The Economist Intelligence Unit has cut its forecast for Spanish GDP growth to just 1% in both 2008 and in 2009 (previously 1.9% in both years), compared with an annual average rate of expansion of 3.8% in 1998-2007. The Economist magazine poll of major forecasters from April 19th still showed average forecasts of 2.4% for 2008 and 2.1% for 2009. Despite being well below consensus, The Economist still sees the risks primarily on the downside, particularly for 2009. The main reason for the pessimism stems from their view that construction and housing booms rarely peter out smoothly.

The following is an extract from The Economist’s report:

Spain has clearly gone through such a boom over the past ten years. One of the clearest indicators of this has been the rising share of residential investment to GDP, which increased to 9.3% in 2006 and 2007, compared with an average for Spain since the early 1970s of 5.5% and a current average of around 6.5% for industrialised economies. Rising employment in the construction sector has accounted for a substantial share of overall employment growth in recent years, while house prices are estimated to have increased by 190% between 1997 and 2007—only Ireland and the UK have experienced a similar hike in prices among major industrialised countries. At the same time, household liabilities surged from 47% of disposable income at the end of 1997 to 135% at the end of 2007. Although this was backed in part by easier access to borrowing resulting from lower interest rates (a consequence of euro area accession), it has also reflected increased leverage among consumers. That said, further rises are now unlikely given the tightening in credit conditions in response to continued financial market uncertainty.

A return to a more normal level of housing investment would take off some 3 percentage points of GDP, and in order to absorb earlier excess construction, a temporary fall to below the normal level would probably be necessary. The experience of Sweden, where housing investment declined by 71% between the peak in 1990 and the first (not final) trough in 1995, suggests that such adjustments can be dramatic. Apart from the direct effect of weaker construction investment, private consumption would also be affected by a decline in consumer confidence and negative wealth effects. Most estimates suggest that these wealth effects would be weaker than in the UK or the US, not least because conditions for home equity withdrawal in Spain are more stringent. However, the high level of household indebtedness and the extraordinarily high current-account deficit (a measure of savings of the economy as a whole)—which widened to an estimated 9.1% of GDP in 2007—suggests substantial potential for an increase in household savings, which automatically would depress private consumption.

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