The global economy faces a supply shock as a result of the impact of the conflict in Ukraine on energy and other key commodity markets. This shock has the dual consequence of exacerbating inflationary pressures already becoming entrenched as a result of the pandemic, as well as delaying the economic recovery. Growing risks for stagflation are more aggravated in Europe, due to its proximity to the hostilities and its dependence on Russian gas. The scenario is also accelerating the outlook for monetary policy normalization. Such a scenario is particularly worrisome for Spain, which is still lagging in the post-pandemic recovery and carries a high public debt burden.

Within this uncertain context, the March issue of Spanish and International Economic & Financial Outlook (SEFO) begins with an analysis of the impact of the conflict in Ukraine on the Spanish economy. The conflict in Ukraine is exacerbating pre-existing tensions in European energy markets, hugely dependent on Russia for supplies, with oil and gas prices already up 12% and 15%, respectively, since the start of hostilities. Those pre-existing tensions are precisely what drove the sharp uptick in inflation in Spain since mid-2021, with inflation becoming widespread from last summer on, affecting a growing number of goods and services. Since the eruption of the conflict in Eastern Europe, initial expectations that commodity prices would start to ease by spring have been set aside, painting a worrying picture for inflation, already at its highest levels in decades, with a severe impact on consumer purchasing power and, by extension, economic growth. Spain’s economic recovery is therefore more complicated – promising more inflation and less growth. A supportive monetary policy and smart fiscal policy are crucial to containing the risks. The permanent nature of the energy shock, along with the geopolitical context, also underlines the need for a higher profile role for the EU in coming years, notably as regards European-wide fiscal, technology and energy policy. Spain would be wise to understand these dynamics and, framed by its clear European commitment, bring its contribution to the table.

Also on the macro level, we provide a comprehensive assessment of Spain´s recent labour reform. The long-standing structural problems in Spain´s labour markets have translated into significant inequality and loss of economic efficiency. In efforts to address these issues, the labour reform approved at the end of 2021 represents a broad social agreement that dissipates some uncertainties, at least in the short-term, regarding the framework governing labour relations since the reform of 2012. Indeed, in addition to introducing improvements, such as narrowing the set of available contracts for employers and workers and increasing the focus on training, the reform maintains several of the achievements secured over the last decade, such as those related to dismissals, firm-level flexibility mechanisms (i.e., furlough schemes), and contracting/subcontracting arrangements. However, due to the limitations shaped by sharply-clashing starting positions across the various negotiating parties, the reform is not sufficiently ambitious to tackle the structural problems affecting the Spanish labour market. In calibrating the ‘flexicurity’ trade-off, the reform leans towards security, introducing elements of rigidity and ultimately restricting temporary hiring rather than stimulating open-ended hiring, potentially weighing on employment growth. A few months into the reform, preliminary evidence points to some favourable improvement in labour market trends. However, it is too soon to draw any definitive conclusions. The coming years will be key to determining how the private and public sectors implement the reform and how the legal system interprets these changes.

We then track the recent evolution of another important segment for the Spanish economy, the housing, and in particular, mortgage market. Spain’s mortgage market is recovering gradually in the wake of the pandemic, with new transactions outstripping loan repayments. Mortgage lending activity began to register year-on-year growth in April 2021, which has stabilised at around 0.7% in recent months. Average mortgage interest rates are climbing slowly, nudged along by global market trends, and rates could move higher again if the ECB is forced to withdraw its quantitative easing rapidly to curb inflation. Mortgage renegotiations are also on the rise, and we are seeing a rapid switch from floating to fixed-rate mortgages. While it is hard to quantify the potential relationship between monetary policy trends and the Spanish mortgage market, interbank rates –the key benchmark for many floating-rate mortgages– are rising strongly in the eurozone, albeit still in negative territory, which could provide upside support to bank profitability. The mortgage market recovery is, however, very recent, and has not yet consolidated. Lingering and new sources of uncertainty (pandemic, inflation, conflict in Ukraine) are affecting savings and borrowing patterns in ways that are hard to gauge. 2022 could well be a year of stable, yet moderate, growth. It will be worthwhile to monitor potential changes in key variables for this market, including interest rates and inflation.

The next section of this SEFO explores issues related to the capital markets. First, we look broadly at the performance and outlook for eurozone peripheral debt, mainly that of Spain and Italy, within the evolving monetary policy context. Next, we examine recent trends in the behaviour of foreign capital inflows to Spain, offering some considerations regarding the possible impact on investor confidence of an accelerated normalization of monetary policy.

The potential withdrawal of monetary stimulus measures marks a very significant milestone for the price of public debt issued by peripheral eurozone member states. The ECB has been the biggest investor in peripheral sovereign bonds in recent years, acting as a price-taker with the unwavering objective of preventing episodes of financial fragmentation that hinder the correct transmission of monetary policy and increase the risk of financial instability. The heightened probability of accelerated withdrawal of the ECB´s monetary stimulus will likely be accompanied by the rebalancing of the relative prices of EMU peripheral sovereign debt. Indeed, the main consequence of the anticipated ECB policy shift –albeit subject to significant uncertainty related to the degree of economic fallout from the escalation of geopolitical tensions– is that the market needs to define a new equilibrium price for Spanish and Italian debt relative to that of Germany. Nonetheless, the improvement in those economies’ structural health, the ECB’s commitment to preventing fresh episodes of financial fragmentation and the outlook for strong progress towards European integration should help to reduce the risk of episodes of intense stress in the eurozone sovereign debt markets.

An analysis of IMF and Bank of Spain data ranging from the onset of the financial crisis of 2007-2008 through the present reveals that seven countries (France, Germany, Luxembourg, the US, the Netherlands, Italy and the UK) account for over two-thirds of total foreign investment (portfolio and direct) into Spain. Consequently, Spain’s high level of foreign debt leaves the country vulnerable to potential interest rate increases, as a higher percentage of Spanish income would get transferred abroad as debt service. To shore up international investor confidence, Spain needs to make its public debt more sustainable, as public borrowings have increased significantly in recent years, rising from 95.5% of GDP in 2019 to 121.8% of GDP as of September 2021, in contrast to the deleveraging observed in the private sector. The challenge of improving public debt sustainability is currently more pressing given the growing prospects of an increase in the risk premium if the ECB accelerates the withdrawal of its debt repurchases to tackle rising inflation.

Moving past current debt dynamics, on a related note, we look at the importance going forward of upcoming changes of EU fiscal rules from a Spanish perspective. There are currently two key fiscal processes playing out simultaneously across EU countries: i) a recovery in national finances following the tremendous shock caused by the pandemic; and, ii) the reform of the EU´s Stability and Growth Pact (SGP). The interplay of these processes is particularly key in Spain –a country that has been among the hardest hit by this crisis, with GDP contracting (-10.8%) in 2020, and expected to be among the last of the EU-27 to revisit pre-pandemic GDP levels. While Spain´s recent fiscal performance has been better than expected, this will likely prove temporary, and in the absence of structural changes aimed to address the country´s high level of structural deficit, Spain´s fiscal imbalances will remain among the highest in the EU-27 in 2024. Indeed, without a reduction in the structural deficit, the total deficit would stagnate at over 4% and public debt would continue to trend higher, reaching 135% by 2050. Going forward, the EU is set to resume the task of reforming its existing fiscal rule framework, with an eye to correcting the issues of the past and taking into consideration the impact of the pandemic on many member states´ performance on current targets. As different European and national actors debate their positions, Spain´s seat at the negotiating table would be strengthened if the country were to, in parallel, present a credible path towards fiscal consolidation.