Europe's Favourite Destination

Dec 14, 2005

On May 19, national statistics INE published the first annual accounts based on the new 2001 Census. All of a sudden, we now find out that between 2000 and 2004, Spain grew in real terms half a percentage point more than we had previously believed. At current prices, Spain’s GDP level is now nearly 5% higher. We think migration is at the core of these developments. In response to this, the Spanish economy has not only been able to create jobs at a fast rate, but it has been also flexible enough to let migration exert substantial downward pressure on wages. This is the source of a virtuous circle made of more jobs, more demand, more profits, and so on, which is likely to continue over the next 18 months. On the back of this analysis, we now see real GDP growing 3.3% this year, up significantly from 2.5% previously. Our forecast for 2006 also edges up to 3.2% from 2.9%. In a parallel piece, my colleagues Pablo Beldarrain Santos and Davide Serra assess the investment implications for the Spanish banking sector

One in three immigrants entering the European Union picks Spain as their final destination. In our view, this striking piece of evidence is one of the main factors — if not the single most important one — currently affecting the Spanish economy and has plenty of implications for the future course of events. Around 1.7 million immigrants crossed the borders of the European Union in 2003. According to National Statistics INE, nearly 600,000 of them reached Spain. This number not only places the country at the top every 1,000 inhabitants, but also says that Spain on its own captures over 35% of the annual migratory flows into Europe. This huge wave of migration is set to shape up the age pyramid of the Spanish population, the structure of the labour market, and the overall performance of the economy. In fact, this is already happening.

Based on new registrations and registry removals, INE estimates that a total of 55,000 foreigners entered Spain between 1994 and 1996. Over the following three years, this number picked up to 190,000 before soaring to 1.6 million in 2000-03. When last month statisticians published the first annual accounts based on the new 2001 Census, which in turn incorporated the acceleration in migratory flows, they literally re-wrote Spanish economic history. All of a sudden, we now find out that between 2000 and 2004Spain grew in real terms half a percentage point more than previously believed. At current prices, Spain’s GDP level is now nearly 5% higher. To be fair, the new numbers stem from a major conceptual and statistical overhaul of the national accounts, described in detail in the technical box on the previous page. Yet, the adoption of the 2001 Census is by far the single most relevant source of discontinuity.

The first tangible sign of a significantly higher number of immigrants is in the job market. The new annual accounts rely on population projections based on the 2001 Census and employment estimates built on the new Labour Survey (EPA-2005), appropriately integrated with other statistical sources. The increment relative to the previous system of accounts is striking. On a full-time equivalent basis, the total number of employed individuals reached 17.419 million in 2004, 989,000 higher than previously measured. Among employees, the jump is even greater, with the new data revealing 1.026 million new positions as of 2004. It is worth pointing out that this is not the outcome of a discrete step, but a full parallel shift of the job creation curve. Between 2001 and 2004, the employment growth rate moved from 1.9% to 2.7%.

A solid labour market is a key ingredient of strong economic growth. The accounting changes described above lifted nominal GDP growth by half a percentage point over the past four years. The same kind of progress applies to real GDP growth, leaving the Spanish economy on track for a solid 3% economic expansion over the same period. As net exports subtracted on average nearly one percentage point from GDP, domestic demand advanced at a sustained 4% pace. This trend is in stark contrast to the meagre 1.3% GDP growth rate (1.1% for domestic demand) exhibited by the Euro area over those years. The sizeable increase in growth implies that migration is weighing only modestly on labour productivity. This is a positive surprise, as one might have expected the addition of so many jobs in a short period to come at the expense of productivity, at least in the near term.

The Spanish economy is not just a job fair though. There is a second equally important dimension emerging from the adoption of the new census. Spain has managed to absorb such a high number of immigrants owing to noticeable wage moderation. Once the migratory wave is accounted for, unit labour cost drops by as much as seven-tenths of a percentage point, and this happens despite slightly lower productivity gains. This is at odds with the conventional wisdom on Spain, according to which a rigid wage-setting process contributes to high and persistent inflation differentials vis-à-vis the Euro area. While indexation clauses still apply to almost half of the workers, the labour market appears to have been flexible enough to let migration exert substantial downward pressure on wages. The relatively high degree of decentralisation of the Spanish wage bargaining system probably played an important role here.

Wage moderation is crucial to the future course of events, we believe. The combination of strong job creation and moderate wage gains warrants sustained income generation in the midst of this big migratory wave. Nominal disposable income has hovered around 6% over the past four years, enough to support a 3% path for real private spending. Furthermore, falling unit labour cost is as important as historically low interest rates in boosting corporate profits. This is particularly the case for an economy where the labour-intensive services sector gains overwhelming ground at the expense of the uncompetitive traditional industry. Our rough measure of profitability, obtained by subtracting unit labour cost from GDP deflator, suggests that migration might have doubled profit gains in labour-intensive productions. This is the source of a virtuous circle made of more job creation, more demand, more profits, and so on.

We find the sector analysis of these developments particularly revealing. Spain is currently accelerating its transition away from an uncompetitive manufacturing base towards a powerful demand-geared services economy. The new set of national accounts highlights the active role played by immigrants in this process. New jobs are plentiful in construction, some areas of retail, tourism infrastructure and business services. In most of these sectors, unit labour cost is slowing down compared with the pace observed in the second half of the nineties. In construction and retail, where wage moderation is less of a factor, companies enjoy sustained pricing power.

The adoption of the 2001 Census in the new set of national accounts has triggered this analysis, which deliberately focuses on one specific angle in assessing the performance of the Spanish economy. These accounting changes have offered us the pretty unique opportunity of running a sort of counterfactual experiment, comparing the reality of a country benefiting from huge migratory flows with the abstraction of the same country in the absence (almost) of immigrants, as represented in the old data. Migration emerges clearly as a key ingredient of Spain’s success story.

Will the economy keep absorbing these kinds of flows? The presence of sustained income and rising profits indicate that this is likely to be the case. Wage flexibility holds the key to future developments. The evolution towards further decentralisation in the wage-bargaining process may prolong the current job euphoria. In contrast, excessive upward adjustments in the minimum wage level may seriously hinder the current virtuous circle.

By Morgan Stanley’s Equity Research Team

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