Sudden Siesta In Spain

It has outgrown the low-wage model that long attracted foreign investors

Is the spanish miracle at an end? After 11 years of buoyant growth, Spain's standard of living has soared, unemployment has plunged, and the country's biggest companies, from BBVA to Telefónica, are playing an increasingly active role on the international stage. But cracks in the economy are showing. Although growth is expected to be around 3% this year, foreign direct investment is diving, the current account deficit is ballooning, inflation is on the rise, and productivity growth lags behind the rest of the core 15 members of the European Union. And from 2007 on, the billions of dollars in net aid Spain receives every year from the EU -- equivalent to 1% of annual gross domestic product -- will begin to dry up. That money will go instead to the new, poorer EU members from Eastern Europe. By 2013, Spain is expected to be a net contributor to EU aid funds. The country will then have to find other ways to finance investments in schools and infrastructure -- such as issuing debt or raising taxes -- or reduce spending.

Long one of Europe's best-performing economies, Spain has outgrown the low-wage model that enabled it to lure big multinational investments and close the income gap with its wealthier neighbors to the north. But it hasn't yet succeeded at joining the ranks of the world's high-tech producers, which other European success stories such as Ireland and Finland have managed to do. Today, "Spain is a developed country, but it isn't an advanced one," says José Antonio Herce, an economist at the Madrid-based Foundation for Applied Economic Studies.

In the past four years, companies such as Royal Philips Electronics (PHG ), Levi Strauss, Lear (LEA ), and Samsung Group have transferred their Spanish manufacturing to Eastern Europe or Asia. Native Spanish industry is feeling the pinch as well. Hundreds of manufacturers in low-value industries such as textiles have set up production facilities in Morocco. Locals also are starting up production in Asia, including the Basque industrial cooperative Mondragón and Valencia toymaker Famosa. According to the Bank of Spain, average wage costs increased from $12.35 per hour in 1998 to $17 in late 2004.

The Socialist government of Prime Minister José Luís Rodríguez Zapatero faces the urgent task of reinventing Spain's economic model. In February, Economy & Finance Minister Pedro Solbes unveiled a package of more than a hundred measures aimed at attracting foreign capital, boosting productivity, encouraging investment in research and development, and increasing competition in protected sectors of the economy. But economists are skeptical and say the plan is too vague. If Spain fails to pull off an urgent economic overhaul, it risks joining the ranks of Europe's stagnant economies, including Germany, Italy, and France. The Spanish economy is still growing quickly by European standards, "but its engines of growth haven't kept up with the times," Solbes said at a conference on May 9.

INFLATION PRESSURES

Although public spending is well under control, the government's failure to eliminate rigidities in the labor market and introduce competition into protected sectors such as electricity, mobile phone service, and retail distribution has stoked inflationary pressures. The collective bargaining system, for example, pegs wage hikes to inflation. Rising labor costs have squeezed foreign multinationals, forcing them out of the market for low-tech goods with little value added. "We invested to upgrade our factory, we cut costs, and we introduced flexible work schedules. But it wasn't enough," says Maite Tarazona, an official at Philips Ibérica in Madrid, which closed its lightbulb factory last year and moved production to Poland. Not surprisingly, direct foreign investment plummeted, to $6 billion last year, from $26 billion in 2003 and $36 billion in 2002.

Other warning signs are appearing in the inflation numbers. With year-over-year inflation of 3.5% in April, almost 1.5 percentage points above the EU average, Spain could do with a tough-love regimen of higher interest rates. Instead, the country enjoys among the lowest real interest rates in Europe, thanks to the European Central Bank, which has kept its key interest rate at 2% for all members of the European monetary zone, including Spain. The ECB is focused on reviving France and Germany, not containing Spanish inflation.

Now, with money so cheap, consumer demand has soared, raising some fear that the economy may be overheating. Housing prices have doubled since 1997, and the 700,000 housing starts registered in Spain last year were more than Germany and France together. Spanish exports have grown, but imports have grown even faster as Spanish consumers suck in cheaper goods from around the world. "Spain right now is subsidizing consumption through low interest rates," says Spanish economist Fernando Fernandez. The current account deficit is around 5% of gross domestic product, a clear sign that Spain is losing competitiveness.

OLD MODEL

Even more dangerous for the long term, the economy is not creating a high-tech sector to sustain future expansion. Since 2000, unemployment has dropped from 14% to 10.8%. But almost 40% of the new jobs are in low-skilled sectors such as construction and domestic services, according to the labor union CCOO. Over 30% of Spanish workers have temporary contracts, the highest proportion in the EU. Construction alone accounts for 9.5% of GDP. "Our growth model served a purpose in the past, but now it's obsolete," says Almudena Briones, an economist at Uníon General de Trabajadores, Spain's largest union. "We're losing industry." The UGT is pressing the government to introduce an active industrial policy at home, and pressure Asian governments to improve working conditions and wages.

To forge a more globally competitive economy, Spain needs to push harder for flexible labor markets, greater competition in services, and higher spending on education and R&D. These are the kind of reforms that Germany, France, and Italy have been struggling to enact, with only marginal success. In the 2003 Program for International Student Assessment, or PISA, Spain performed below the Organization for Economic Cooperation & Development average in mathematics, reading, and science, indicating the need for more investment in education. But closing the technology gap with the rest of Europe will take more than money. Economy Minister Solbes says boosting productivity is a government priority. "If we can't create competitive advantages in high-tech sectors and if we don't focus on quality, market forces will punish us," he said at the May 9 conference.

It's not too late. Spain still offers some cost advantages, especially in white-collar work and high-end manufacturing. Earlier this year, GE Advanced Materials, a unit of General Electric Co. (GE ), inaugurated a $750 million factory in Murcia, a depressed region of southern Spain, bringing GE'S total investment in its Spanish production facilities to $2.2 billion. Simultaneously, the U.S. multinational announced plans to construct a fourth plant for the production of high-performance polymers for export to international markets. "GE couldn't be happier with its investments" in Murcia, says Mario Armero, chairman of GE's Spanish unit. If the country can speed reforms that would encourage similar investments, it will prove to other poor EU members that they don't have to be low-wage havens to prosper.

By Carlta Vitzthum in Madrid

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