pH, más que hamor, frensi.

Deconstructing Spain
December 18, 2006

Spain's economy is booming. So, more dramatically, is its housing market, with prices up 180% in the past decade. Rising wages and low interest rates fuel the housing demands of the upwardly mobile in this Iberian tiger.

Here's a reality check: All fiestas must end, or at least wind down. In this case, the thriving housing market covers up structural shortcomings in the economy to which the center-left government has paid scant attention. For Spain's sake, and the euro zone's, let's hope that changes soon.

Spain is disproportionately important to Europe's economic fortunes. Though its own economy is about 11% of the euro zone's, in the past five years it has accounted for a whopping 32% of the growth in demand among the countries that use the single currency. In other words, Spanish consumers keep the EU going.

Much of that spending goes into housing. Prices are still rising, albeit at a slower pace. In Spain, "slower" means prices at the end of September still rose 9.8% compared to the same month last year. Alan Greenspan might call that more than just "a little froth."

Even more dramatic is the accompanying boom in construction. The government offers a wide array of incentives like tax exemptions and a lower capital gains tax, to boost home ownership. This year alone about 800,000 homes will be built, more than double the number in France, which has 17 million more inhabitants and where property prices rose a respectable 128% in the past 10 years.

Home ownership is now at 85%. Second-home buyers, domestic or foreign, won't be able to keep up demand at 800,000 homes a year. More than 80% of Spanish mortgages are structured with variable rates, meaning that the European Central Bank's gradual monetary tightening often translates straight into higher mortgage payments.

Much of the Spanish construction seems to be for investment purposes and not for residential or commercial space that's going to be filled immediately. In Sesena, for instance, authorities have approved the development of 13,500 homes for up to 40,000 people. But the small town near Madrid has a population of only 10,000.

Then there's corruption, which also raises prices. The Spanish media is awash in stories of bribes for issuing building permits. In March, the mayor and town councilors of the holiday resort of Marbella were arrested in a multi-billion-euro money-laundering scandal. Antonio Vercher, the specially appointed prosecutor for town planning and the environment, has hinted that up to 100,000 illegally built houses could be demolished.

How much longer can the building boom continue? Many of the country's biggest banks seem to think the answer is, not long -- which explains why they have been selling stakes in Spain's leading construction companies.

A property correction would have a big impact on the economy, whose two main drivers are consumer spending, which itself is driven by the wealth effect generated by rising property prices, and the construction sector. This is a self-feeding cycle that could come to an abrupt stop.

Last year, the daily Expansión cited an internal report prepared by the Spanish secretary-general for employment, Valeriano Gomez, warning that "the high concentration of economic growth and employment in the construction sector in recent years represents a major risk in the event of a possible (and expected) contraction of this sector." Since then things have only gotten worse. As the nearby chart shows, the construction sector now accounts for 10.4% of the Spanish GDP, nearly twice the euro-zone average.

Absent a nimble policy response, Spain faces a painful economic readjustment ahead. This may sound hard to believe given that for the past 10 years the economy has known only one direction: arriba. Economic growth averaged 3.6% a year during that time, almost double the euro-zone average, and unemployment has been cut to about 8% from over 20% in the 1990s.

But beneath these impressive figures is another story. GDP per capita has barely budged. Half the growth over the past five years has been due to immigration, the government recently said. Labor productivity actually fell and is expected to fall even further, remaining below the euro zone average.

Construction, a mostly sheltered sector, is not the kind of industry that yields huge productivity gains to compete in a global economy. Once it starts unwinding, the excess labor force will be difficult to absorb elsewhere in the economy.

Any prescription for a fix would look to diversify and free up the economy. Businesses have to deal with too much red tape, the energy markets await deregulation, and hiring and firing rules remain among the most restrictive in the OECD. The government of Prime Minister José Luis Rodríguez Zapatero seems far more content to ride the economic coattails of reforms introduced by its predecessors. But unless Madrid tackles these issues, Spain's boom times may soon be followed by a return to the more familiar mediocrity of the past.