Its present strategy of adjustment is clear: a restrictive fiscal policy; an improvement in cost-competitiveness to rebalance foreign trade; and the acceptance of European aid to recapitalise banks in distress. The last action hinges on purchases of government bonds to push down long-term interest rates. However, this strategy is risky.
A scenario may help us better understand this strategy: a fall in real wages due to price-stickiness discourages household demand, which has a knock-on effect to make business investment decline. Hence, there is a major decline in domestic demand and activity, making it very difficult to reduce fiscal deficit. In early 2012 we saw this in action when
There could also be a reduction in the external deficit due to the decline in purchasing power. That said, imports would have to be reduced by a further 20% for
The only hope for this strategy is that improvements in cost-competitiveness could increase
Strategy Two: Exit from the euro, default and devaluation...A possible solution or suicide?
The other strategy would be for
But what would the likely consequences of this strategy be?
For a start, it requires an immediate rebalancing of foreign trade. The country could no longer borrow, which would result in a much weaker economic situation in the short term.
Our econometric estimate shows elasticity to the real exchange rate of 0.73 for
Devaluation would increase the price of imports and therefore reduce real income by about 5.9 percentage points, which would leave a net gain of approximately 2 percentage points of GDP.
When the Spanish peseta was devalued in the early 1990s (twice in 1992, once in 1993), the current account deficit disappeared in 18 months, exports accelerated strongly, while domestic inflation reacted only slightly to the rise in import prices. The decline in GDP only lasted one year, and from that point growth was strong because of falling interest rates.
In today’s instance, devaluation would also increase the competitiveness of tourism and increase the surplus for these services in local currency, though perhaps not in foreign currencies such as the euro.
As financing becomes completely domestic, it is not impossible that there could be a reduction in the sovereign risk premium.
Devaluation could subsequently attract direct investment by businesses. With 30% devaluation, for example, labour costs in
Conclusion: What strategy to choose for
If the improvement in
The other strategy (leaving the euro, devaluation and default) could be successful if the devaluation attracted new activities, but it involves a lot of uncertainties – such as the impacts on Spanish multinationals, interest rates and foreign trade.
As stated earlier, both strategies are rather bleak, but positive aspects are still evident. Considering all of the factors, we believe that the strategy of devaluation and default could be the most efficient, particularly due to the high price elasticity of exports and the fact that Spain's entire current account deficit is accounted for by the interest on its external debt. As in 1992, it could also be effective due to the domestic financing of fiscal deficits, which will prevent a rise in interest rates.