginning of 2024

The data that preview the dynamism of activity, particularly in Europe, show a general worsening by country and sector. Added to this is the recent increase in the price of oil.This would be a consequence, among other factors, of:

  • the prolongation of the lack of dynamism of the external demand, which will also weaken the economic activity of our country in the final stretch of this year;
  • the continuation of the process of transmission of the tightening of monetary policy to the costs of new credit operations and to the financial burden of indebted agents, which will still have a negative impact on the pace of GDP growth during a good part of the projection horizon;
  • the increase in energy prices and the foreseeable end of public support policies originated during the energy crisis, which has sustained activity in 2022 and 2023 and whose withdrawal will have a negative impact in 2024-2025. It is also important to highlight that during the 2024-2025 period the price of oil would be 20% higher than before the pandemic, while the price of gas will have multiplied by four.

At the domestic level, services could begin to show signs of exhaustion, as unused capacity disappears and the outlook for external demand moderates. Moreover, in recent months, the cost of new financing operations for households and companies has continued to increase.

Uncertainty over economic policy may increase in the coming months. So far, different indicators do not show a deterioration in confidence, despite the uncertain electoral result of the last elections in July. Following the re-election of Mr Sanchez as PM, the potential economic uncertainty that a repetion of the elections would have brought has been dispelled for now. For example, the risk premium paid by the Treasury on German debt remains relatively constant at around 100 basis points.

In terms of average annual rates, headline inflation will moderate significantly in 2023, from the 8.3% recorded the previous year, will rebound in 2024 and will decline again in 2025, below the 2% target. In particular, the average annual increase in the HICP will be 3.6% in 2023 and will rise to 4.3% in 2024, as a consequence of the rebound in the contribution of the energy component and which is a consequence of:

(i) the recent rise in energy prices,

(ii) the base effects associated with the price declines that energy products registered in the final stretch of 2022, and

(iii) the eventual withdrawal of the measures deployed by the authorities to address the energy crisis, which will more than offset the reduction


In 2025, the stabilization of energy HICP prices and the prolongation of non-energy disinflation will lead to the headline figure registering an increase of 1.8%. Regarding core inflation, it is expected that, after a growth of 4.1% in 2023, its rate of change will reduce to 2.3% in 2024 and 1.7% in 2025.


Risks in our base scenario 2024-2025

The persistence of inflation, the weakness of economic activity at a global level and the worsening of geopolitical and commercial tensions constitute the main sources of risk. The price of oil has recently risen again and the final impact of the war between Israel and Hamas is still uncertain, while the transfer of oil price increases to underlying inflation is faster and more intense than in the case of drops in the price of crude oil.

The open war between Hamas and Israel that began on October 7 could still escalate and include new actors (the West Bank, Lebanon (Hizbollah), Syria) and in the worst case could lead to an open confrontation between Iran and Israel that could lead to a new oil crisis.

A potential escalation of the conflict would likely have two primary transmission channels to the global economy and markets: a general deterioration in risk sentiment and a significant jump in oil prices, possibly prompted by tighter sanctions on Iranian oil.

The risks surrounding the central scenario presented in this Report are biased downwards with regard to activity and balanced in relation to inflation. A very important source of uncertainty is the difficulties in calibrating the magnitude of the effects on activity and prices of the tightening of monetary policy carried out to date, which could lead to scenarios of greater weakness in activity and prices, or, on the contrary, the entrenchment of the current high inflationary pressures.

The persistence of high underlying inflation in the euro zone as a whole, supported by greater growth in wages and business margins, could result in a more restrictive tone of monetary policy for a longer period of time, as some members of the Governing Council of the ECB have already anticipated. This could weaken the financial situation of the most indebted households and companies and slow down their consumption and investment decisions to a greater extent than expected.

Furthermore, it cannot be ruled out that global economic developments will present a more unfavorable evolution than that contemplated in the central scenario, which, in particular, could be related to a more pronounced slowdown than expected in the Chinese economy and an impact of the tension in financial conditions on activity potentially more intense than expected, which in turn would imply a lower inflation path. Additionally, the global geopolitical environment presents multiple sources of instability, the hypothetical revival of which could lead to a scenario of higher inflation and worse prospects for economic activity. A hypothetical escalation of geopolitical tensions could have an upward impact on the prices of energy and food raw materials, and even cause some alteration in their availability.


Spain: dynamics of budget deficit and public debt

In the fiscal section, we must highlight the vulnerable situation in which public finances find themselves, with a high level of debt and public deficit. The Independent Fiscal Authority (AIReF) projects a stagnation of the public deficit at around 3% of GDP and a debt at around 100% of GDP and that, in the longer term and taking only into account the effect of demographics, AIReF expects both parameters to rise again. In this sense, it is necessary to promote economic growth and act as soon as possible to avoid having to make major adjustments.

In the absence of fiscal rules for 2023, the Council of Ministers of July 22, 2022 set a reference deficit for 2023 of 3.9% of GDP for the whole of the public administrations, with the following distribution: a deficit of 3.2% of GDP for the Central Administration (A.C.), 0.5% of GDP for the Social Security Funds (F.S.S.) and 0.3% of GDP for the Autonomous Communities (CC. AA.), while a surplus of 0.1% of GDP was assigned to the Local Corporations (CC. LL.).

In the fiscal area, Spain remains in our opinion in a “certainly vulnerable” position, given the high level of public debt and public deficit. The AIReF forecasts point to a deficit of 4.1% of GDP in 2023, two tenths above the one set as a reference rate by the government and around 3% of GDP in 2024, provided that the measures put in place to confront the energy crisis and inflation and to moderate the growth of spending in the Territorial Administrations.

In any case, the government’s 2023-2024 budget plan assumes that the autonomous communities and social security will be the main administrations that will contribute to the reduction of the deficit, something doubtful given the lack of coordination that currently exists, given the lack of parameters that help regional governments to make budgets consistent with these objectives. An important part of the expected adjustment in territorial treasuries in 2023 originates from the greater account transfersof their financing systems, which would more than compensate for the withdrawal of extraordinary aid from previous years.

Consequently, the reduction in the deficit in 2023 would be seven tenths of GDP from 4.8% in 2022. The reduction of 2.1 points between 2021 and 2022 was mainly explained by the progressive withdrawal of most the COVID related measures and due to the good performance of the economy, while the measures approved to alleviate the energy crisis increased the deficit by 1.3 points.


FIGURE 4 Deficit evolution by component (% GDP)

AIReF forecasts that Spain will close 2023 with a deficit of 4.1%. Thus, in 2024 the 3% objective could be achieved. However, this milestone will depend mainly on two factors: on the one hand, the withdrawal of the measures that the central government adopted (and that are) in force to face the energy crisis and the price crisis (which this year represent an impact of 1.1% of GDP); on the other hand, that the regional administrations decide to moderate the growth of their expenses.

Under current forecasts, only 4 autonomous communities (Catalonia, Castile-La Mancha, Murcia and the Valencian Community) would close with a deficit higher than the reference set for the subsector, -0.3% of GDP; six autonomous communities would be around the reference target (Aragon, Cantabria, Castile-Leon, Extremadura, Madrid and La Rioja); and seven autonomous communities could achieve budget surplus or balanced budgets.

After the sharp increase caused by the pandemic, the debt ratio shows a downward trajectory, with eight consecutive quarters of reduction, which has meant the correction of approximately half of the increase caused by the pandemic (a total of 12.9 points since the peak level reached in the first quarter of 2021). However, Spain is currently one of the EMU countries with the highest levels of debt, behind Greece and Italy and with a level similar to that of Portugal and France. In
2019, Spain was already one of the eurozone countries with the highest debt ratio and the pandemic has contributed to consolidating this situation.


FIGURE 5 Debt (% GDP): Quarterly evolution till 2Q23

For the aggregate of the Spanish public administrations, under the macro-fiscal forecasts prepared by AIReF, a decrease in the debt-to-GDP ratio of 3.1 points is projected over the level recorded in 2022, which would place the ratio between 108% and 109% at the end of 2023. The update of the macro-fiscal forecasts prepared by AIReF project a decrease in the debt-to-GDP ratio of 5.3 points in the next two years, placing it at 106.3% in 2024, a reduction that will be supported mainly by the growth of nominal GDP, where the deflator will have a very notable contribution.

Therefore, in the medium term, the new monetary cycle together with the high level of existing debt, greater than 100% of GDP, places the sustainability of public finances in a situation of vulnerability. Furthermore, we must not forget that there is great political uncertainty, especially in relation to the formation of the central Government. This represents a risk for our country to the extent that Spain faces the fact that there will no longer be a suspension of fiscal rules and, if the new framework of rules is not in force, the previous pre-pandemic more stringentone will be in force.
Regarding this last point, it is worth remembering that the European Commission has formulated a specific recommendation for Spain, which urges our country to adjust the growth of primary spending net of revenues measures to a rate of 2.6% during the next year.

Focus on territorial administrations: Autonomous Communities

We estimate in our central scenario that the Autonomous Communities will reduce their level of debt in 2023 by more than one point of GDP, standing at 22.7% at the end of the year. Starting from 23.9% in 2022, the ratio would improve by more than one point due to the effect of the expected GDP growth, partially offset by the expected balance and by certain adjustments, such as the financing of the excess deficits of the previous year, the application of the excess financing pending at the end of 2022 or the postponement of the 2008-2009 negative settlement of the regional financing system.

At the individual level, the debt-to-GDP ratio drops in all the regions., although unevenly. Due mainly to the effect of nominal GDP growth, all regions havetheir debt/GDP ratio reduced compared to the previous year. The largest reductions in percentage points of GDP occur in the Balearic Islands, the Basque Country, Navarre and the Canary Islands. Under the aforementioned assumptions, the Canary Islands, Madrid, Navarre and the Basque Country could place their debt in 2023 below 13%.


FIGURE 6 Debt/GDP ratios of the Spanish autonomous communities (% GDP)

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Author: Cristina Nogaledo Castaño
October 2023