III. ECONOMIC TRENDS AND OUTLOOK Upside of Economic Cycle The Spanish economy appears to be engaged in a slow export-led recovery from recession. After a one-percent decline in 1993, GDP should increase by roughly one percent this year, possibly followed by slightly faster recovery in 1995. The current recovery depends largely on net export growth and tourism receipts, which compensate for stagnant domestic consumption and continued weak investment. Export growth has been strong in late 1993 and the first quarter of 1994; it responds to the incipient recovery in Spain's largest trading partners and to increased competitiveness of Spanish products due to the 1992/93 devaluations of the peseta. Anecdotal evidence suggests that recovery of industrial exports, including cars, is beginning to contribute to increased demand within Spain for industrial intermediate goods (inputs). 1994 is likely to be a year of improved economic balance sheets. Although few wage settlements have been reached so far in 1994, the trend appears to be for wage increases close to or slightly below expected inflation. Apparent productivity is up, due mainly to the reduction in employee rolls. Furthermore, the rapid reduction in interest rates is a boon to the non-financial business sector, which is a large net borrower. Job insecurity has led families to increase savings rather than consumption. Furthermore, the decrease in interest rates has a negative impact on household wealth, further depressing consumption (significantly outweighing the boost to consumer borrowing normally provided by lower interest rates). Adjustment to Europe While a slow ride along the up-slope of the economic cycle appears likely during 1994 and 1995, the longer-term prospects are clouded by challenges that have yet to be met. First, is the incomplete process of Spanish adjustment to full membership in the European Union's economy. While Spain's industrial sector survived substantial adjustment to entrance into the EU in the late 1980's, other sectors of the economy -- including the labor market and the services sector -- were less exposed to the new competition and thus slower to adjust. A reasonable guidepost for Spanish adjustment to the EU can be found in the "convergence criteria" established by the Maastricht Treaty to qualify for Europe's planned single currency. These criteria set a challenging European "norm" for inflation, government debt and deficits, and market interest rates. Spain is unlikely to meet these criteria without adopting significant reforms needed to achieve more competition in services, wage moderation, and a sharp reduction in the government deficit. A start in this direction has been made, with the labor reforms approved in May, and some restraint in government spending so far in 1994. When the needed reforms are completed, Spain would recover its earlier status as a very attractive location for investment in Europe. Challenges to the Welfare State At the same time, however, Spain along with most of the industrialized West faces the challenges presented by a new global economy. Technological change, worldwide liberalization of trade in goods and of financial flows, and the incorporation of hundreds of millions of (low-wage) workers and consumers from formerly communist economies into the global economy, present new demands for Spain and the rest of the West. Meeting this challenge, and taking advantage of its opportunities, place an increased burden on Spanish policy makers, Spanish businessmen and workers, and the EU policy makers who now determine so much of the economic context in which Spain competes. In many cases this reinforces the argument for improving Spanish competitiveness through reform of the labor and services markets. In addition, Spain may need to increase the flexibility of its business and labor structures to adjust to change, through improved education and training, R&D, and the relaxation of the strict rules limiting geographic and functional mobility of workers. Along with the rest of the EU, Spain must reconsider if it can afford the burden of its "social safety net" in its current form. Principal Growth Sectors Expectations that construction would pick up significantly, due mainly to government infrastructure projects, have not proven true; during the first half of 1994 this sector remained depressed. The sectors experiencing the strongest growth during this period center around manufacturing industries, especially those oriented toward exports or production of inputs for exporting industries. Automobiles, chemicals and similar basic industries appear to be recovering from the 1992/93 recession. In the services sector, there is a possibility that a new cable- TV law will be approved in the second half of 1994, opening the way for major investments in this sector. Continued development of the telecommunications sector also is a strong possibility, as a second mobile telephone license is supposed to be awarded soon. The sector with the strongest immediate prospects is tourism. Hotels reportedly are substantially over-booked for the peak summer season, and high occupancy rates are anticipated for most of the year. Services related to tourism, including transportation, rentals, etc., should also do well. Spain's tourism sector is boosted this year by the 1992/93 devaluations of the peseta, and by the political/military situation in traditional competitors for European tourists' D-marks, such as Yugoslavia. Agricultural Economic Trends and Outlook Agriculture's contribution to Spain's overall economy is substantially less important now than it was in the years prior to Spain's accession to the EU in 1986. Nonetheless, agriculture still employs about 9 percent of the country's total active population and comprises about 4.6 percent of the country's total GDP. Spain is now subject to EU agricultural policies, which have not always favored the most competitive Spanish crops. In 1992 the EU reformed its farm policies for grains, milk, beef, oilseeds, and sheep, and these reforms could have a major impact on Spanish agricultural production. Most importantly for Spain, the EU is in the midst of reforming programs that will affect many Mediterranean crops such as olive oil, rice, almonds and others. Spanish lamb, beef, grain, dairy, pulse and other sectors have had difficulties competing with increased competition from other EU countries, while for competitive sectors such as horticultural crops production or exports have not significantly increased. Livestock and poultry are the most important sectors in terms of value of agricultural production in Spain, accounting for about 40 percent of total farm output. Horticultural crops (citrus, deciduous fruit, olives and olive oil, nuts, wine and vegetables) is the second most important sector in value (35 percent) of output, but account for over 70 percent of Spain's agricultural exports. Field crops (grain, tobacco, cotton, forage, sugar beets and oilseeds) cover a larger proportion of total planted area, but comprise only 25 percent of the value of total production. The most significant problems currently facing Spanish farmers are the lack of stable support prices for key commodities, growing competition from agricultural imports from other EU countries, high interest rates and high production costs. Despite producer prices in ECUs for many key products that remained static or even dropped in 1993, prices in pesetas rose by about 15 percent due to a series of devaluations of the Spanish peseta that took place in late 1992 and in May 1993. The outlook for 1994 suggests continued difficult conditions for certain farm sectors in Spain. A major challenge for Spanish agriculture is adapting to the reality that other EU members may have a comparative advantage in producing certain agricultural commodities, especially grains, lamb, beef, poultry and beet- sugar. In addition, a drought which occurred during the fall and the winter of 1993/94 resulted in a dramatic decline in corn, cotton, rice and other irrigated crop production in southern Spanish production areas, leading to substantial losses in income for certain producers which may not be adequately compensated by present crop insurance programs. Government Role in the Economy Spain's social-democratic government exercises influence in the economy more through regulation than through direct ownership. In fact, during 1993 the government began partial privatization of several major firms, a process that is expected to continue. Most of the government-owned banks were gathered into one corporation, Argentaria, in 1991. In 1993, the government sold 49 percent of the capital of Argentaria. An additional tranche of Argentaria shares is expected to be sold in 1994, leaving the government with a minority, albeit controlling interest. Similar partial privatization, through public offering of shares, have occurred in major firms including Repsol (oil), Endesa (electricity), Telefonica (telephones) and Iberia (airline). Balance of Payments Situation Spain's current account balance improved dramatically during 1993, declining from a deficit of US$19 billion in 1992 (about 3.3 percent of GDP) to US$5 billion in 1993 (about 1 percent of GDP). That deficit was easily covered by foreign investment -- although a significant share of foreign investment was attracted by short-term gains in the stock and bonds markets. In early 1994, preliminary reports suggest that continued growth in exports may have contributed to a slight positive current account balance during several months. During the remainder of 1994, exports should maintain their pace of expansion as markets recover in Spain's major trading partners, Germany and France. Receipts from tourism also should further boost the current account. If domestic demand also recovers, however, demand for imports is likely to pick up as well, preventing Spain from achieving a significant current account surplus. Trade and Investment Barriers Spanish rules on trade and, increasingly, investment are established more in Brussels by the European Union than in Madrid. Outside of agriculture and few other protected sectors, EU trade and investment policies are generally quite open. Spain in particular is interested in attracting investment, both for the job creation and for the impact of foreign investment on the modernization of domestic management and technological levels. A rough rule-of-thumb suggests that 25-30 percent of Spanish industry is foreign-owned. Labor The Active Population Survey (EPA) indicated over 15 million Spaniards in the work force at the end of 1993. National Employment Institute (INEM) unemployment figures for the end of May 1994 (the most recent available at this writing) reveal an improving employment situation, with 58,000 fewer unemployed workers than during the previous month. This equals an unemployment rate of 17.2 percent. Spain's two unemployment indexes (EPA and INEM) vary by as much as five percentage points and neither is generally accepted as precisely accurate. Also, actual unemployment is estimated to be considerably lower than the government's figures indicate, due to the existence of an extensive underground economy. However, what is clear is that Spain's real unemployment continues to be among the worst in Europe. Employers have long criticized Spanish labor law (much of which originated in the Franco era) as unusually inflexible and mandating very high severance payments, thus discouraging new hiring. Labor market reform legislation introduced in 1993 and passed in 1994 over the objection of the unions, liberalizes old work rules and makes the transfer of workers from one task to another easier. The legislation went into effect on June 12, 1994 and the Government hopes it will boost hiring and reduce dismissals. Every four years Spanish workers elect delegates to represent them to negotiate with management. If a certain proportion of those delegates are union-affiliated, those unions form part of the workers' committees. Dues-paying union membership is among the lowest in the EU (generally estimated at about 10 percent of the work force), but unions are involved in negotiating collective agreements for over half of the work force. Large employers generally have individual collective agreements, but in industries characterized by smaller companies, collective agreements are often industry-wide or regional. The right to strike is guaranteed in the constitution and has been interpreted to include general strikes called to protest government policy. There have been several such strikes in recent years, the most recent being a one-day nation-wide strike held collectively by Spanish trade unions on January 27, 1994 to protest the government's proposed labor market reform legislation. Third Country Competitors Most of Spain's trade is carried out with European Union members. Imported goods manufactured in the European Union make up 59.9 percent of total imports. Leading suppliers are Germany (16.2 percent of total imports), France (15.2 percent of total imports), Italy (10 percent of total imports) and the United Kingdom (7.5 percent of total imports). Imports from the U.S. make up roughly 8 percent of total. The Unites States maintains competitive lead in high tech and audiovisual sectors. American manufacturers provide most of computer hardware equipment sold in Spain (including super- computers, mainframes, work-stations, PCs, laptops, peripherals, etc.). U.S. also supplies a large percentage of the software sold in Spain. New technology in telecommunications equipment is primarily American. This market will grow even further as telecommunications sector is gradually liberalized. Despite Government barriers, U.S. films have an 80 percent market share in box office and TV. Infrastructure situation Infrastructure development in Spain is about 80 percent of the level of the average of the United States. The Government is undertaking important investments in upgrading the road network, airport infrastructure, seaport facilities, and telecommunications. These investments will span over the next decade or so and will be partially funded by EU development funds. Major Infrastructure projects underway The government of Spain approved the general infrastructure plan (Plan Director de Infraestructuras - PDI) in April 1994. This plan contemplates investment of 20 trillion pesetas (US$143 billion at current exchange rates) in roads, railroads, seaports, airports, hydraulic works, coastal refurbishment, environment and water quality. The period established for this plan is 1995 to 2010. Around 77 percent of total investment will go to enhance transportation infrastructure.