OREANDA-NEWS. November 20, 2014. Spain not only returned to growth in 2014 after five years of contraction, it became the fastest growing of the major eurozone members. Its large fiscal adjustment between 2009 and 2013 helped restore market confidence, cutting the government’s borrowing costs to all-time lows, and that allowed fiscal adjustment to be slowed in 2014, reducing the drag on growth.

Spain also undertook deep labour-market reforms in 2012, including more flexible contracts and reducing the cost of lay-offs. This allowed a significant downward adjustment in wages that helped boost exports which, together with the recession shrinking imports, in 2013 gave Spain its first current-account surplus since 1997. Alongside its rapidly falling unemployment rate – now below 25 per cent – negative inflation has pushed up real wages causing a strong rebound in domestic demand.

Rationalisation of the banking sector means non-performing loans are falling and all lenders comfortably passed the stress test by the European Central Bank (ECB). This, combined with cheap ECB funding, has allowed banks to lend to the economy again. Investment is picking up and even the housing market is finally showing signs of stabilisation.

The consensus view is that Spain, after swallowing the hard pill of structural reforms, is now on a path of strong sustainable growth. However, while improved credit conditions and falling unemployment should sustain growth at around the current levels of 1.5 per cent in the near future, we think it unlikely they will be sufficient to push growth up to 3 per cent in 2017 as the government expects. Spain might have hit its speed limit.

The upside potential is likely to be limited by high structural unemployment and the large pool of long-term jobless, while a shrinking government and smaller construction sector will put a ceiling on job creation. More decentralised wage bargaining systems will also limit nominal wage growth and the return to moderately positive inflation rates will erode real wages.

Also, the likely stabilisation of the household savings ratio – or even reversal towards its long-term average – could slow domestic consumption. Credit growth will be ultimately constrained by the ongoing deleveraging, high regulatory burden and capital requirements on banks. Investment growth will also continue to be limited by ongoing consolidation in the public sector and the unlikely imminent return of a construction boom.

Export growth already weakened in 2014 on the back of weak external demand and with half of Spain’s exports going to the eurozone, export growth is likely to remain subdued in the near future. And Spain’s large negative net international investment position – close to 100 per cent of GDP – will limit its ability to borrow from abroad to sustain higher growth.

Spain’s government debt is close to 100 per cent of GDP and still rising, largely because of low inflation and a budget deficit of at least 5.5 per cent of GDP in 2014. Lower potential growth will mean the debt-to-GDP ratio will not stabilise without further fiscal consolidation measures.

While the government believes that higher growth can do almost all the remaining task of closing the budget deficit, we think further cuts to expenditure and constraints to regional deficits will be needed to stabilise the debt ratio at current levels. This might put an additional drag on growth.