Spain’s economy has grown rapidly over the past 10 years. Since joining the EU in 1986 growth has averaged more than 3% a year and gross domestic product (GDP) per head now stands at almost 92% of the eurozone average, up 50% on where it was on entry.
The economy has outperformed both the Organisation for Economic Co-operation and Development (OECD) and eurozone averages in almost every year in the past decade. Unemployment, which in 1996 was running at 20%, has tumbled despite the economy pulling in a rising number of immigrants and the stock market growing by 33% since 2001.
At the heart of this economic success have been a construction boom and a soaring housing market. Prices have more than doubled since 1997 and bank credit has grown by an average of 40% a year since the end of the 1990s. Loans on property now account for a quarter of all bank credit in Spain. Low interest rates and increasing foreign investment have helped to lift current lending to more than €900bn from €125bn 10 years ago.
Demand for property has been driven by a dramatic increase in the formation of new households in Spain, a massive wave of immigration from north Africa and eastern Europe, and by the speculative buying of holiday homes by wealthy northern Europeans. As a result, along with lower interest rates and cheaper mortgages, property developers have been building thousands of homes to meet demand.
Last year, the construction sector supplied more than 800,000 new homes. That is four times the number completed in the UK and more than the totals built in Germany, France and Italy combined. Depending on the measure used, house building accounts for 7%-10% of GDP.
That alone is “a reason for some concern”, says Javier Pérez de Azpillaga, economist at Goldman Sachs. “Spain should be looking to build 600,000 units a year, equivalent to 6% of its GDP.”
According to Lombard Street Research, as a result of this extended boom, Spain is currently “over-housed, households are over-indebted yet the construction industry continues to churn out houses”.
In the past 10 years, prices have risen by 270% and the average price of a property in Spain is now €276,000 with household debt standing at 133% of disposable income. There is still price growth in the housing market despite a slowdown. Price growth is running at an annualised rate of 7%, down from 18% in 2006.
Construction addicts
Worries over the economy and its dependence on the construction sector have been growing and were highlighted in April, when the stock market took a tumble based on growing fears that a property crash was imminent.
The fears were triggered after the shares in property company Astroc Mediterráneo, based in Valencia, fell by 65% in April after a routine audit led to allegations that profits had been artificially inflated through the sale of assets. As a result, the Ibex-35 index of Spanish shares was hit by a wave of panic selling.
Share prices of property developers, such as Fadesa, Urbis and Metrovacesa, construction firms that included Spain’s biggest, Sacyr Vallehermoso, and even some commercial banks like Banco Santander and BBVA, all fell.
However, talk of an economic collapse is wide of the mark, according to Guillaume Menuet, an economist at Merrill Lynch. “It was simply a correction. Share prices may have fallen steeply but they were returning to where they had been just six months earlier,” he says. Share prices of property developers had surged by up to 900% over the previous six months before plummeting.
Government confidence
In response to what appeared to be a sudden collapse in confidence, the economy minister, Pedro Solbes, said that the country was not in a “worrying situation”. Household earnings, growing by 4% a year, are rising steadily and are based on strong employment growth so the fears of rising debt repayments are unwarranted, he said.
Spanish economists have forecast that the house-building boom will not slow until the new-build rate more closely matches the rate of new household formation, which is currently about half a million a year.
However, the impact that a sharp correction would have was recently highlighted in a report by Standard & Poor’s. It said: “A market downturn, precipitated by high interest rates, would present serious risks for the Spanish economy as a whole.
“The construction sector represents a major share of GDP and makes a significant contribution to employment: more than 2.6 million people are currently employed in the construction sector, out of a total of 20 million in employment at the end of 2006.”
The report cited research by BBVA, a Spanish bank, which suggested that there remained severe shortages in the places of highest demand – Spain’s main cities. In 2005, the major cities accounted for only 8% of new construction.
Standard & Poor’s concluded: “We consider this red-hot and unbalanced construction sector to be a major risk to the economy as a whole.”
Ismael Clement, managing director of RREEF Real Estate for Deutsche Bank in Spain, agrees. “What we’re seeing is the typical behaviour of a market bubble and I think we will see a sharp correction, especially as interest rates are rising just when, with a weakening economy, they should be coming down,” he says.
So could the Spanish economy take a turn for the worse later this year, or are the fears of an economic crash being oversold?
Interest rates are certainly rising in response to growing inflationary pressure across the eurozone. The European Central Bank is expected to raise rates from their current 4% to 4.25% by the end of the summer.
Although mortgage demand in Spain has slowed, about 96% of mortgage debt is based on variable lending rates, which means that, should interest rates continue rising, the impact on over-stretched consumers could be significant.
Despite these obvious risks, most economists remain sanguine. “I think we’re going to see a soft landing for the Spanish economy – a re-arrangement of the economy or a rebalancing rather than a crash,” says Mr Pérez de Azpillaga.
Economic flexibility
Not only has growth been strong but the government has run a budget surplus, equivalent to 2% of GDP, for the past two years and gross debt is only about 40% of GDP. So fiscal policy could pick up the slack should the economy take a turn for the worse, and the country’s dual labour market, where one third of workers have temporary contracts, makes it one of the most flexible in Europe.
There is certainly a heated debate about whether Spain is witnessing a classic asset price bubble or whether current high prices are simply mirroring the strength of the Spanish economy. Demand for housing is being driven by a number of factors and arguments rage over whether these factors are temporary, helping to create a bubble that will ultimately deflate under its own weight, whether interest rates continue to rise or not.
Property prices in Spain have risen at an unprecedented rate and research from the International Monetary Fund suggests that where there is a sharp increase in real terms, there is likely to be an equally sharp correction. With interest rates rising, the chances of a crash have risen.
Rental returns have also been driven down by the continued strong growth in property prices. Those who argue that Spain is facing a property bubble argue that this divergence would suggest that people are buying housing speculatively. They expect prices to carry on rising faster than rents and when asset prices diverge from actual or implied cash flows, bubbles arise and ultimately burst.
Risk exposure
Of most concern is the view that people have come to see Spanish property as risk free, leaving themselves over-exposed to corrections in the market.
In contrast, those who believe that current prices are not over-inflated believe that property in Spain may be expensive by historical standards but is not necessarily overpriced. They argue that prices simply reflect current levels of supply and demand, and believe that demand is being driven by low real interest rates, deregulation, innovation, and competition in the Spanish mortgage market, meaning that companies are prepared to lend more money, for longer periods, to more people.
So is Spanish property over-priced and suffering from a surfeit of exuberance? If the current market is a bubble and bursts under the pressure of rising interest rates then higher mortgage rates, restrictive bank lending and a massive housing oversupply could send the Spanish economy spiralling into recession in 2008 – with all that entails for the rest of Europe.
