The Strength Beneath Spain's Struggle

You would never know it by looking at Spain's battered financial markets, but under all the currency turmoil and political scandal lies an economy that is recovering briskly from its worst recession in 30 years.

Real gross domestic product rose at an annual rate of 3.1% in the fourth quarter, the fastest pace of the year. Growth is also becoming more self-sustaining, as its composition shifts from exports to domestic demand. Capital spending is strengthening, as rising industrial output and capacity use bolsters profits. Consumer spending is also a bit perkier but still muffled by wage restraints and subdued consumer confidence that likely reflects job insecurity. Overall, the economy grew 2% in 1994, and analysts expect about 3% in 1995.

The problem is Spain's lack of needed fiscal reform, made harder by the scandal that has weakened both the government of Prime Minister Felipe Gonzales and the peseta. Spain devalued its currency by 7% vs. the mark on Mar. 6, setting a new, lower boundary of 98.79 pesetas per mark within Europe's exchange-rate mechanism. Cutting the fiscal deficit from 5.9% of GDP in '94 to 4.4% in '95, as called for by the European Union's convergence plan, will be difficult. Welfare--which accounts for 35% of public spending--is growing by 12% per year, but the ruling Socialists may oppose cuts, leaving the peseta vulnerable to further weakness.

That leaves tighter monetary policy as the only means to defend the peseta and stave off inflation. January producer prices rose 5.8% from a year ago, the fastest rate in nine years. February consumer inflation jumped to 4.8%, after hitting a 25-year low of 4.3% in 1994, and the government estimates that the devaluation will add 0.57 percentage points to 1995 inflation.

The Bank of Spain hiked official rates by half a point on Mar. 14, to 8.5%, and more increases totaling an additional percentage point seem likely. The problem: Higher interest rates could choke off domestic demand just as exports begin to wane.

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